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Investing in Stocks

Investing in Stocks

It's more then just a piece of paper

When buying a stock, you are taking an ownership stake in a company. At some point, just about every company needs to raise money, whether to open up a West Coast sales office, build a factory or hire a new crop of engineers.

In each case, they have two choices:

1. Borrow the money.

2. Raise it from investors by selling them a stake (issuing shares of stock) in the company. Own a share of stock, and you are a part owner in the company, with a claim (however small it may be) on every asset, and every penny in earnings.
   
   Now, typical stock buyers rarely think like owners, and it's not as if they actually have a say in how things are done. Owning 100 shares of Microsoft makes you, technically speaking, Bill Gates' boss, but that doesn't mean you can call him up and give him a tongue-lashing. Nevertheless, it's that ownership structure that gives a stock its value. If stock owners didn't have a claim on earnings, then stock certificates would be worth no more than the paper they're printed on. As a company's earnings improve, investors are willing to pay more for the stock.
   
   Over time, stocks in general have been solid investments. That is, as the economy has grown, so too have corporate earnings, and so have stock prices. Since the end of World War II, the average large stock has returned, on average, 11 percent a year. If you're saving for retirement, that's a pretty good deal, much better than U.S. savings bonds, or stashing cash under your mattress.

Number of Things You Need to Know About Stocks

1. Stocks aren't just pieces of paper. When you buy a share of stock, you are taking a share of ownership in a company. Collectively, the company is owned by all the shareholders, and each share represents a claim on assets and earnings.

2. There are many different kinds of stocks. The most common ways to divide the market are by company size, sector, and types of growth patterns. Investors may talk about large-cap vs. small-cap stocks, communication vs. technology stocks, or growth vs. value stocks, for example.

3. Stock prices track earnings. Over the short term, the behavior of the market is based on enthusiasm, fear, rumors, and news. Over the long term, though, it is mainly company earnings that determine whether a stock's price will go up, down, or sideways.

4. Stocks are your best shot for getting a return over and above the pace of inflation. Since the end of World War II, the average large stock has returned, on average, 11 percent a year, well ahead of inflation, and the return of bonds, real estate and other savings vehicles. As a result, stocks are the best way to save money for long-term goals like retirement.

5. Individual stocks are not the market. A good stock may go up even when the market is going down, while a stinker can go down even when the market is booming.

6. Great track records doe not guarantee strong performance in the future. Stock prices are based on projections of future earnings. A strong track record bodes well, but even the best companies can slip.

7. Compare stock prices to other factors to assess value. To get a sense of whether a stock is over- or undervalued, investors compare its price to revenue, earnings, cash flow, and other fundamental criteria.

8. Smart portfolio positioning for the long-term includes strong stocks from different industries. As a general rule, it's best to hold stocks from several different industries. That way, if one area of the economy goes into the dumps, you have something to fall back on. Plus, financially sound companies with above average earnings growth are the best bet for steady long-term returns.

Different Kinds of Stocks

Not sure what a small-cap is? Or why you should care? Read on

There are more than 9,000 stocks to choose from, so investors usually like to put stocks into different categories. You can slice and dice the stock market into all sorts of different groups, but the most common ways are by size, style, and sector.

By Size

When talking about a company's size, we're referring to its market capitalization, the current share price times the total number of shares outstanding. It's how much investors think the whole company is worth. Ford, for example, has 1.6 billion shares outstanding, and in February 2001, each share was trading for $28, for a total market capitalization of $45 billion. (Technically, if you had an extra $45 billion lying around, you could buy each share of stock, and buy the whole company.)

Is $45 billion a lot or a little? No official rules govern these distinctions, but below are some useful guidelines for assessing size.

Large-cap companies tend to be established and stable, but because of their size, they have less growth potential than small caps. As a result, over the long run, small-cap stocks have tended to rise at a faster pace. Krispy Kreme Doughnuts, a relatively new chain with a market cap of under $1 billion is slated to increases earnings at a 25 percent clip over the next five years, and its stock more than doubled in 2000. General Electric, the most highly valued company in the world with a market cap of more than $450 billion, has posted steady long-term returns, but don't expect a double anytime soon.

But there's a trade-off: With less developed management structures, small caps are more likely to run into troubles as they grow expanding into new areas and beefing up staff are examples of potential pitfalls. (Of course, even corporate titans get into trouble. Witness the stock-price collapse of AT&T in 2000, stockholders lost more than 60 percent of their money.)

By Style

A "growth" company is one that is expanding at an above average rate. Cisco, for instance, increased its earnings at a rate of nearly 40 percent a year in the late 1990s, the average tends to run around 10 percent.

Catch a successful growth stock early on, and the ride can be spectacular. If you'd picked up 100 shares of Cisco in 1995, your stake would have cost you a little more than $3,000. By early 2001, that investment grew to $68,400.

But again, the greater the potential, the bigger the risk. Growth stocks race higher when times are good, but as soon as growth slows, those stocks tank. Cisco fell from grace in 2000, with a decline of more than 50 percent.

The opposite of growth is "value." There is no one definition of a value stock, but in general, its share price is in the dumps. Maybe the company has messed up, causing the stock to plummet -- a value investor might think the underlying business is still sound and its true worth not reflected in the depressed stock price.

A "cyclical" company makes something that isn't in constant demand throughout the business cycle. For example, steel makers see sales rise when the economy heats up, spurring builders to put up new skyscrapers and consumers to buy new cars. But when the economy slows, their sales lag too.

Alcoa, the leading aluminum maker, grew its earnings by 16 percent, well above average a year in the late 1990s, but might actually lose money if aluminum prices fall in the next recession. Cyclical stocks bounce around a lot as investors try to guess when the next upturn and downturn will come by the time you read aluminum prices are at a high, Alcoa probably has already peaked.

By Sector

Standard & Poor's breaks stocks into 11 sectors, and 59 industries. Generally speaking, different sectors are affected by different things. So at any given time, some are doing well while others are not. Generally speaking, finance, health care, and technology are the fastest growing sectors, while consumer staples and utilities offer stability with moderate growth. The other sectors tend to be cyclical, expanding quickly in good times and contracting during recessions.

What is a Fair Price for a Stock?

How to use P/E and other valuation tools

When times are good, investors think the happy days will last forever, and they are willing to pay exorbitant amounts for earnings. When times are bad, they assume the world is ending and refuse to pay much of anything. In assessing how much a stock is worth, investors talk about "valuation," the stock price relative to any number of criteria. The P/E, for example, compares a company's stock price to its earnings.

Price/earnings (P/E) ratio

There is no right answer. The P/E based on the past four quarters provides the most accurate reflection of the current valuation, because those earnings have already been booked. But investors are always looking ahead, so most also pay attention to estimates, which also are widely available at financial web sites. Wall Street analysts generally compute earnings per share estimates for the current fiscal year and the next fiscal year (though there is no guarantee that the company will meet those estimates).

The P/E can't tell you whether to buy or sell, it is merely a gauge to tell you whether a stock is overvalued or undervalued. Is a $100 stock more expensive than a $50 stock? Maybe not. IBM, for example, was trading at $110 in February and was expected to earn nearly $5 a share in 2001, a P/E of 22. Home Depot, meanwhile, was trading for just $44 -- but it was slated to earn little more than $1 per share in 2001, for a P/E of around 40. So IBM, selling for more than twice the price of Home Depot, is a actually the cheaper stock (though not, necessarily, the better buy).

What's an appropriate P/E? Different types of stocks win different valuations. Generally, the market pays up for growth. That's one reason Home Depot has a higher P/E than IBM, its earnings are growing at 23 percent annually, versus just 13 percent for IBM.

To quickly compare P/Es and growth rates, use the PEG ratio. The P/E (based on estimates for the current year) divided by the long-term growth rate. Home Depot, with a P/E of 40 and a growth rate of 23 percent, has a PEG of 1.7. In general, you want a stock with a PEG that's close to 1.0, which means it is trading in line with its growth rate, but for a quality company, you can pay more.

Also, don't get excited by rock bottom P/Es, some companies are doomed to low valuations. One group the markets tend to penalize is cyclicals, companies whose performance rises and falls with the economy. Ford, for example, is arguably the best run auto maker and is highly profitable. But its P/E is just 10, and that's considered generous for an auto maker.

Price/Sales ratio Just as investors like to know how much they're paying for earnings, it's also useful to know how much they're paying for revenue (the terms "sales" and "revenue" are used interchangeably). To calculate the Price/Sales ratio, divide the stock price by the total sales per share for the past 12 months. (Revenue estimates are not as widespread as earnings estimates.)

Like P/Es, Price/Sales ratios are all over the map, with fast growers tending to get the highest valuations. Cisco's Price/Sales ratio is more than 8, for example, while Ford's is just 0.3.

Picking Stocks For Your Investment

"Low-risk growth investing"

Although there are some 9,000 plus publicly-traded companies, the core of your stock portfolio should consist of big, financially strong companies with above average earnings growth. Michael Sivy. A good stock portfolio should consist of 15 to 20 stocks in at least eight different industries, but you don't have to buy them all at once.

Since you want to be able to hold your stocks for a long time, they should offer a total return higher than the 12 percent historical market average. You can estimate the likely return by adding the dividend yield to the projected earnings growth rate, a stock with 11 percent earnings growth and a 2 percent yield could provide a 13 percent annual total return.

As a general rule, stocks with moderately above average growth rates and reasonable valuations are the best buys. Statistically, high-growth stocks are usually overpriced and have a harder time meeting inflated investor expectations. The first thing to look at is the stock's price/earnings ratio compared with its projected total return. Ideally, the P/E should be less than double the projected return (a P/E of no more than 30 for a stock with 15 percent total return potential).

A well-balanced portfolio might include a couple of industrials (an example might be Boeing) with 9 percent growth rates and 3 percent yields, selling at 17 P/Es. Consumer growth stocks (maybe WallMart) with 13 percent growth rates and 1 percent yields, at 23 P/Es. And perhaps a couple of tech stocks with 25 percent growth rates and 60 P/Es (don't overdo it on those). If you can average a 14 percent return over the next 10 to 20 years, you'll reach your financial goals -- and probably outperform most pros as well.

How to Buy Stocks

When you're looking for a broker, you have four distinct choices. From the most to the least expensive, they are: full-service brokers, discount brokers, deep discounters, and online brokers. What differentiates them is the advice they provide and cost. Full-service brokers will call with stock ideas, and back this advice with reports from their firm's research department. They'll keep an eye on your picks and let you know when they think changes are necessary. Discounters do less of this. Deep discounters do nothing of the kind. And while there's typically plenty of research available on the best online brokerage sites, it's up to you to dig for it.

You may want to choose different kinds of brokers for different purposes. I believe that full-service brokers should get paid for their stock ideas. That seems only fair. But if you've done your research yourself, I don't see any reason to pay a hefty commission, discounters probably are fine. The nice thing about the way the brokerage world is shaping up is that you may be able to have both of those things in one account at one firm. Merrill Lynch and many other full-service brokers are quickly coming around to the fact that they need an online component -- and need to charge you lower commissions when you use it. And discounters like Schwab and Fidelity have both started offering a fuller range of services in recent years, while retaining their low-cost structure.

If you decide to sign on with a full-service broker, you should make sure that person has nothing to hide. To get a report on any broker, call the National Association of Securities Dealers at 800-289-9999, or visit their web site.

Full-Service Brokers

Cost: Commissions are typically based on a percentage of your purchase (or sale) price, but start at about $70 for a 100-share trade.
Notable names to choose from include Merrill Lynch, Morgan Stanley Dean Witter,  and Salomon Smith Barney.

Discount Brokers

Cost: Schwab charges $29.95 for a trade, and on average, discounters charge one-third the price of full-service brokers.
Notable names to choose from include Charles Schwab, Waterhouse Securities, Quick & Reilly, and Fidelity.

Deep Discounters

Cost: Usually a flat fee ($15 to $25) for a trade of up to 5,000 shares.
Notable names to choose from include Brown & Co., and National Discount Brokers.

Online Brokers

Cost: At ($8 to $15) a trade, it doesn't get any cheaper than this.
Names to choose from include Ameritrade, Datek, E-Trade, and NDB.

When trying to place a buy or sell order, you'll be faced with all sorts of questions: Market or limit order? "Day only" or "Good 'till canceled"" Here's the vocabulary you need to know to place a trade.

If you place a market order with your broker, then you are saying that you're willing to buy at whatever happens to be the prevailing price for the stock. If you have a specific price in mind, you can set a limit order specifying the price you're willing to pay. If the stock dips down to that level, your order will be automatically filled. Limit orders can be left open for a single day (a day order) or indefinitely (good until canceled).

After you've bought a stock, you can instruct your broker to sell it if the price drops to a level you specify (a stop loss order). That's a kind of insurance; it means that no matter what happens to a stock's price you'll never lose more than a specified amount. In a volatile market, however, setting a stop-loss order at 10 or 20 percent below the purchase price will sometimes cause you to cash out of the stock on a momentary dip, thus locking in a loss even though the shares may immediately head back upward.

Investing in Stocks

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