Stock Investing Course (Overview and Fundamental)

[Highest Prime]

It's been a while (about 5 months, according to the GL's "last visited" date stamp) since I've popped 'round GL way, so I figure that as long as I'm coming back, I might as well do so in a way from which others might benefit.

A quick perusal of the SAC forum will reveal that the GL harbors no shortage of poker enthusiasts. Yet there's a far more popular method by which fortunes are amassed - one with lower overall risk and the potential for immense rewards.

It's the stock market.

And it's one of the few places around where a few hours of study a month - consistently and diligently over a working lifetime - not only can but often does make its practitioners millionaires.

Standard disclaimer: I am not a stock-market professional. I don't work on Wall Street, nor do I manage a hedge fund. ⁽¹⁾ 'Playing the market' is, however, my foremost hobby (and I am pursuing, albeit slowly, a course of study in financial planning). I'd like to try to share here some of the knowledge I've gained for many reasons: so that others can build on my experience and avoid the many mistakes I've made; because I happen to agree with Borodog that teaching is often the best way to learn; and because I'm a fervent Adam Smith libertarian who believes that the capital markets are our society's single greatest invention, and hope that in spreading knowledge, I might also help spread appreciation.

I don't know whether, or to what extent, others in this forum might themselves be successful amateur investors (or, for all I know, running a mutual fund at Fidelity or something). So, of course, everyone is welcome to contribute - ask questions, answer questions, offer suggestions on content or format.

I was thinking about splitting the course into two separate threads - Fundamental Investing and Technical Investing - because though they're both means to the same end, the disciplines themselves are so different. I'll use this, the Fundamental thread, to address whatever overview topics come to mind, but the remainder of each thread will be given over to explanation of each area individually.

Thoughts? Suggestions? If there's interest, I guess I'll begin, as they say, at the beginning.

H'

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⁽¹⁾ - I may be the last 30-something male in America who doesn't run his own hedge fund or maintain his own blog. And this thread is a perfect way to scratch both those itches, come to think of it.

[Antrax]

Can you explain to me the logic behind the stock market? I mean, if a bunch of people decide they want something, that decision alone makes it good. Doesn't this mean you can get infinite profit if nobody chickens out? How does this work? Who's in charge of deciding the price of everything?
_________________
After years of disappointment with get rich quick schemes, I know I'm gonna get rich with this scheme. And quick!

[GH]

Assuming you're serious, Antrax, the exchanges are the ultimate free market. The people who decide the prices are the buyers and sellers themselves. If you hold a commmodity and wish to sell it, you can either set a price (called a "LIMIT") and wait for someone to pay it, or you can choose to sell it to the buyer whose offer is currently highest. Likewise for buyers, if you want something, you can either make an offer (again, the "LIMIT"), or you can buy at the lowest offer by a seller. Taking an existing offer in eother case is called a "MARKET" order.

It's true that the price of any particular holding will increase as demand increases, but the only way to actually realize the profit is to sell the holding. If that's what you mean by "chickening out," then you could certainly realize infinite theoretical profits, but paper profits won't pay the rent.

(This, of course, is a very simplistic overview. I'm sure H' has much greater plans.)

[Antrax]

I am serious. It's very difficult for me to grasp economic concepts, I'm not sure why.
I don't understand how "people" set the price - there are large tickers that tell everyone how much a unit of stock X costs, right? Someone operates them, and he gets his info from someone. Who is that someone? Why does he set high prices if a lot of people decide "oh wow, let's all buy stock"?
Now, if I can theoretically make an infinite amount of profit, where does this money come from? There's a finite amount of money in the world.
_________________
After years of disappointment with get rich quick schemes, I know I'm gonna get rich with this scheme. And quick!

[Highest Prime]

[GH]

The tickers actually tell the prices of recent trades (actual transactions that have already occurred).

You can get a stock quote from a lot of places. I just typed in the symbol for Ameritrade (AMTD) in Google to get this one. I'll paste it here because the information changes almost constantly, but we can reference this "snapshot in time."



Here's what we can tell from this quote: the last trade on this stock was for 19.95 per share. That's the price that would scroll past at the bottom of CNN, and it's the best estimate we have for the "current value" of the stock. If you held AMTD stock, you could estimate it's worth at 19.95 and be reasonably close. But we can also get some information from the "Bid" and "Ask" prices.

When this shot was taken, 19.95 was the "Bid" price. One or more buyer(s) would have been willing to buy 11900 shares of AMTD at 19.95 per share. That information comes from the exchange, where people send their orders. The exchange has open orders for 11900 shares of AMTD where the buyer(s) specified a 19.95 LIMIT, meaning that they are willing to pay up to 19.95 per share. If you held a share of AMTD, you could enter an order to sell it at the MARKET price and would expect to have the order executed at the "Bid" price.

When this shot was taken, 19.96 was the "Ask" price. One or more seller(s) were willing to sell 500 shares of AMTD at 19.96 per share. Like before, that means that holder of AMTD have sent order to the exchange to sell their shares at 19.96 or more. If you wanted to buy a share of AMTD, you could enter an order to buy it at the MARKET price and would expect to have your order executed at the "Ask" price.


And, of course, H' is right. There's not really infinity. I assumed you meant "extremely large." But regardless of how cheaply you buy a commodity, you can't realize a profit by holding onto it. You can only realize the profit when you sell it. It's just like a baseball card. There can be people that are willing to pay thousands of dollars for your card, but unless you sell it, you don't have the money.


(Sorry if I'm stepping on toes, H'. I'm a computer consultant, and I spend the majority of my time at my largest client who happens to be a discount brokerage. This is on of the few times I've felt like I had valuable contributions to make.)

[Antrax]

Don't worry, I have enough ignorance to go around.
What I don't understand about stock is that, unlike money:
a) It doesn't really exist outside the heads of people.
b) It doesn't have any inherent value. If I have a coke, I can drink it. If I have a baseball card, I can play with it. If I have stock, all I can do is sell it.
In essence, stock is an artificial construct, whose price seems to be arbitrarily determined. I used to think the reason "running" stock (artifically buying a lot, then selling when the price increases, and screwing everyone else) was illegal because it inflated the price of the stock to more than it was really worth. I then learned there's no meaning to what a stock is really worth, and this is what I find baffling.
About the asking price and all that: let's say there's 1000 of us GLers, and we have one GL stock each. If we arbitrarily decide "okay, we're only selling our stock for $100000", its value will begin to escalate towards that $100000, just because there will be SOME demand (at a lower price) and no supply. How does that make sense to anyone? Why do people even want to buy stock? As soon as they buy it, the price is going to drop, because everybody buys lows and sells high.
As for "infinity", I meant n+1, where n is the total converted value of all assets on earth in a unit of your choice.
_________________
After years of disappointment with get rich quick schemes, I know I'm gonna get rich with this scheme. And quick!

[Highest Prime]

I'm hopeful that the information below might help answer some of Antrax's questions. Might as well put it out there and see what happens.

Overview, Part 1: Stock and the Capital Markets

P.J. O'Rourke starts off one of his best-selling works, his economics-textbook-for-real-life Eat the Rich, with a chapter entitled "Good Capitalism." (The three chapters that follow are "Bad Capitalism", "Good Socialism", and "Bad Socialism.") Arguments could be made for many illustrative examples of each of the last three, but no reasonable person could disagree on O'Rourke's choice for the first: Wall Street.

America's capital markets are a shining testament to the genius of Adam Smith, more than two centuries after his death. Society works best, he concluded, when members of its society have absolute freedom to trade with other members - trade which takes place not out of a common compassion for humanity, but in the self-interest of each party. Markets, in other words, want to be free. And what freedom means today is tens of millions of people trading hundreds of billions of pieces of paper a year back and forth - paper issued by companies that these people have trusted to do better with their money than they could do themselves. It is no exaggeration to presume that America's rise and superpower status over the past 150 years is owed primarily to the size, strength, and liquidity of its capital markets. ¹

What is Stock?

There are literally thousands of ways to invest your retirement fund (or whatever other money you stash away after paying the bills each month), with more new types of investments invented every day. Yet for all the fancy names, glossy full-color booklets, and Super Bowl TV commercials, every single investment ever created is done with one (or both) of two goals in mind:

(1) To provide income, or
(2) To grow in value.

Income and Growth are the twin pillars of investing, the objectives toward which every single dime of investment around the world are focused. When it comes to the capital markets, the standard-bearers for these pillars are referred to as Debt and Equity, respectively. ²

Debt

For a business - any business - to grow and expand, it requires capital - in other words money, cash, moolah, dinero. For most small businesses in America, that capital comes in the form of debt (and in the most basic sense, too; a large majority of American businesses use their founders' credit cards for initial funding). Debt can take many forms: a common one is a bank or government loan, which functions just as your mortgage or car loan does - equal payments each month until the principal plus the loan's interest is paid off, regardless of how the money obtained in the loan was used.

Most debt has several common characteristics:

(1) The amount of the initial investment (the "principal") is fixed and is paid up-front.
(2) The income generated by the principal (the "interest") is usually paid in fixed installments.
(3) Your investment does not entitle you to a stake in the business.

A CD (certificate of deposit, not compact disc) is a classic example of a debt investment. If I buy a 1-year CD paying 4%, I will pay $1,000 up front; I will receive (let's say) 4 quarterly interest payments of $10 each and my $1,000 back at the end of the 1-year period; and I'll receive this $1,040 in total payments regardless of the profitability or financial health of the bank that sold me the CD. (The bank, obviously, is willing to pay me 4% on my deposit only because it expects to be able to loan my $1,000 out at a higher interest rate - say as part of a 7% mortgage.)

Equity

For some businesses, however, their owners have expansion plans that are larger or longer-term than they can afford to fund through bank loans, credit cards, or the business' current profits. These folks adopt a different plan - they sell off a stake in their business to other parties in exchange for an agreed-upon sum of money. Initially, these part-owners may be friends or business associates; over time, a company may decide to "go public," meaning that they extend the opportunity to buy shares in their company to the general population. When you hear the word "equity", this is what the speaker is likely talking about: shares of stock in publicly-traded companies.

These shares can be listed on any of literally hundreds of different stock-market exchanges around the world. In the USA alone, we have not just the big three (the NYSE, Nasdaq, and Amex) but regional exchanges as well, in places such as Philadelphia, Denver, and Chicago. For purposes of this thread, we will consider only common stocks listed on the three largest exchanges mentioned above - which still leaves us with over 8,000 companies from which to choose, from glorified lemonade stands to the largest single private enterprise in world history, Wal-Mart.

Aside: Once a company goes public on one of these exchanges, it is given what we refer to a "ticker symbol" - a unique identifier that provides a simple way to distinguish a given stock from any of the thousands of others out there. Stocks trading on the NYSE or AMEX have 1, 2, or 3-letter tickers; Nasdaq stocks have 4-letter tickers. (For instance, C is Citigroup; MMM is 3M; MSFT is Microsoft; and so on.) At any time, anyone can check the latest current prices for any of these 8,000 stocks on any of a number of free financial sites on the Web. The easiest to use, and my personal favorite, is Yahoo! Finance, at finance.yahoo.com. Yahoo! also features a symbol lookup link, in case you don't know the ticker associated with a given stock.

Just as most debt had several things in common, so does most equity. The key points:

(1) The price it will cost you for one share (representing a fixed percentage ownership in the business) can vary from day to day, even from minute to minute, based on current supply and demand.
(2) The business is not obligated to pay you any income at all on the equity, so in many cases you will have to sell it to recognize any gains;
(3) Your investment entitles you to an ownership "stake" in the business - so the potential profitability of your stake relates directly to the success of the company.

Point (3) is worth repeating: By owning stock you are, in fact, a part-owner of a public company. Granted, you may be a very small owner (your 100 shares of Yahoo!, for example, represents a 0.0000072% ownership of the company!), but nevertheless your fortunes will, over time, rise and fall with those of the business. And the more shares you hold, the greater your ownership. As in a democracy, the majority rules, and can vote for anything from approving a takeover bid to removing an entire board of directors.

Reading the quick comparisons of debt and equity above, you're likely to notice that there's a lot more certainty involved with the former than with the latter. After all, short of a total liquidation of the business, virtually nothing can prevent you from receiving your interest payments, as well as your return of principal, on a bond (the most common form of debt, which we'll talk about more later). But there's a lot more that can go wrong with a stock investment!

This is why stocks, over time and as a whole, will provide a greater return than bonds ... they contain a greater degree of risk. And rational investors will always demand the opportunity for greater returns in return for assuming greater risks. (More on this below.) So now we know what stock is, and how it comes to be.

But enough with the background information; let's get to understanding how the game works. ³

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¹ - "Capital markets", as the definition is commonly used, consist of stock, bond, and commodity markets. Apart from the contents of this post, you'll hear very little about the latter two in this discussion.
² - These aren't exact synonyms. Equities can provide income as well as growth, and debt prices can rise and fall as well as provide interest. But let's not quibble this early on.
³ - As you've probably already noticed, I'm a big fan of footnotes. This style of discourse is shamelessly plagarized from, among others, Ric Edelman - author of the fantastic financial planning books The Truth About Money and The New Rules of Money. These two books, together with William O'Neil's How to Make Money in Stocks, have taught me more about personal finance and investing than any other sources in any medium. They may do more for your financial security than any other books ever written. When you finish reading these threads, surf yourself over to half.com and buy them. You won't regret it.

(Oh, and GH: It's great to have your input - I'm hardly the sole font of knowledge when it comes to the stock market.)

H'

[GH]

A share of stock is a small percentage of ownership in a company. It absolutely does exist outside the heads of people. Looking at the screenshot, we can see a line called "Market Cap" (for "market capitalization"), which is the entire value of all "outstanding" (publicly traded) shares in the company. If we divide the Market Cap by the Last Trade price, we can figure out the number of shares outstanding.

In your example, if we all held one share of GL stock, we actually own 1/1000 of the GL. We could certainly agree that none of us would sell it for less than $100,000, but it wouldn't matter unless there was a buyer who was willing to pay that much. The only way anyone would do that is if s/he could reconcile that a 1/1000 ownership share in the GL was "worth" $100,000.

People buy stock because companies make money. When companies make money, ownership shares in them are more valuable. On the other hand, when a company loses money, ownership shares are less valuable. The stock market is basically created around people trying to predict which of those things will happen and buy/sell their ownership shares accordingly.

(Hm. It would appear that my entire post is moot. Maybe my familiar tone will be of value. )

[Antrax]

Let's say there's a 1000 of us, and we buy one GL stock each. Then Kevin decides he wants more money, and makes 1000 more shares. Didn't he just effectively screw us out of half of our money?
_________________
After years of disappointment with get rich quick schemes, I know I'm gonna get rich with this scheme. And quick!

[GH]

It's not Kevin's decision anymore. The GL Corp would need a vote of its shareholders to issue more shares of stock (unless the incorporation rules state differently). If the GL is publicly held, the only way Kevin can make arbitrary decisions is if he holds more than half the stock.

Interestingly, the Green Bay Packers (an NFL team) are publicly held. Several years ago, in a capital improvement campaign, they decided to sell more shares, approved the new issue, and priced them at $100 apiece. Just before the offering, though, all existing shares underwent a 1000-for-1 split. Essentially, the effect was to raise a lot of money by offering people an insignificant ownership share, because the "old" stockholders held far more than enough shares to maintain control.

[Highest Prime]

(Edited because GH has already answered)

I'll just add that there are certain companies where the board of directors can make such decisions without a shareholder vote - or where the management team does own more than half the outstanding shares, which they can vote as they please.

In all cases, however, the board is expected to exercise what is known as 'fidicuiary responsibility' on behalf of all shareholders. Sadly, there are many companies in which this sense of responsibility is, shall we say, lacking - which is why it's always important to check out the management behind the companies in which you want to invest.

H'

[extro...]

[Guest]

you idiot!

[Highest Prime]

[Highest Prime]

Overview, Part 2: Why Invest in Stocks?

What's the first thing you think of when I mention investing in the market?

Dollar bills? CNBC? Numbers flashing across a computer screen? Perhaps a bunch of overweight men holding up pieces of paper on a stock exchange floor while screaming unintelligibly?

Put those thoughts out of your mind. I want you to instead draw this parallel: a game of poker.

Yes, poker! On a micro level, there is no better composite model of mathematics and human psychology than a poker table. And on a macro level, there is no better composite model than the stock market. The two activities are, in many ways, remarkably similar. This is why, since I assume many of those on this forum have read Borodog's poker threads, I will borrow liberally from the game in drawing analogies to the market. ¹ One could just as easily reverse these perspectives were one crafting a poker thread for a group of seasoned investors!

"But I don't want to gamble with my retirement money!" you might cry. Well, yes and no. Let's ponder for a second the difference between gambling and investing.

Poker, or any casino game, is a form of gambling. Economists employ a rigorous definition of the word 'gambling': an activity that, across the entire universe of participants, is a negative-sum game. Let's imagine that 100 people were locked in a casino poker room, with no one allowed to enter or leave and everyone playing until they went bust. Although on average the bad players would go broke quicker than the good ones, in the end the only big winner would be the house ... by taking its cut out of every pot, large or small, as the money sloshes back and forth between participants. Even poker at its best - a home game with no rake and no time charge - is fundamentally zero-sum. Money is neither created nor destroyed in such a game; people aren't walking in from off the street, dropping money into the pot, and walking back out. ²

The stock market, by contrast, is a positive-sum game - an economist's definition of an investment, as opposed to a gamble. Over the long term ³ , the composite value of the stocks publicly traded on United States stock exchanges increases. The S&P 500 (a common market index, reflecting the combined market value of 500 of America's largest companies) is higher today than it was 30 years ago. 30 years hence, it will be higher than it is today; 30 years after that, higher still; and so on. Why can one state this with such certainty? Two main reasons: ⁴

(1) There is more risk involved in stocks than there is in other investment choices (some of which offer government-guaranteed returns). Therefore, stocks must offer the potential for greater returns than these guaranteed investments, or the stock market as an institution would cease to exist. (After all, given two investment choices - Choice A being both safer and more profitable - why would you, or anyone, invest in Choice B?) ⁵
(2) The stock market has a survivorship bias built in. A stock that trades at $10 can never go lower than $0. But give it good management and good products and it can go not just to $20, but to $200, or $2,000, or higher still! Over time the "footprints" of larger and faster-growing companies overwhelm those that shrink or go out of business. Since stock indices are generally weighted by company size (and no index continues to track companies that have gone out of business!), the "market", as measured by any such index, will be higher from one generation to the next.

And this certainty reflects itself in past performance: Over the past 200 years, no asset class in the world - be it bonds, bullion, or Beanie Babies ⁶ (no, not even real estate!) ⁷ - has provided an average annual return on investment greater than that of stocks. Not one. So the answer to the question "why invest in the stock market?" is easy: It's the single best way to generate long-term wealth in America.

But Why Individual Stocks?

But investing in the stock market is easy: Dozens of mutual fund companies offer so-called "index funds", which are meant to mirror the performance of a given stock market index (commonly the S&P 500, mentioned above). Investing in "the stock market" is as simple as sending off a check to Vanguard and putting it in one of these index funds. Why go one step further and invest in individual stocks?

Well, perhaps you shouldn't. ⁸ You certainly shouldn't if (a) you're investing money that you need to pay the rent, or the grocery bill; (b) you want a "quick score" and aren't willing to keep that money invested for years (or, preferably, decades); and, most important, (c) you don't want to roll up your mental sleeves and really learn how and why certain stocks become winners, and others become losers.

The fact that the stock market is a positive-sum game doesn't preclude you, or anyone, from losing money - any more than poker, a negative-sum game, precludes you from winning. Which brings up another thing the two activities have in common: Those who jump into either feet-first without knowing what they're doing wind up giving their money to those who do.

So why bother to learn? To take full advantage of an individual investor's single greatest asset: flexibility.

Mutual funds such as Vanguard - together with hedge funds, pension funds, and other gigantic entities controlling billions of other people's dollars - are the real "movers and shakers" in the stock market. Where you might buy 100 or 200 shares of a given stock, they might buy 100,000 or 200,000. Their charters often require them to be fully invested at all times; their sheer size makes owning shares of many small and mid-sized companies virtually impossible.

But you, the individual investor, can jump in and out of virtually whatever stock you please, and can keep part or all of your money in reserve while you wait to buy the best companies at the best time. And, with commissions at online brokerages as low as $7 to $10 per transaction, the economies of scale once flaunted by those large mutual funds are now virtually extinct!

Stock-picking is not easy. But a little bit of knowledge, and a little bit of consistent, diligent work, can result in rewards that far outweigh the effort.

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¹ - It's also why those who are already winning poker players have a giant leg up in understanding, and being successful in, the stock market.
² - Although the play of some of your fellow home-gamers may strongly resemble this!
³ - "Over the long term" is a critical phrase in investing, just as in poker. It doesn't mean that you won't have losing days, weeks, months, and sometimes years in the market, just as on the felt.
⁴ - Well, three, actually. The primary one is known as 'Ricardo's Law of Comparative Advantage.' But this is an investing course, not an economics textbook, so I won't get into it here.
⁵ - Actually, there are reasons why certain people might choose a riskier, lower-return investment over a safer, higher-return one. These might include liquidity, tax considerations, etc. Generally, however, higher returns are only available by assuming higher risk. But note that the converse of this statement is not true! Higher risk does not guarantee higher returns. Rather, it guarantees the potential for higher returns.
⁶ - Because alliteration is fun!
⁷ - Ric Edelman uses an example like such: The Dutch purchased the island of Manhattan (now that's prime real estate!) in 1626 for $24 worth of beads. Had the stock market been around in that day, and had it delivered the same average annual returns since then that it has for the past 125 years, that $24, if invested, would have grown into $7,000,000,000,000 - that's seven trillion dollars. Such is the awesome compounding power of the stock market!
⁸ - Bet you weren't expecting that answer!

[Highest Prime]

Not to put too fine a point on it, but is anyone reading and/or expressing an interest in this? Just thought I might inquire before plowing on.

H'

[Antrax]

I am. I disagree with and/or don't understand several things, but I'm reading
_________________
After years of disappointment with get rich quick schemes, I know I'm gonna get rich with this scheme. And quick!

[Chuck]

I read somewhere that many stock market players actually buy high and sell low. They'll buy a stock that's been climbing for a high price and hold it while it stays high because it seems like a good investment. Then when it drops below what they paid for it they panic and sell it.

[mikegooo]

I'm reading.

[MacSulach]

Not me!!! I'm too busy on my yacht planning how to spend the millions of dollars I've made since this thread started. Unfortunately I've got too many scantily-clad underwear models prancing around my deck (that's right, deck] to be able to decide.

[Jack_Ian]

I decided to invest in stocks last year and ended the year with a small fortune
Unfortunately I had started that year with a large fortune

Of course that was when... oops

SELL! SELL! SELL!

Uh! Oh!
I'll come back later (if I can afford the internet connection)

[Highest Prime]

[Highest Prime]

Overview, Part 3: Investing Styles and Success

It's tough to boil down how to be a winner at investing into a single book, much less a single sentence. But if I were forced, I'd probably phrase it something like this:

Successful investing involves identifying and taking advantage of not the greatest potential returns, but rather the greatest potential returns relative to risk.

OK, so that's the short answer. What does that mean, and how does one go about "identifying and taking advantage"?

Let's return to the felt for a second. In order to be a long-term winner in poker, a player needs to have three qualities:

(1) A knowledge of the underlying mathematics (the basic probabilities) governing the game;
(2) Comfort with the game's psychology (e.g. the ability to 'read' one's opponents); and, most importantly,
(3) A great deal of discipline.

These same three characteristics largely determine one's success in the stock market. And, as in poker, your relative strength in these three areas will determine what kind of 'game' suits you best. Regardless of your natural style, you cannot succeed - in poker or in the market - without discipline. But there are those who make a living in poker by being the best in the world at the mathematics (David Sklansky comes to mind); and those who make a similar living by being the best in the world at the psychology (such as Phil Ivey).

Likewise, everyone who makes a living in the stock market - every professional, every mutual fund director, every hedge fund manager - can be categorized somewhere in between two extremes: the fundamental investor and the technical investor.

Fundamental investing is (to employ a gross oversimplification) the limit cash game of the stock market. It is doubtful whether Warren Buffett, the foremost fundamental investor of our time, spends any meaningful time analyzing stock charts. Yet he's made billions by knowing balance sheets, cash flow statements, and solid financial principles better than almost anyone else in the world. ¹ Fundamental investing is a mathematician's (or a grinder's) game ... buying shares of solid companies at less than they "should" sell for based on your investing principles, and waiting weeks, months, or years for others to come around to your point of view.

Technical investing, by contrast, is the no-limit tournament of the market. Many experienced 'swing traders' never bother to read financial statements; yet they know the psychology of the markets, and charts in particular, so well that they make a career out of it. Technical investing is a high-flyer's game ... understanding when the chart of a stock "looks right" to jump in, riding the wave, then cashing out at the right time and moving on. ²

Fortunately, you don't have to be world-class at either one to make money. This is where your most important asset - discipline - comes in. Experienced poker pros exercise it in three distinct areas: game selection (knowing what game to sit down in); hand selection (knowing which hands to play when they are in a game); and hand play (knowing when to bet, call, raise, or fold with a hand once they decide to play it). And as an investor, you face three similar decisions: (a) stock selection; (b) when to buy; and (c) when to sell. The best news of all is that, in the market, there are 8,000-plus different 'games' running at once! ³ And you don't even have to be in a game all the time - you can step aside and keep your money in cash when the games as a whole aren't running well. It is this immense freedom of choice that makes the stock market the world's greatest place to invest one's money.

********************
And thus ends the "introductory" component of the course. From this point, like the 'Choose Your Own Adventure' books of yore ⁴ , the reader may continue on with this thread to begin learning about utilizing fundamentals to identify the best stocks to buy, or may flip over to the "Technical Investing" thread to explore how to better understand the psychology of the markets, and how to use it to your advantage. I'd encourage you, of course, to read both! But the order in which you do so shouldn't really matter.

H'
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¹ - More appropriately, he made his first billion this way. There's a Wall Street saying: Turning $1 million into $10 million is inevitable; it's turning $1,000 into $1 million that's the hard part.
² - So-called "day trading" is technical investing taken to an extreme, trading on established patterns not on a week-by-week basis, but on a minute-by-minute basis. Although day trading can be based on a very solid technical foundation, it's a losing strategy long-term, since even today the spreads and commissions are simply too high to allow its practitioners to turn a profit.
³ - Or, as Jim Cramer ends every episode of his TV show Mad Money by saying, "There's always a bull market somewhere."
⁴ - I can't remember to pick up a 12-pack of soda on the way home from work, but I can remember the name of my first CYOA book: The Third Planet from Altair. I don't want to know what this says about me as a person.

[Antrax]

[Jack_Ian]

How come they are stupid when you are the one holding on to the worthless stock?

Seriously though, you still have a share of a presumably profitable company so the stock that you have is undervalued and that situation does not last long. If I were you then I would take this opportunity to buy more.

There is one problem with this though. A company sometimes uses it's share price as an indicator to banks when seeking finance or in share-for-share deals when merging etc. If the company in question is about to seek finance or is about to merge/take-over another company then it is likely that they will get a bad deal and this will certainly effect future performance.

[Highest Prime]

[Highest Prime]

^{The overview complete, the Investing thread now takes a fork in the road. The remainder of this thread will cover Fundamental investing principles; the other thread, Technical principles. And without further ado, we charge, William Wallace-like, into the ...}

Basics of Fundamental Investing

Chapter 1: Risk and Reward

Fundamental investing is predicated on one simple notion:

All investments, over time, will possess a potential return roughly in line with their relative risk.

That, basically, is that. Really! The process of fundamental investing involves identifying certain investments that, at certain times, will be valued at less than they "should be" based on their underlying risk factors. Why? Because of psychology. Stocks may be faceless pieces of paper, but, as we've discussed, they are bought and sold by humans. And humans, being creatures of emotion, often base their buys and sells on some combination of hope, greed, fear, and despair. It's when the short-term stock price most grossly fails to reflect the long-term profit potential and risk of a business that the fundamental investor gets the most interested.

Let's explore the concept of "relative risk" for a second. In the world of finance and all the thousands of choices that it offers, there is only one group of investments that is considered to be truly "risk-free." That Holy Grail of financial security is ... (drum roll, please) ... debt obligations of the U.S. Treasury - Treasury bills and notes. There's an obvious reason for this: If the U.S. were to run out of money to meet its obligations, it could simply print more! (You can do this, too, if on your list of things to do before you die is "Be the subject of an intensive Secret Service manhunt.")

So what's the catch? ¹ Well, because these investments are the "risk free" benchmark, they offer fairly low returns - typically in line with current or expected inflation rates. Today, for instance, 10-year Treasuries pay right around 4% per year. You buy a newly minted $1,000 10-year T-bill, you get $40 in interest payments every year for 10 years, and at the end of Year 10 you get your $1,000 back.

But - and it's a BIG but! - inflation also typically grows at about 4% per year. And you'll find that if you add up the total you receive from the gub'mint over those 10 years and subtract out the expected effects of 4% inflation along the way, you end up with exactly $1,000. So in return for keeping your money under lock and key for 10 years, the Federal Government is in reality offering you ... nothing! "Fairly low returns", indeed. ²

It's tough ³ to create massive amounts of wealth by turning $1,000 into $1,000 every 10 years, and thus smart investors look for alternative places to put their money. So where can we do better? How about corporate bonds? (Again, everything we've discussed so far are debt obligations, not stocks. We'll get to those in a second.) GE's 10-year corporate bonds pay about 4.5%, half a percentage point better than Treasuries. Now, instead of a $40 check from Uncle Sam every year on that $1,000 bond, you'll get a $45 check from GE, and you'll still get the same $1,000 back at maturity.

Of course, GE is just a corporation, and they could conceivably go belly-up within the next 10 years. Given GE's size and scale, that's not too likely ... but, then again, the same thing was once said about Studebaker and Eastern Airlines. So you're taking on a small additional risk in return for a small additional return. ⁴ As you move down the financial stability ladder, bond yields rise - reflecting the additional compensation bond investors demand in return for the higher risks associated with lower-quality companies.

Armed with this short tutorial, let's move over from the bond market to the stock market. Instead of buying a $1,000 bond from ABC Corp., let's buy $1,000 worth of their stock. What return should we expect?

???

Well, how should we know? We know how much ABC stock costs per share, and we know the current dividend it pays, if it pays one - but, unlike the bond principal (which ABC has an obligation to pay back to us at maturity), we certainly don't know how much that $1,000 worth of stock is going to be worth to someone in 10 years. It might be worth $5,000. Or $1,450.

Or zero.

This is the crux of fundamental investing: assessing the underlying profit potential and risk of a company to determine what it will be worth when it comes time to sell it and, therefore, whether it represents a good buy at the price it would cost to buy it today.

Determining that isn't something one can do easily. ⁵ But in the next chapter, we'll start trying to peel the layers off the onion.

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¹ - And there's always a catch.
² - The moral of the story is that there is no truly "risk-free" investment. It's true that Treasuries have zero "credit risk" - since you can always be assured of getting your money back. But what you can't avoid is "inflation risk" - the risk that the money you do get back will be worth less in the future than it is today. In other words: See footnote 1.
³ - "Impossible" would be a more appropriate word. But I'm trying not to be judgmental.
⁴ - Quantifying the size of this and other such risks is, in a nutshell, what actuaries do for a living. Exciting, ain't it? If you have a friend who's an actuary, take them out after work and buy them a sympathy beer.
⁵ - Actually, this is a *good* thing. If poker were easy to play properly, everyone could do it, and no one could make any money at it. And if fundamental investing were easy, everyone would be an expert, and the stock market would be a very boring place indeed.

[Doc Borodog]

Just wanted to say that I'm reading with great interest.

[Da5id]

[Da5id]

[Highest Prime]

* tiptoes in, stage left *
* peeks briefly around *
* taps microphone *

Ahem. Err, hello?

A thousand apologies to everyone who might have been (with varying degrees of eagerness) following this thread ... well, umm, last summer or thereabouts. I won't bore you with the details of my Sopranos-like hiatus (I'll try to pop in on VSN and bore a much larger audience instead).

I'm not sure whether anyone still cares about this topic. I suppose I shall post the next installment and let the ticker tape fall where it may thereafter.

* Chapter 2: Cash is King *

Let's go back to Chapter 1 and revisit corporate bonds for a moment. When you receive an interest payment on a 5% bond from XYZ Corp. (or a Treasury note or, for that matter, a bank CD) every year, does XYZ send you that interest in additional bonds? In XYZ stock? In Best Buy gift cards?

No, no, and no. ¹ That interest comes to you as a check for $50 in cash. Sign it, bring it to the counter at your bank ² , and it's yours - two 20's and a 10 burning a hole in your pocket. It doesn't matter what happens to XYZ next week, or 5 years from now - they can never take that $50 back from you.

This is why, in the world of investing, there is one overriding truism, and it's this: Cash is King.

Just as a bird in the hand is worth two in the bush, a dollar paid to you by an investment today is worth more than a dollar paid to you next year. The best investments are those that provide, back in your pocket, a high probability of lots of cash soon; the worst ones, a low possibility of little cash far in the future.

Recall that all investments come down to providing Income and/or Growth. Stocks are great investments because they offer you the potential for both. They can produce income in the form of dividends; they can produce growth in the form of capital gains, by being worth more per share in the future than they are today. Historically, the majority of stock market appreciation derives from capital gains, meaning that your shares - your fractional ownership in the business - are worth more when you sell than when you bought. But why would anyone choose to pay a higher price in the future for the same percentage of the same business?

The answer lies in each company's ability to generate cash from its day-to-day operations. When companies choose to issue stock rather than bonds, they don't have to make regular (or any!) cash payments as they would to bondholders. Instead, any cash generated from running the business can be invested back into the business - whether that involves buying new equipment, hiring additional employees, purchasing airtime to show dancing-monkey commercials during the Super Bowl, or what have you. Those additional expenditures will (theoretically) produce greater sales and profits yet, which can themselves be re-invested, and so on until a single five-and-dime store in Bentonville, Arkansas, winds up at No. 1 on the Fortune 500 list.

How do we know whether this is the case? The business tells us! Every three months, we can see in black and white how much cash the business is generating, and what it's choosing to do with that cash. Which brings us to a corollary of the 'overriding investment truism' above:

The single most important indication of the strength of a company's business is its cash flow statement. Not its management profile, not its press releases, not even its earnings statement.

And now the good news: This critical measurement of business performance is among the easiest to uncover and decipher! Every publicly traded company in America must file such a statement on a quarterly basis with the SEC, which then makes it available for review by anyone with a computer and an Internet connection. (All such filings can be accessed directly from Yahoo! Finance, at finance.yahoo.com, by simply typing in a stock symbol and then selecting "SEC Filings" from the menu on the left. It's easy to access and, since it's in HTML, easy to read.)

The filings we want are labeled "10-Q", for Quarterly Report (once a year, a company issues a "10-K", or Annual Report, instead, which contains the same financial statements, just in a different part of the document). At the very top of a 10-Q you'll see three statements - the Cash Flow Statement discussed above as well as the Income Statement and the Balance Sheet. Each is important in its own way, so we'll review them all, but we'll begin with Cash Flow.

How Much Cash can a Cash Flow Flow ... ?

Reviewing a few of its cash flow statements will help you determine whether a company (not to put too fine a point on it) knows what the hell it's doing. Any company with a halfway decent business model can make a profit; but it's the ability to take that profit and reinvest it in a way that will generate a greater profit still - quarter after quarter, year after year - that separates good management teams from mediocre ones, and the great from the merely good.

Looking through a cash flow statement for the first time usually evokes a statement and a question:
(1) Accountants are insane.
(2) What kind of "cash" am I supposed to be looking for?

No dispute on Point (1) - as, within the boundaries of a cash flow statement alone, there exist about six different "flavors" of cash. As to Point (2), what we're interested in comes in a simple version and a slightly more complex version.

The "simple" version is the line labeled "Cash Flow from Operations", or CFO. This represents how much good old-fashioned moolah dropped to the bottom line in the course of doing whatever it is their business does. (Bet you thought that's what earnings represented. Nope! "Earnings" are ... well, not exactly a fantasy ... more an artifical construct, a modern-day Potemkin village for public consumption. More on this later.)

The "slightly more complex", and more accurate, version is what's known as Free Cash Flow. This represents the available cash that the company generates - after paying for both its operating expenses and its capital investments. More simply, this is the cash that it could, theoretically, distribute to its shareholders as a dividend. ³ Calculating FCF is simply a matter of taking the line marked "Capital Expenditures" (or "Property, Plant and Equipment") further down the statement and subtracting that number from the CFO. This backs out the portion of cash spent on such things as new machines, new office buildings, a new exercise room for senior management, etc. These expenses are treated differently from regular "operating expenses" for earnings (and tax) purposes - but, bottom line, it's money spent, not available to pay out to shareholders, so it should be removed from the CFO number.

Thus: Free Cash Flow (FCF) = Cash Flow from Operations (CFO) - Capital Expenditures

That's it! (No, really!) But do this simple calculation for a few random companies, and pretty soon you'll start to notice something: There are a surprising number of public companies that don't generate any cash at all! Their free cash flow is negative - it actually costs them money just to keep their core businesses running. This was on greatest display back at the peak of the dot-com bubble (c. 1999), when literally thousands of companies went public having never generated a dime of operating cash flow. And guess what? The vast majority of such companies are no longer in business.

I started this section with a truism, and I'll end with another that's closely related:

If a company cannot generate free cash from its business, the intrinsic value of its stock is zero. Any positive value the market affixes to such a stock is a product merely of speculation ... the "Greater Fool" theory at work. Run, don't walk, away from companies fitting this description!

The upshot: In five minutes or less, we can track down the single most critical measure of success for any public company's business. Now, what do we do with it? That's a topic for the next post.
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¹ - There are, in fact, bonds that offer these alternatives (well, except for the gift cards), but I know little more about them than anyone else here. But then, that's why the world has financial advisors.
² - Hee-hee! What a quaint notion!
³ - Dividends are simply a return of a company's excess cash by its management to the holders of its stock. They differ from interest payments (on bonds) in that they are voluntary - management can choose to create, change, or eliminate a dividend at any time.

[Highest Prime]

[Highest Prime]

* Chapter 3: The P/E Ratio (or, Pay No Attention to the Man Behind the Curtain) *

Even those with only a passing knowledge of Wall Street have likely heard the term "price-earnings ratio", or its abbrevation "P/E", used before. Below I will briefly attempt to explain how this simple term acquired such importance - "briefly" because I will then explain why P/E's are, for serious fundamental investors, irrelevant.

Recall from Chapter 2 the importance of a company's ability to generate cash. However, for fundamental investors, this is necessary, but not sufficient, to hold our interest. Just as important is how much it costs to acquire a "cut" of that cash flow in the form of shares of the company's stock. To understand why, let's bring our old friend Mr. Bond back into the discussion.

If I buy a $100 10-year 5% bond from XYZ Corp, I will (as you now know) receive $5.00 in interest payments each year for 10 years, and (unless XYZ goes out of business ¹ ) get my $100 back at maturity. Put another way, I am "tying up" $100 of my money now in return for an annual cash flow of $5. Do the division, and we wind up with a "price to cash flow ratio" of 20. (We'll abbreviate this "P/CF" for now.)

It's easy enough to calculate this for a bond (it's just the reciprocal of the bond's yield). But what about for a stock? Let's say that we're blessed with psychic powers, and we're able to divine that XYZ will produce cash earnings of $5 per share, per year, for the next 10 years. If XYZ is trading at $100 a share, and were it to return that entire $5 to their stockholders as annual dividend checks, you would be paying $100 now for a cash stream of $5 per year - just as with the bond. This corresponds to a "price to earnings ratio", or P/E, for XYZ's stock of 20 ... the same as the bond. And presumably, given their consistent earnings history, in 10 years you would be able to sell each share of XYZ stock for right around the $100 you paid, just as you would have your $100 bond principal returned to you at maturity.

But remember, this isn't how equity usually works! Instead of returning that $5 to you as a dividend, XYZ's management will instead reinvest most or all of that $5 in the business ... so that, instead of $5, XYZ might earn $5.25, or $5.50, or $6 per share next year. If management can produce, say, 8% annual earnings growth through shrewd reinvestment, then through the wonder of compounding, in 10 years they'll be earning not $5 per share but $10.80 per share! It seems likely someone would be willing to pay more for $10.80 of earnings per share than you did for $5 per share, and you would see that willingness reflected in a higher price for XYZ's stock.

On the other hand, if management reinvests that cash poorly, it spells bad news for stockholders. If XYZ reinvested that $5 per share each year (eschewing dividends), but is still only managing to generate $5 per share in cash 10 years from now, it's unlikely anyone will offer you much more than the $100 per share you paid a decade ago. In the meantime, you've received no cash from the company, and 10 years of inflation will have eaten away at the value of that $100 or so you'd get back when you finally do sell that miserable excuse for XYZ stock.

Thus we have two competing factors that determine the price of a company's stock relative to that of a bond:

• On the one hand, the cash a company can generate per share of stock can increase over time; but the interest payments on a bond will never change. This would suggest that stock buyers should be willing to pay more now for the prospect of increased future earnings - in the form of a higher P/E ratio for the stock than the P/CF of the bond.
  
• On the other hand, you the stockholder are assuming additional risk by allowing management to reinvest your share of the company's earnings in this manner rather than paying them to you now (because Cash is King!). This would suggest that stock buyers should demand a higher return in exchange for this increased risk - corresponding to a lower P/E ratio for the stock than the bond's P/CF.

So which is the "right" way to look at stock valuations? Both. Umm, I mean, neither. Actually, every stock (and, in fact, every investment) lies somewhere along an infinite continuum of reward and risk. A stock's P/E, in essence, reflects the market's current opinion on the risk-adjusted return expected from that stock (which is the key to fundamental investing, as you'll recall from Chapter 1). As such, it's an easily calculated yet immensely useful snapshot view both of a company's business and of the market's opinion of its prospects.

Enter Statler and Waldorf, Balcony Right ...

Unfortunately for something of its relative ubiquity, the P/E ratio has several serious flaws. The most glaring is that, in this day and age, a company's "earnings" bear only a passing resemblance to the money that actually flows into or out of the company coffers. Through techniques ranging from 4-point-type footnotes to outright legeredemain, businesses that generate 50 cents per share in free cash (cash flow from operations less capital expenditures) can sometimes claim "earnings" of 60 cents, 70 cents, even $1.00 per share! If a company trading at $10 generates 50 cents of free cash per share annually but can, at the same time, somehow report "earnings" of $1.00 per share, the P/E ratio as viewed by "the market" would drop from 20 all the way to 10! Such a bargain! Buy it! Buy it now, I say! ²

Bondholders won't stand for that kind of chicanery - and neither should you. The only number of interest to them is the cash value of their interest checks; likewise, the only number of interest to you should be free cash - what your business generated and could send to you, even if they don't (because you trust them to reinvest that cash wisely instead, remember?) Rather than using any form of "earnings" as the baseline for the attractiveness of a potential investment, always use free cash flow. (And you wondered when I was going to circle back to that!)

So now we've 'fine-tuned' the denominator of the P/E (morphing it into P/FCF) to make it more useful. In the next chapter, we'll do the same for the numerator - which means tackling another oft-ignored financial statement, the balance sheet.
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¹ - Which brings up another point of comparison between bonds and stocks: If a company declares bankruptcy - whether Chapter 7 liquidation or a Chapter 11 reorganization - bondholders rank second in priority only to the IRS on the list of creditors in bankruptcy court. Therefore, if that company has any assets to speak of, bondholders often get at least some of their principal back. Stockholders, on the other hand, rank dead last on that priority list, and thus are usually wiped out when their company files for bankruptcy.
² - Laugh if you will ... but I've read many an analysts' report for which these three sentences could have served as a nearly exact synopsis, and saved some trees to boot.

[arandomguy]

Get a life.
_________________
Monkeys are better dead.

[groza528]

Holy shijt, arandomguy has opened my eyes.
My life has been meaningless. The stock market? It's a game of tiddlywinks. I need to stop investing in slips of paper that will probably just sit in the same place for *years* while they grow.
What I need to do is go out into the cyberworld and find a forum full of people who are much smarter than absolutely nothing like me. Then I can belittle their petty "opinions" until just reading my name makes them cringe. THAT'S power. Screw money, I want infamy.
Thank you arandomguy, I find what you say very interesting and wish to subscribe to your newsletter.

[arandomguy]

groza thinks he's smarter than me. ROFL, that's a good one. I love how all you GL nerds think you're the shit. It's honestly hilarious watching you numbskulls mingle with other losers who don't have lives outside of AN INTERNET FORUM.
_________________
Monkeys are better dead.

[Dan]

Why do you keep coming back? It just makes it look like you want to be one of us. The time you spend here or even just thinking about this place is evidence that you too are a nerd and a numbskull, as you so graciously put it.

You must really hate yourself. Get a life of your own. I think you've been banned (again?), but if you bother to find some way to respond to this it only proves my point about your hypocrisy.

EDIT: Why did I bother? Oh well.

[Samadhi]

Exactly. DNFTFT

[Chuck]

The stock market is a scam set up long ago in anticipation of me being born, growing up, getting a job, and saving up a little extra money so it could take it away from me. Well, I'm not falling for it.