Stocks are one of the most popular investment vehicles that people have consistently used to build wealth. A report shows that nearly every member of the Forbes 400 list got there because of a large portion of shares in public and private corporations.
If you have decided to take investing seriously, one of the investment vehicles, you have to consider is stock investing. In this article, we look at the different types of stocks and how you can get started with stock investing.
Types of Stocks: Structure
A stock is a portion of ownership in a company. When you purchase a share (shares) in a particular company, you own a specific portion of the company. The portion of the company you own depends on the number of shares you buy and the total number of issued shares.
There are two broad ways that companies structure their stocks:
Preferred stock, as the name implies, gives you a preference over common stock owners. When you own preferred stock, you are entitled to dividend payment before common stock owners. Also, in the case of dissolution, preferred stock owners have a prior claim to the assets of the company before the common stock owners (after debentures and other interest-paying debts)
However, preferred stock owners do not have voting rights in the company. Consequently, they do not have a say in the management of the company.
Preferred stocks are not as popular as common stocks. They are a blend of common stock and bond and provide lesser returns and lower risk in comparison to common stocks.
Common stocks are the most popular. In ordinary language, when someone refers to stock, he or she means common stock. With common stocks, you have voting rights, which gives you a say in the management of the company. However, common stock owners have the last claim on the assets of a business in the event of dissolution, and they receive dividends after the preferred stock owners. Common stocks are riskier in comparison to preferred stocks but with a higher possibility of returns.
When you decide to invest in stocks, the first decision is if you want preferred stock or common stock. With preferred stock, you get lower risk and lower possibility of returns, and with common stock, you get higher risk and higher possibility of profits, among other things (as discussed above)
Types of Stocks: Returns
Another way to differentiate stocks is how you earn returns from them. You earn returns from stock in two ways: dividend and capital appreciation. A dividend is a payment out of the net income of the company that they make to their shareholders. Companies usually pay a dividend every quarter. The company declares a dividend in absolute amount, which is then structured on a per-share basis (dividend per share). Consequently, the amount (gross) you get is the DPS * number of shares you hold.
The other way to earn returns from a share is through capital appreciation. CA occurs when the market price of a stock grows over the years. If you bought a share of Apple for $113 in August of 2015, you have gained about $200 on every stock of Apple as of today. If you decide to sell, you have earned over $200 (gross) on every share.
In terms of returns, there are two types of stocks:
Dividend stocks are stocks of companies that decide to pay a regular dividend to their shareholders. There are two options that a company has when they earn income (net). They can either pay a dividend or reinvest that money in the business. Reinvesting the money increases the equity of the company, which leads to an increase in market price going forward.
With dividend stocks, the company prefers to pay dividends rather than pursue aggressive reinvestment.
Growth stocks are stocks of companies that prefer to reinvest their earnings into the business and grow the market price of shares rather than pay a consistent dividend.
There is no right and wrong choice here for the investor. A dividend stock can be a good investment if you need a reliable source of consistent income for one reason or the other. Dividend stocks also protect you from the endless “external factors driven” fluctuations of the stock market. However, with dividend stocks, there is often a cap on your earning power. Growth Stocks, on the other hand, can be a sound investment if you need a huge nest egg at a later time. With growth stocks, there is no cap on your earning potentials. However, growth stocks expose you to continuous fluctuations in the stock market.
Types of Stock Investing: Goals
We can also differentiate stocks based on the goal of the investor. There are also two types of investors here (broadly speaking):
Value investors are those who invest for the long term. These are the Warren Buffet type of investors who purchase stock for the long term (5 years and more). Value investors tend to focus less on the daily fluctuations in the market, instead, focusing their attention on the company’s fundamentals (earning, debt, equity, product, market, etc.)
Value investors can invest in growth stocks as well as dividend stocks. However, the former will form a big part of their portfolio.
Profit investors are those who invest in stocks for short to medium term. They can be day traders, swing traders, scalpers, among others. The goal of profit investors is to make a profit from the fluctuations in the prices of stocks. Profit investors can invest in dividend or growth stocks depending on their strategies.
Most of those who have built wealth from stock investing are value investors who have a long-term focus. It is, therefore, advisable that the more substantial part of your strategy focuses on value investing.
Two Key Steps in Stock Investing
Once you have decided on your preference (common or preferred stock, growth or dividend stocks, value investing, or profit investing), the next step is to decide on the particular shares you want to buy and when to buy them.
To accomplish this, you need to carry out some analysis. There are two types of analysis in stock investing – fundamental analysis and technical analysis.
Fundamental analysis involves the evaluation of the fundamentals of a company. When you carry out fundamental analysis, you are looking at:
- Does the company have a competitive advantage or not?
- In what industry does the company operate, and what are the future trends of the industry?
- In what way will future technology affect the product of this company? Does it have a future going forward?
- Who are the managers of this company? Are they responsible and trustworthy decision-makers?
- Does the company have the potentials for a sustained increase in earnings power?
Answering these questions has qualitative and quantitative aspects. On the quantitative side, you are looking at the company’s historical financials and considering some metrics like:
- Earnings Per Share
- Price to earnings ratio
- Price to book value ratio
- Return on equity
- Growth in book value
- Growth in Earnings
- Debt to equity ratio
- Current ratio, etc.
There are many metrics in addition to the ones above. Majorly, what you are looking for is the ability of the business to stay in business, declare consistent earnings, improve return on equity, grow its book value (if you want a growth stock), and expand its operations without too much debt (if you want a growth stock)
Another related thing is deciding when to enter the market. If you decide that a stock has good fundamentals, there is still a need to enter the market at the right time. Value investors enter the market when the stock is underpriced, i.e., when the intrinsic value of the stock exceeds the market price. Entering the market at this point guarantees higher returns going forward. Value investors also prefer to buy stock in a bear market or when the economy is down, and prices are much lower than the intrinsic value.
While value investors spend much time doing fundamental analysis, technical analysis is the work of the profit investors (broadly speaking).
Technical analysis is a process where you use the historical variations in the price of a stock to predict future variations. The purpose of technical analysis is to enter the market and exit the market at points where you can earn a quick profit on a stock.
Profit Investors have different strategies they use that helps to determine their entry and exit points. Whatever the strategy, the goal is to buy when prices are low and sell when prices are high. There is not so much focus on the fundamentals of the company. The primary focus here is the strategy of the profit investor and the ability to make profits than losses.
Value investors can also use TA, but it is to determine the best time to buy stock rather than continuous monitoring of prices. Alternatively, value investors just hold the cash and wait for the bear market or any of the other economic conditions that result in low prices. Another option is to use dollar-cost averaging rather than waiting endlessly for those conditions to hit.
For comprehensive guides on technical analysis, subscribe to this Youtube Channel. (Since I am an advocate of Value Investing, I am not a big fan of TA, and I don’t really recommend profit investing. But if you want to do it, this channel has the best materials)
To purchase the stocks of your choice, you will need to open an account with a broker. There are many brokers, and you need to shop around.
Some of the things you need to consider when choosing a broker include:
- Fees: This is an issue for profit investors. Since they buy and sell repeatedly, the fees they pay, eat into their profits. It is, therefore, essential to shop around for quality brokers with cheaper fees.
- Online Platform: A broker should have an online platform where you can purchase and sell shares.
- Information availability: While a stockbroker is not your financial advisor, they should provide you with some quality information that could help your decision-making. Whether it is a blog, industry report, national economy report, investment research, etc. there must be something of value in addition to buying and selling shares on your behalf.
- Quality of service: You will want to be sure of the quality of the service of the broker. Read reviews and ask for recommendations.
After purchasing stocks, you have to track the performance of the shares. For value investors, this means keeping an eye on the company to stay abreast of fundamental changes like change in management, technological development, investment decisions, etc. The value investor wants to be sure that the fundamentals are still solid.
The Profit investor wants to keep an eye on the price movements of the stock to know when it gets to the expected price where he or she wants to take the profit.
Value investors sell stocks when they no longer trust the fundamentals of the company. Perhaps an untrustworthy man joins the board or debt is scaling up in proportion to equity and assets, or the company is not keeping up with industrial dynamics that may hinder its future growth. In such cases, a value investor may sell and invest in another company.
The profit investor sells when the stock has gotten to his or her projected price. He then buys again and sell and continues the process. For a profit investor, the fundamentals are not as relevant as the price movements (though in many cases, without a strong fundamental, there are no predictable price movements).
Here are some recommendations when it comes to stock investing:
- Be a Value Investor
- Combine a mix of growth stocks and dividend stocks depending on your investment goals
- Fundamental Analysis is critical. Do not buy shares because you have an emotional attachment to a company.
- Diversify your investments across the different sectors and industries in the economy
- Have concrete goals and plans. If you listen to other people’s advice, do so with your goals and plan right before your face. What is suitable for A is not ideal for B.
- Learn to identify opportunities rather than following the trend
- Commit to making data-backed decisions rather than emotionally charged decisions
- Use dollar-cost averaging to build up your positions in a stock gradually
- Don’t be afraid to sell your position in a company when there are good reasons to do so
- Monitor your stocks but do not over-monitor. It will save you from unnecessary panic
Stock Investing is one of the tried and tested ways to build wealth. Like every other thing, knowledge is at the foundation. Grow your knowledgebase on stock investing and ensure you make decisions that are in keeping with your investment goals and overall personal goals.