Doing your homework
Before investing in publicly traded securities, it would be wise to do some research--at least enough to understand just what you're investing in. An educated investment decision involves some knowledge of the stock and bond markets, the economy, and the companies issuing the securities. Because investors must try to forecast whether prices will rise or fall, multiple theories have been developed to assist with securities selection by explaining market and price fluctuations.
Attempts to evaluate stocks and their price movements typically take one of two approaches--the fundamental analysis approach or the technical analysis approach. Whereas fundamental analysis presumes that company-specific factors (such as its profitability) will govern prices, technical analysis asserts that market trends can be used to project future prices. Many investors combine the two approaches in evaluating a security.
Bond analysis generally depends on the creditworthiness of the issuer as well as the direction of interest rates generally. Because bond prices fall when interest rates rise, the actions of the Federal Reserve Board in managing the nation's money supply and availability of credit can be very important. Fundamental and technical analysis techniques also are sometimes employed with bonds and other markets.
Before getting into analytical approaches, it's important to define some basic terms. "The stock market" is a general term referring to the organized trading of securities through various exchanges and the over-the-counter market. The query, "How did the market do today?" is often answered by a reference to the Dow Jones Industrial Average (DJIA), which is composed of 30 stocks listed on the New York Stock Exchange (NYSE). The DJIA is the best-known (though not necessarily the most broadly applicable) indicator of how the market as a whole performed on a given day. The DJIA changes from day to day with stock price fluctuations.
A bull market refers to an overall trend of rising prices over a given period, and a bear market refers to an overall trend of declining prices.
Caution: Remember that any investment approach or methodology involves some type of risk, including the potential loss of principal, and there's no guarantee that any investment strategy or technique, however well-researched, will be successful.
If you want to invest, become familiar with some financial terminology. The more financial lingo you know, the better. At a bare minimum, you should understand the following economic and financial terms:
- Gross Domestic Product (GDP): This may be defined as the final market value of the goods and services produced in a country during a given period (such as a year). Historically, during periods of prosperity, when GDP is high, security prices as a whole have tended to rise.
- Leading economic indicators: The most widely cited overview of statistics that foreshadow economic conditions is published by The Conference Board, a nonprofit research organization, in its Leading Economic Index®; the Commerce Department also publishes data in its Survey of Current Business. Items considered include the number of new businesses started, new orders for consumer goods and materials, building permits for new homes, and the average work week for manufacturing. Declines in the above numbers suggest that the level of economic activity in the country is falling and that a recession could lie ahead.
- Earnings: Earnings (or earnings per share) refers to the number of dollars (net earnings) made on behalf of each outstanding share of common stock. Net earnings are the profits that remain after a company has paid operating expenses, interest payments on outstanding bonds, taxes, and dividends on preferred stock. Typically, investors prefer companies with higher earnings.
- Dividends: A dividend is a distribution of profits declared by a company and paid to its stockholders on a per-share basis, usually quarterly. They may be paid in cash or in additional full or fractional shares of stock. Many investors believe that dividend payments represent a company's strength.
- Stock splits: These occur when a corporation or mutual fund issues additional stock to stockholders of record at a specified ratio. The purpose of the split is to reduce the price per share, making the stock more attractive or available to more investors. The number of stock shares grows, but the total value of the company's stock does not.
- Index: A statistical composite used to represent the performance of an economic force (such as inflation), an asset class (such as stocks) or a specific financial market.
- Interest rate: This is the cost of using or borrowing money, expressed as an annual percentage. The market prices of bonds and preferred stock fluctuate inversely to changes in interest rates. Investors prefer high rates of return, and borrowers prefer low interest rates.
- Commodities: This includes bulk goods such as oil, agricultural products, and metals, many of which can affect the prices of other goods and services.
- Yield: The interest paid by a bond divided by the bond's price is called its yield. There are several types of yield, which tend to move in the direction opposite price. Current yield represents the bond's annual interest payments as a percentage of its current price. Yield to maturity represents the return on a bond that is held until it matures.
- Premium: With bonds, a premium is the amount paid for a bond over and above its face value. With stocks, it represents the amount by which a stock's price exceeds those of comparable stocks.
- Asset class: A category of investment. For example, stocks, bonds, and commodities all are examples of asset classes. How you divide your assets among various asset classes is known as your asset allocation.
Fundamental analysis is a means of forecasting price movements, often contrasted with technical analysis. Fundamental analysis is based on the premise that a company's fundamentals--financial statistics that indicate its productivity and profitability--will ultimately govern a stock's price. Forecasting the price of a particular security involves analysis of the economy and of the relevant industry, as well as consideration of the particular company, including a ratio analysis of its financial statements (explained below).
Before investing in a particular company, you should consider general economic conditions. Changes in interest rates, in the level of employment, inflation, and economic growth all can have an impact on the prices of securities. You must forecast the economy's future before you can analyze a firm's financial condition and potential for growth in that setting.
Economists often use the term "business cycle." The basic economic cycle includes expansion to a peak (usually accompanied by inflation), followed by decline to a trough (recession). Recessions involve rising unemployment and a decline in national production. Although the length of expansionary and recessionary periods may vary, the entire cycle itself repeats over time. Business cycles can affect stock prices. During periods of economic prosperity, the demand for goods and services may result in increased sales and profits, so stock prices tend to rise. Recessionary times generally have the opposite effect on the market as a whole, though individual securities may do well.
To a certain extent, monetary and fiscal policy can minimize drastic swings in the economy. Monetary policy refers to the Federal Reserve's changes in the supply of money and credit. When the Fed wants to contract the money supply, for example, it sells government securities. This decreases the price of those securities and increases overall interest rates. Fiscal policy, by comparison, involves taxation, expenditures, and debt management by the federal government in an attempt to influence price stability, employment, and economic growth. Although securities prices can be affected by both monetary and fiscal policy, economists differ as to which has more impact on the economy.
Industries typically go through a life cycle. Technological advances or changing consumer desires can cause rapid growth in an industry that often slows as the industry matures; eventually, an industry may decay as it gets outdated. Obviously, the rapid growth period of the cycle generally has the most profit potential; it's also important to know when an industry is on the decline. It would have been a mistake, for instance, to keep your money in phonograph-producing companies when word leaked out about compact-disc technology.
In addition, be aware that some industries are cyclical (they move with the direction of the economy), whereas others are more stable. Also, certain industries are subject to extensive government regulation, labor relations rules or labor needs, and financing requirements. These external factors can affect securities prices.
You must also consider individual firms; what applies to the economy or the industry might not apply to a particular firm. For example, even though most airplane manufacturing firms might be doing pretty poorly in a given year, one firm might be doing well. Engaging in ratio analysis is one way investors can analyze individual companies.
Ratio analysis: an important subset of fundamental analysis
Ratios provide a quick way to measure a company's financial condition. Ratio analysis is also used to compare a firm's performance with that of similar companies over time. Each industry has different acceptable ratio levels. These ratios are derived from information contained in a firm's income statement and balance sheet. Although an accounting background is certainly useful for understanding financial terms (e.g., "cost of goods sold") contained in the financial statements, you can get by with ratio analysis if you have a general idea of what the ratios mean, what direction they should be heading, and how to compare different companies.
A cross-sectional ratio analysis involves the comparison of different firms' financial ratios (within a particular industry) at the same point in time, and a time-series analysis allows you to view one firm's performance over a period of time.
Financial ratios are often divided into four categories: liquidity, activity (or turnover), debt, and profitability.
The liquidity of a business is measured by its ability to satisfy its short-term obligations as they become due. If a company can't pay its bills, it's in trouble.
Creditors and investors typically begin by reviewing a company's net working capital. Net working capital equals a firm's current assets minus its current liabilities. Current assets include cash, marketable securities, accounts receivable, inventory, and other miscellaneous items. Current liabilities include accounts payable, dividends payable, income taxes payable, current maturities of long-term debt, and the like. In addition to net working capital, two ratios are used to measure a firm's ability to pay bills in a timely manner: the current ratio and the quick ratio.
- Current ratio: This measures a company's ability to pay current liabilities. It equals current assets divided by current liabilities. The current ratio should be neither too low (an indication of financial weakness and potential inability to pay bills) nor too high (an indication that the company is not using its current funds optimally). A current ratio of 2:1 is often cited as acceptable. This means that there are two dollars of current assets for every dollar of current liabilities. However, acceptability really depends on the industry.
- Quick ratio: This ratio is also called the acid-test ratio. It equals current assets minus inventory, divided by current liabilities. Sometimes it can take several months for inventory to be sold and converted into cash. Therefore, this ratio provides a better measure of overall liquidity when a firm's inventory cannot easily be converted into cash. The quick ratio will always be lower than the current ratio, owing to the exclusion of inventory.
Activity ratios (or turnover)
Activity ratios can be used to assess the speed with which assets (e.g., inventory, accounts receivable) are converted into sales or cash. If two firms have identical current ratios, activity ratios can help you determine which firm is really more liquid. The higher the turnover to cash, the better position the company is in to meet its current liabilities. Several ratios are used, including the following:
- Average collection period: The average age of accounts receivable is useful in evaluating how well a firm's credit and collection policies are followed. It measures the speed with which receivables are collected. The faster a company collects its accounts receivable, the faster it accumulates cash (and the better able it is to pay current expenses). The average collection period is determined by dividing the total accounts receivable by the average sales per day.
- Receivables turnover: Like the average collection period, this ratio measures how quickly a company collects its accounts receivable. The formula is: annual sales divided by total accounts receivable. The larger the receivables turnover ratio, the faster a company turns its sales into cash.
- Fixed asset turnover: This measures productivity, or the efficiency with which a firm has been using its fixed assets to generate sales. Fixed assets consist of long-term assets such as property, plant, and equipment. This ratio is computed by dividing a firm's total annual sales by its net fixed assets, and it tells you the amount of sales generated for every dollar invested in fixed assets.
- Inventory turnover: This measures the liquidity of a firm's inventory (i.e., the speed with which inventory is sold). You must divide the cost of goods sold by the inventory. Compared with industry averages, a low inventory turnover might indicate that a company is carrying too much inventory. This is viewed as a warning sign because the company may then be vulnerable to falling prices.
Debt or leverage ratios
When analyzing a company's debt position, you consider the firm's degree of indebtedness and ability to pay its debts. The more debt a firm uses, the greater the potential for both risk and return.
- Debt ratio: This measures the proportion of total assets financed by the firm's creditors. The debt ratio equals total liabilities divided by total assets.
- Debt-equity ratio: The debt-equity ratio indicates the relationship between the long-term funds provided by creditors and those provided by the firm's owners. You must divide long-term debt by stockholders' equity (the sum of common and preferred stock, retained earnings, and other paid-in capital).
There are many ways to measure a firm's profitability. These ratios relate a company's returns (earnings) to its sales, assets, equity, or share value. Without profits, a firm has difficulty attracting outside capital and holding on to current investors.
- Operating profit margin: This measures pure profits earned on each sales dollar (i.e., profit before interest charges and taxes). The operating profit margin equals operating profits (i.e., earnings before interest and taxes) divided by total annual sales.
- Net profit margin: This is the percentage of each sales dollar remaining after all expenses, including interest and taxes, have been deducted. The net profit margin equals net profits after taxes divided by total annual sales.
- Return on total assets (ROA): The ROA is also called the firm's return on investment (ROI). It measures the overall effectiveness of management in generating profits with available assets. It is computed by dividing net profits after taxes by total assets.
- Return on equity (ROE): The ROE measures the return earned on the owners' investment in the firm (both preferred and common stockholders). It's calculated by dividing net profits after taxes by stockholders' equity (the sum of common and preferred stock, retained earnings, and other paid-in capital).
- Earnings per share (EPS): This figure represents the number of dollars earned on behalf of each outstanding share of common stock (not the earnings actually distributed to shareholders). It's considered an important indicator of corporate success and is watched closely by investors. You must divide the earnings available for common stockholders by the number of shares of common stock outstanding.
- Price/earnings (P/E) ratio: The P/E ratio represents the amount investors are willing to pay for each dollar of the firm's earnings. It indicates the degree of confidence investors have in a firm's future performance. You must divide the market price per share of common stock by the earnings per share. Like earnings per share, the price/earnings ratio is very important to potential investors.
Technical analysis attempts to forecast securities prices and market trends by analyzing past price and market trends. Because it charts price and volume patterns and is unconcerned with outside factors such as industry strength and a company's earnings, technical analysis is really the opposite of fundamental analysis. Technicians believe that, for the most part, all information necessary to forecast the movement of the market is contained in the market itself. Charts and graphs of price movements can be used, the volume of security transactions can be studied, or records of sales and purchases by particular investors can be analyzed.
There are many different approaches to the purchase or sale of securities that rely at least in part on some form of technical analysis. Some examples include:
- Dow Theory: This theory is one of the oldest methods for predicting overall stock market direction, and it is sometimes used to try to identify the top of a bull market or the bottom of a bear market. Two of the Dow Jones averages--the industrial and the transportation--are examined. Dow Theory asserts that measures of stock prices tend to move together. If the DJIA is rising, then the transportation average should also be rising. These simultaneous price movements--when they reach new highs--suggest a strong bull market. If the industrial average rises while the transportation average is falling, however, it is likely that the industrials may soon start to fall.
- Conventional theory: Conventional wisdom has it that rising inflation and interest rates may be harbingers for falling securities prices, as higher interest rates may lure investment capital that might otherwise be used to purchase stocks. Rising interest rates also can affect bond prices; as bond yields rise, bond prices fall.
- Confidence theory: This theory (also called Barron's confidence index) asserts that, during periods of optimism, investors will be more willing to bear risk. Thus, they'll move away from investments in higher-quality debt into more speculative (but higher-yielding) securities. According to this theory, when investors are confident, the difference between yields on higher-quality debt and lower-quality debt will diminish, and security prices will tend to rise.
- Odd-lot theory: This theory involves the purchase and sale of small quantities of securities by small investors. It asserts that small investors are frequently wrong, especially just prior to a change in the direction of the market. Bearish behavior by small investors is taken as a bullish sign, according to this theory.
- Contrarian opinion: This is based on the premise that investment returns are maximized by going against prevailing opinion by buying when everyone else is selling and selling when everyone else is buying. The theory argues that if everyone believes a security is headed higher, the supply of potential future buyers may soon be exhausted, and that when there is no one left to buy, the price will begin to fall because of that reduced demand. The same would be true in reverse; if everyone is bearish about a security, at some point the demand will be so low that it is likely to attract potential buyers. According to this theory, investors can benefit from acting in a way that is contrary to the bulk of prevailing opinions.
- Elliot wave theory: Based on the ebb and flow of collective mood, the hypothesis is that a bull market is caused by our need to build a better future based on material values, and a bear market is caused by our need to take a rest. Bull markets and bear markets follow a predictable pattern, which (when charted) appear as waves.
Other techniques are focused not on the overall market but on security-specific indicators that may suggest when to buy and sell that individual security. Example of such indicators include:
- Moving average: This is an average of security or stock prices computed over time. Moving averages are used as trend indicators. The most common is the 200-day moving average. When a stock price falls below its own moving average, certain technicians tend to view it as a "sell" signal. Likewise, a price movement above the average is viewed as a "buy" signal. Moving averages smooth out chart patterns.
- Volume: Volume may be defined as the total number of shares traded in a given period of time. A large deviation from normal volume may mean a change in the demand for (or supply of) the stock.
Random walk theory
The random walk theory asserts that changes in securities prices are random and unpredictable over time, thus making it impossible to accurately forecast market direction. This is not to say that security prices are randomly determined. On the contrary, they change in response to such factors as earnings, interest rates, and the overall economic climate. The random walk theory stipulates that those changes occur haphazardly.
The random walk theory is based on the idea that in an efficient market, investors are highly informed and have access to all sorts of information about a company and its securities. As a result, securities prices reflect all or most of the information obtainable about companies and their securities, and change quickly in response to any new information. If an investor thinks that a company's security is priced too high, he or she will either sell it or choose not to buy it. However, if an investor feels that a security is underpriced, he or she will most likely purchase or continue to hold it. Competing beliefs among investors results in a price that reflects what the universe of informed investors think a security is worth, and price movements resemble a "random walk" rather than a predictable pattern over time.
Evaluating various types of investments
Each type of investment product presents you with different issues. Your analysis in each case will be guided by different tools and types of information relevant to that type of product.
When analyzing cash alternatives, you are usually concerned with several major factors:
- Financial strength of the issuer
- Maturity date of the instrument (if any)
- Early withdrawal penalties (if any)
- Stability and protection of principal
These factors can help you evaluate issues such as default risk, liquidity, return, and timing, and choose the cash equivalent that best suits you and your portfolio. If, for instance, you need maximum liquidity and aren't concerned about returns, then analysis of these factors will likely lead you to the conclusion that a savings account would better suit your needs than a certificate of deposit.
Some cash alternatives pool individual securities. Bear in mind that not all cash alternatives carry the same protection for your principal.
Evaluating a bond purchase is very different from researching an individual stock. However, there are just as many factors to consider. Some of the questions you'll need to consider include:
- Should I buy individual bonds or a bond fund?
- Do I plan to hold a bond to maturity, or will I sell it before it matures?
- Will taxable or tax-free bonds provide a better return?
- Should I buy a new issue or an existing bond?
- What level of risk does a particular bond involve?
- How does a specific bond pay interest?
- What is the bond's coupon rate? Its yield to maturity?
- Does the bond include a call feature?
- Can it be converted to shares of common stock?
- Is the bond selling at a discount or premium to its par value?
These factors can help you determine the potential risks and returns associated with any particular bond as well as analyze timing and liquidity issues associated with bond investing generally.
Evaluating stocks to determine which ones you want to invest in can be a daunting task. Most good investors understand why they're investing in a particular stock and how it fits into their overall portfolio strategy. Understanding how to evaluate stocks based on data rather than stock tips, intuition, and guesswork can help you know when your reasons for investing in a particular stock are no longer valid. Some of the concepts that can be useful in helping you screen stocks and analyze their potential risks and rewards include:
- Investing in stocks that you believe have the greatest potential for growth
- Investing in value stocks that you believe are relative bargains
- Fundamental analysis (as discussed above)
- Technical analysis (as discussed above)
There are several ways to invest in real estate. Buying and selling land is only one option. You also have the choice of investing in entities that profit from real estate activities. How you plan to invest will affect the information you need in order to choose an individual real estate investment. For instance, if you are investing in residential real estate, you will probably want to go out and view the property. If, however, you are investing in a real estate investment trust (REIT), then you may be more concerned with the experience and reputation of the people running the trust.
Mutual funds can be made up of almost any combination of other investment types. Before investing in a mutual fund, it's important to analyze and carefully consider a wide range of factors, including the fund's investment objective, risks, fees, and expense. These can be found in the prospectus available from the fund. Before investing, obtain a copy and read it carefully.
Determining how a fund achieved its returns can be just as important as analyzing the returns themselves. Evaluating a fund properly not only helps you compare it with other funds, but lets you see whether a fund matches your investing needs and how it would complement your other investments. In addition to the factors mentioned above, some of the considerations you'll need to pay attention to include:
- A fund's investment objective (whether it focuses on growth, income, capital preservation, or some combination)
- The type of securities it invests in, as well as whether it focuses on a single type of investment or multiple asset classes
- Whether it is actively or passively managed
- Its past performance (though past performance is no guarantee of future results) and how that compares to similar funds or an appropriate benchmark
- The types of risks it incurs in trying to achieve its objective, and the level of volatility involved
- The fees and expense you'll pay as an investor (including its expense ratio and any sales charges) and any minimum investment requirements
- Tax considerations, such as whether it generates a lot of capital gains.
Your first consideration should be the financial stability and commercial rating of the company with whom you plan to do business. After that, issues of primary importance may vary depending upon whether a whole life product, a universal life product, or an annuity is what you're choosing for your portfolio.
Investing internationally presents additional challenges in considering the factors that apply to an equivalent domestic investment. Language barriers, accounting standards, inaccessible markets, political risk, and currency fluctuations all make the analysis of foreign investments more difficult. This is one area in which it can be especially useful to have expert assistance from a financial professional, particularly for securities that are not t