Jyothis George - Freeman Publications

Mutual fund vs stock; A guide to choosing to making the right choice

Posted on December 14, 2021 by Jyothis George

Here is the ultimate dilemma a beginner investor faces; ‘stocks or mutual funds?’ That is, which one should a beginner investor choose to invest his/her money in.

Before we move on to answer that question (Yes, I will settle that debate once and for all), let’s look at mutual funds and stocks in detail and understand how they make money.

Mutual funds vs stocks

First off, mutual funds and stocks are interconnected. Because most mutual funds are comprised of stocks. These mutual funds that are comprised of stocks are known as equity mutual funds.

Now, let’s lay out the differences between a mutual fund and a stock.

A mutual fund pools money from investors to buy securities. The securities mostly vary between stocks and other fixed-income securities like bonds. A stock represents a portion of the underlying company. By owning a stock, you’re owning a portion of the company.

Mutual funds have Net Asset value (NAV), which is the fund’s market value per share. Which is roughly the equivalent of the share price of an individual stock.

Mutual fund investors make money when they sell the shares of the fund. And if it is a mutual fund that is focused on dividend stocks, you might receive a dividend once in a while. The same goes for stocks; you make money when you sell the stock, and when the company issues dividends.

These are just a few of the basic differences between a mutual fund and a stock. However, when it comes to deciding which investment vehicle should you choose, it all comes down to one thing and one thing only.

How much money is it going to make?

And certainly, it’s not that simple. But your objective as an investor is to grow your money. So naturally, you should choose what’s best for that.

Keeping that in mind, let’s look at the two factors that determine your profit; returns and cost. The returns are the money you make from your investment. Cost is what you should be willing to spend to achieve the expected return. Cost includes both the money you spend towards fees and commissions and the time you spend on doing the necessary due diligence.

Let’s analyze mutual funds and stocks based on these factors.

Returns; Mutual funds vs stocks

Mutual funds pool in money from investors to buy assets – mostly stock. And they aim to maximize returns for the investor. Generally, mutual funds are actively managed funds. They are run by finance professionals who are known as mutual fund managers. A fund manager decides where to invest and how much to invest.

Stocks, on the other hand, can be bought by anyone with money and a brokerage account. And they can do that either passively or actively.

One of the factors that investors associate with returns is risk. Now, the amount of risk that an investor can tolerate varies from person to person. I am fine with having my stocks go down 30%-50% at times. I can live with that. But that might not be the case for every investor.

People mostly choose mutual funds as they see them as a less risky investment. But guess what? They also generate lower returns.

Individuals tend to assume that mutual funds are the better option. Especially in terms of returns, as they are managed by finance professionals. Well, let’s take a look at these numbers;

As you can see over the last 10 years, mutual funds have had an annual average return of 12.02%. Over the same period, S&P 500 has had an average return of 13.6%.

And there’s more.

Take a look at this data from S&P Dow Jones;

Over a 15 year period, 92% of large-cap mutual funds have failed to beat the market.

Yes, that’s right – 92%.

Don’t forget that this is despite paying the fund manager huge fees every year. This goes to say, if you choose mutual funds you’re likely to underperform the market in the long run. Mostly because mutual funds tend to be conservative about their investment choices. They care more about reducing the downside risk than growing money.

But that’s not the case with individual stocks. If you pick the right stocks for your investment strategy, you can enjoy significantly higher returns than the market average.

Take Apple, for example, a $1,000 investment made in June 2011 would be worth $11,628.19, as of June 2021. That’s a 1,062.82% gain in just 10 years.

Costs: Mutual funds vs stocks

Costs include both the money you spend towards fees and commissions, and the time you spend on research.

Mutual funds are created by financial institutions and regulated by the Securities and Exchange Commission. And they are run by financial professionals known as fund managers. They decide which companies to invest in. By investing in a mutual fund, you’re just following suit.

Also, every mutual fund has something called an expense ratio. You can think of it as a management fee. It is the amount you need to pay as fees for investing in the mutual fund. It is represented as a portion of your mutual fund investment. For example, if you invest $10,000 in a mutual fund, and the fund has an expense ratio of 2%, you’ll pay $200 annually towards fees.

The fees must be paid no matter what. Even if the fund is underperforming the market.

Stocks, on the other hand, don’t cost you much apart from the stock price itself. Earlier, there were all kinds of fees and commissions associated with buying stocks. But with the arrival of discount brokers like TD Ameritrade and WeBull, you can buy stocks with zero commission. And unlike mutual funds, you can choose your stocks.

And even if you don’t want to buy individual stocks, there are better alternatives to mutual funds. Take an index fund for example. Index funds are passively managed funds that track and index. Which means you’ll get the same returns as that of the market index. And fees are less compared to mutual funds. You could also go for exchange-traded funds (ETFs)

Time: Mutual fund vs stock

If we talk about time spent, researching stocks can take up quite a bit of time. Especially, if you’re relatively new to investing. But despite what the mainstream media tells you, you don’t need to know everything from the oil prices to the latest trends in the market. To successfully pick individual stocks you only have to know the basics of how a company operates. Specifically, how they make money and how they spend their money.

Of course, that’s not all. You would need to learn to find information from Annual Reports, Form 10-Ks, etc. But the point is, it can be done. You don’t need to have a degree in finance to do that. Just plain old common sense is enough.

However, it is true that mutual fund investments do not take up as much time as you need with researching individual stocks. But in the long term, it’s worth it, as your returns are likely to significantly outperform the market average and the returns from mutual funds.

And we shouldn’t forget taxes. Mutual funds are not particularly great for your capital gains taxes. Capital gains tax is generally incurred when you sell your investment and make a profit. But mutual funds buy and sell stocks throughout the year. That means, even if you don’t buy or sell your mutual fund shares, you’ll still incur taxes. Even when the mutual fund is not making good returns, you might incur capital gains taxes due to the nature of the fund.

But with stocks, you’ll only incur taxes when you sell stocks and when you receive dividends. And long term investments are taxed at a lower rate than short-term investments. So if you hold on to your investments longer, you’ll make more money and you can pay less in taxes.

Bottomline

Both stocks and mutual funds help you in building up a diversified portfolio. But the key difference is as a mutual fund investor you’re likely to underperform the market in the long run. Mainly due to high fees, and relatively poor returns.

But if you’re not sure about how you can start with individual companies, check out our 8-step Beginners Guide. It has a list of 20 stocks that you can confidently own for the next 20 years.

Dip buying; The truth about the buying the dip.

Posted on December 2, 2021 by Jyothis George

“Time in the market beats timing the market”

Most investors believe that the best time to buy stocks is during a downturn or a ‘dip’.

But the question is – is buying the dip a good long-term investment strategy?

The truth about ‘buy the dip’

First, let’s understand what it means to ‘buy the dip’.

A dip is a decline in stock prices, across the broad market. The price drop of individual stocks and the price drop of stocks in a specific sector are also referred to using ‘dip’.

A dip can be a decline of 5% or 50%. Buying the dip means buying stocks when the dip occurs. Stock prices plummet in a dip. So retail investors looking to ‘buy the dip’ purchase those stocks, whose prices have declined.

Investors do this with the belief that the stock’s price will rise soon back to its previous highs. That means, you get the stocks for a discount, and make money as soon as the stock price returns to its previous level.

Sounds like the perfect strategy, doesn’t it?

Before you answer that let’s look at how this strategy will play out in real life.

Buying the dip

Buying the dip perfectly aligns with the ‘buy low, sell high’ outlook. That’s one reason why a lot of people choose this strategy. But what they don’t realize is that market timing is nearly impossible. So it does not matter how experienced you are, you just can’t predict the ‘lows’ and ‘highs’ in the market.

Nevertheless, let’s see how buying the dip will play out in real life.

Suppose you have decided to buy stocks when the market dips at least 20% from its highs. The plan is to wait till the market declines 20%, and then load up all the stocks you’ve been waiting to buy.

But before that, here are some questions you’ll need to ask yourself.

How long does it take for the market to go down 20%?

Once you decide you’re going to invest only when the market goes down at least 20%, you’ll need to wait for that moment. And believe me, it’s going to take a long time before you witness a dip of that magnitude.

You see, price drops aren’t that common. Since 1965, there have been only 8 drawdowns of 20% or more in the United States, once every seven years on average. That means you’ll be sitting on the sidelines with piles of cash, waiting for the market to go down, while regular investors grow their money by consistently investing in the market.

And even when the market finally goes down and you jump in and buy stocks at a 20% discount, it won’t matter. Because while you were waiting for the dip, the market went up 80%. That means, even with a 20% discount, you’re buying stocks for a 60% premium.

Even when the market rebounds and returns to its highs, you’d only have made a profit of 20%, whereas long-term investors who had been in the market all this time, managed to grow their money by 80%.

What if the market keeps going down?

This is another question you need to ask yourself; what if the market keeps on going down even after you buy the dip? What will you do then?

No, this is not an unlikely scenario. It has happened in the past, and it’s likely to happen in the future.

Because it’s impossible to predict how low the market will go. So buying at the lowest point is not exactly possible. For all you know, a small dip might be a major market crash, and it might take quite some time for the market to recover. So if your idea is to make some quick profits by buying the dip, you’re most likely to end up losing your money.

How sure are you about the market bouncing back?

The whole point of buying the dip is the belief that the stocks will bounce back, and they will go even higher.

But you’re not buying the whole market, only individual stocks. So hoping your target stocks will bounce back along with the broad market, is not a sound investment strategy. If you don’t analyze the fundamentals of each stock you might end up holding stocks that might not go up in the near future. You need to look at factors like; how the dip/crash has affected the business, how the company plans to bounce back, are there any permanent damages, and more.

Consider the case of airlines after the pandemic. Airlines were one of the many industries that were hit by the pandemic. As countries went into lockdowns, travel came to a halt. And most airline stocks tanked in March 2020.

Now, imagine your excitement seeing this dip. You see this as the perfect opportunity to pick up some good airline stocks for a discounted price. Because, why not? The stocks will be up, once the restrictions are lifted, and people start flying again.

But if you dig deep enough, you’ll find that the pandemic has changed a lot about airline industries and specifically, the part where people fly. You see, airlines made the most money from business travels, and that has been replaced by Zoom. Also, ask yourself, is this going to be the last pandemic we’re going to see in our lifetime?

The point is, blindly jumping at the opportunity to buy a stock at a discount is never a good idea. Especially if you are not sure what caused the dip in the first place.

What if you miss the best days in the market?

Another reason why waiting on the sidelines is a bad idea.

According to this data going back to 1930, Bank of America found that if an investor missed the S&P 500′s 10 best days in each decade, total returns would be just 91%, significantly below the 14,962% return for investors who held steady through the downturns.

There you have it. The final nail in the coffin.

We’ve already established that it’s impossible to time the market accurately. So the only way to make sure you don’t miss the best days in the market is to stay in the market. That means, not sitting on the sidelines, but actively investing in the market. That’s your best shot at making sure you don’t miss out on the massive gains from the 10 best days.

What if you can’t buy when the dip occurs?

Yet another aspect that investors overlook; the psychology of investing.

“Buy the dip is one of those things that works well on paper, but it doesn’t work well in real life”, says Callie Cox, senior investment strategist with Ally Invest. “It’s something that I struggle with because as an investor, I want to buy the dip, but I’m human and sometimes I don’t feel good when the market’s going down’’, said Cox.

This is the truth. It’s hard to buy more stocks when everyone is selling. Because we are humans, and we are wired to follow the crowd. The bandwagon effect explains this. It is a psychological bias that causes people to think or act a certain way if they believe that others are doing the same.

That’s the reason why most investors when they go through dips in the market, do nothing. While many would sell portions of their portfolio, only a few have the stomach to buy more shares.

What to do instead?

The wise alternative would be to stay invested in the stock market. Only then you’ll be able to fully reap the benefits of compounding. You see, if you invest $10,000 in the market earning 5% a year, in 20 years it would be worth $26,533. If you can manage to get that to 10% a year, the investment would be $67,275, in the same period.

That is the reason Albert Einstein described compounding as the ‘greatest mathematical discovery of all time’. And the more time you stay invested, the more valuable the investment will be.

Dollar-cost averaging

Dollar-cost averaging is one of the popular methods you can use to invest consistently. It is a strategy where the same amount of dollars are invested at a regular, predetermined interval. For example, $100 every month for the next 20 years.

This can help you maintain consistency in your investments and reap the benefits of long-term compounded gains. You can also dollar-cost average into index funds or exchange-traded fund (ETFs).

Bottomline

If you’re going to invest, do it consistently. Don’t wait on the sidelines waiting to buy dips. As a long-term investor, you’re likely to witness major and minor dips along the way. If you can see it as an opportunity and buy more shares of the stocks you own – good. If not, that’s okay, just make sure you don’t sell in panic.

Now, everything is obvious in hindsight. It’s easy to look back at March 2020, and regret not entering the market in March. Don’t be fooled by these thoughts.

Stay in the market. Buy stocks whenever you can, dip or no dip.

If you would like to know more strategies that can help in an adverse situation in the market, check out our guide on Bear Market Investing.

Safety margin; How to ensure returns from your stocks

Posted on November 30, 2021November 30, 2021 by Jyothis George

“Value investing is trying to buy a dollar for fifty cents”

– Warren Buffett

The core principles of value investing revolve around the price at which an investor purchases securities. Because for value investors, what they buy is equally important as how much they buy it for.

That’s where the margin of safety comes in.

What is the margin of safety?

The margin of safety is a principle in value investing that encourages investors to buy stocks at a price significantly below their fair value. The term margin of safety was coined by Benjamin Graham, who is also known as the father of value investing. However, the term was popularized by his student and one of the most popular investors ever, Warren Buffett.

The margin of safety aims to reduce the downside risk of an investment, thereby increasing the chances of making a profit.

How does Margin of Safety work?

Calculating intrinsic value (also known as fair value) is the first step in determining the safety margin. It is calculated by taking various aspects of the underlying business into account; assets and earnings, management, industry outlook, etc.

Once you have the intrinsic value of a stock, you can set the margin of safety. The safety percentage varies from one investor to another, based on their risk tolerance. Some go for a margin of safety of 20%, meaning they set their target purchase price 20% below the stock’s intrinsic value. Meanwhile, some investors go for a higher margin of more than 50%.

Remember, it’s not 20% below its market price, but 20% below its intrinsic value. For example, suppose AMD trades at $100 a share, and as per your calculations, it has an intrinsic value of $80. So that means AMD is trading above its intrinsic value.

So an investor looking for a margin of safety of 20%, would set his/her target price at $64, 20% below its intrinsic value, $80. That means, the investor purchasing at $64 is likely to see an upside of more than 25%, as he has managed to buy the stock significantly lower than its market price.

However, it also means that the investor will need to wait for a while for the stock to come down to the discounted price of $64 from $100. At the same time, he also needs to make sure such a drop is not the result of deteriorating fundamentals.

Because often it could be due to a problem in the underlying business. If you go ahead and buy the discounted stock without re-analyzing the fundamentals you may end up in a value trap.

Using the Margin of safety

The margin of safety is incredibly useful in limiting downside risk. The margin of safety ignores the stock price. Instead, it looks at the intrinsic value of the stock and applies a discount on it, thus setting the target purchase price.

This highly increases your chance of making a profit from the stock. Take the case of AMD, for instance. AMD is currently trading at $100. If you can wait long enough to buy it at the price of $64, which is the target price as per margin of safety, you’ll enjoy a good profit from the stock.

At the same time, it also reduces the chance of incurring a loss. As you’re buying the stock for a price significantly below its market value, it’s unlikely that you’ll incur a loss.

Warren Buffet explains it perfectly; “When you build a bridge, you insist it can carry 30,000 pounds, but you only drive 10,000-pound trucks across it. And that same principle works in investing”.

Buffett is trying to say that you shouldn’t buy a stock that’s worth $100 for $90. You need to leave more room for human error in valuation, extreme volatility, or just bad luck in the market. So you buy it for $80 or $70, leaving sufficient room for error. And that’s how the margin of safety works.

Intrinsic value

To understand the margin of safety, let’s see how the intrinsic value of a stock is calculated. Some use discounted cash flow to calculate the intrinsic value, while some others take advantage of metrics such as Earning power value, absolute PE, or even the Graham formula.

But the truth is, intrinsic value is highly subjective. No matter how many variables you use, there’ll always be assumptions.

Hence, the margin of safety.

Because, what if the assumptions are wrong? How do you make sure that your assumptions don’t hurt your investment?

So you focus on the price you pay.

We make sure there is enough room to cushion any downfall, in the event our assumptions turn out to be wrong. So instead of trying to buy at its fair value, like regular investors, value investors apply a margin of safety of 20% – 30% and buy the stock.

Warren Buffett and Margin of safety

Even though Ben Graham coined the term, it was Buffett who popularized the concept.

The margin of safety perfectly aligns with the value investing philosophy Warren Buffett so profusely preaches. While value investing is aimed at finding undervalued stocks, the margin of safety acts as an additional cushion, to limit the downside.

The market price or share price has little or no significance when it comes to the margin of safety, It is calculated purely based on what it’s worth, that is intrinsic value. So even if the stock is currently trading below its intrinsic value, the margin of safety would still be applied to the intrinsic value.

Bottomline

The margin of safety is one of those concepts that most investors gladly ignore. Thanks to social media, investors these days only care about what’s hot – stocks and industries alike. But as a long-term investor, your objective is not to look for what’s hot. But look for stocks that can provide value to your portfolio. And that’s what value investing is all about.

And the margin of safety is will help you make sure you take care of the downside risk as well.

Happy investing!

And if you’d like to know the 20 stocks we think you can hold for the next 20 years, check out our bestselling book The 8-Step Beginner’s Guide to Value Investing.

What is a Moat and why is it important in investing?

Posted on October 5, 2021November 17, 2021 by Jyothis George

What do Amazon, Apple, and Google have in common?

Apart from being some of the largest technology companies in the world, of course.

They all have what Warren Buffet referred to as economic moats.

Competitive advantage – Moat

A company’s economic moat is a long-term competitive advantage a company has over the competing firms. An economic moat can be thought of as an intangible asset – you can’t see it, but they’re key in the success of a company. An economic moat is a durable competitive advantage that sets the company apart from its peers.

Think about the wide and deep trenches surrounding the medieval castles. It protected the castle and the kingdom from enemies. That’s where the word moat originated from.

Just like the trenches, the economic moat helps the company to protect its market share and long-term profits from its competing firms.

Why are moats important?

Having an economic moat is key to the success of a company.

Take Coca-Cola (KO) for example. Their secret recipe is just one of their economic moats. And with that recipe, Coca-Cola sold its soft drinks in every part of the world. And none of their competitors could imitate Coca-Cola’s success, since they didn’t know the recipe.

There have been hundreds of soft drink manufacturers around the world since Coca-Cola first came out. But none has managed to overcome or even imitate Coca-Cola’s success.

Economic moats can help companies dominate a market, resulting in a consistent increase in long-term profits.

As an investor, investing in companies with multiple economic moats is a fail-proof way to generate maximum profits in the long run. As these companies maintain their market share, their earnings will continue to rise, so will the stock price.

How are economic moats created?

Economic moats are created when a company is able to distinguish itself from the rest of its competitors. This distinct advantage could be anything from pricing power to high switching costs.

Walmart is a great example of an older form of an economic moat. By economies of scale, Sam Wolton (Founder of Walmart), was able to grow Walmart into a retail giant, with 10,500 stores spread across 24 countries.

Economies of scale are defined as the ability of a company to sell its products at the lowest possible cost. Walmart achieved this early on in the business, thanks to its large number of stores. The key being Walmart’s ability to buy the merchandise in bulk, at significantly lower prices. As for suppliers, doing business with Walmart meant greater exposure to their products. Besides, Walmart was buying merchandise in huge quantities, which even with a discount, was profitable for the suppliers.

And this in turn allowed Walmart to sell the products at a lower price than their competitors. Thus an economic moat was achieved through economies of scale.

Types of competitive advantages

Walmart’s example shows an earlier type of economic moat. With the rise of technology, in the last decade, economic moats have been created by leveraging different aspects of a business.

Here are some of them.

Network effect

A company, product, or service has a network effect when an increase in the number of users increases the value of its services. The value increases proportionally with the number of users.

An earlier form of network effect can be found on telephones. When telephones were first introduced, only a few people owned them. So there weren’t many people you could talk to using a telephone. But once more people started using it, the value of the telephone increased, as now there were more people you could talk to. So more people started buying telephones.

The same goes for social networks.

Facebook, for example, grew using this network effect. As more people started using Facebook, the company got more data on how people used the platform. That helped Facebook in making improvements, which in turn drove more people to the platform. This flywheel is the reason why Facebook has 2.85 billion users.

A network effect is an example of a wide economic moat. If a company has a wide economic moat, it means that its competitors will have a hard time entering or competing in the market.

On the other hand, if a company has a narrow economic moat, it means that the competitive advantage may not be sustainable. Or a competitor might be able to overcome the moat. An example of a narrow economic moat would be the one created with patents that expire in a year or so.

Cost advantage

We’ve already seen how Walmart used the cost advantage to become the retail giant it is today. Similarly, companies create moats using various advantages related to cost.

Amazon, for example, created a moat for Amazon Web Services (AWS) both using economies of scale and high switching costs. We’ve already discussed economies of scale, so let’s see what switching costs are.

Switching cost is the cost that a customer incurs when switching from an existing service to a new one. Consider the example of banks. Sure, there are no fees to be paid for switching from one bank to another. But imagine the struggles of having to transfer your entire portfolio of assets. And don’t forget the paperwork. Often, the hassle is simply isn’t worth it. Thus, once a customer gets accustomed to a bank, he/she is unlikely to switch.

And the same goes for AWS. Once you get your website and other services running on AWS servers, it simply isn’t worth switching. Remember, we’re talking about large amounts of data here. Besides, AWS provides you with everything you need; machine learning, analytics, AR/VR, robotics. And the more services you use, the more difficult it is to transition to a different cloud provider.

This has helped AWS capture market share, and keep it. Even in 2021, they continue to dominate the cloud computing market with a share of 32% compared to 19% for Microsoft’s Azure and 7% for Google Cloud.

Brand value

Companies can use their brand value to create a moat. Brand value is nothing but the perceived value of the company by the public. This brand recognition allows the company to charge a premium, without losing market share. This can be achieved through some form of unique value proposition, messaging, and culture.

And if they can use the brand value to create customer loyalty, it’s an added benefit. In fact, brand loyalty can ensure dominant market share and consistent revenue.

Case in point, Apple Inc.

Just to illustrate the power of Apple’s loyal customers, here is a survey by SellCell. According to the survey, 91.9% of iPhone owners plan to buy another iPhone when they next upgrade, up 1.4% from 2019.

So how exactly did Apple achieve this level of loyalty?

For starters, Apple always had a strong and unique value proposition; creating personal experiences with the help of technology. They weren’t just making smartphones and computers, they were creating iPhones and Macs.

You might argue that they are just fancy names for an average product.

But when their customers want to buy a smartphone they don’t go like “I want this because it has 4 GB RAM, Quad-core processor, and 64 GB internal storage. Instead, they think; “I want this because it’s an iPhone.

Moreover, Apple created its brand around emotion. It got to the point where having an iPhone makes customers feel sophisticated. That’s the reason Apple continues to dominate the smartphone market even when there are better phones in the market, both in terms of technology and price.

This brand value allows Apple to charge a premium price, without losing market share to its competitors. Owing to that, iPhone sales contribute to half or more than half of Apple’s overall sales revenue, in recent years. It accounted for 48.6% of Apple’s total revenue in the third quarter of the company’s fiscal year 2021.

Intellectual property

While some companies build their brands through brand value and cost advantages others do so by leveraging internal resources, expertise, and legal protections.

These intangible assets are referred to as intellectual property.

Intellectual properties include patents, licenses, unique technology, etc. that are legally protected by intellectual property laws. This prevents competitors from replicating or using those properties. This allows companies to use these properties to create products or services, which can bring in a lot of revenue, as the competitors can’t replicate it.

Intellectual properties also include any form of copyrights and trademarks. For example, Disney has a lot of intellectual property in the form of all the animated characters it has created over the years. Mickey Mouse, one of the most popular characters in the Disney Universe, has been bringing in revenue from merchandise sales even years after the show ended.

Qualcomm is another example of a company that created a moat with intellectual property. The company has a massive patent portfolio with over 130,000 issued patents and patent applications around the world. They achieved this through huge and consistent investments in R&D over the years. The patents are mostly related to technology, such as 5G, wi-fi, Bluetooth, and mobile operating systems. This powerful moat has enabled them in achieving a 40% market share in baseband processors.

Qualcomm also licenses these technologies to other companies. And that has brought a huge source of revenue over the years. It is also a highly profitable business as the costs are limited. Qualcomm’s licensing division reported over $5 billion in revenue in 2020.

Identifying Moats

It is often difficult to identify an economic moat when it is being created. It becomes more clear in hindsight, as the company reaches major heights. But still, if you observe closely, you will be able to identify the significant advantage of a company.

An important aspect that distinguishes an advantage from a moat, is sustainability. The moat should be sustainable. If it is something competitors can replicate, the moat wouldn’t last long. And the longer the company can keep the moat, the greater the profits. So whenever looking at a company make sure the competitive advantage is sustainable.

An efficient products and services ecosystem is another sign that a company might be creating a moat for itself. Especially an ecosystem that benefits from the network effect that we discussed earlier. This is more often found in internet companies.

Another sign that a company is achieving a moat, is when the name of the product or service becomes a verb, or sometimes the category itself. Take Google for example. Nobody search for stuff on the internet anymore – they ‘Google’ it.

Bottomline

Successful companies are built on sustainable competitive advantages. So as an investor it makes perfect sense in looking to companies with economic moats. That’s not to say that every company that does have a moat will be a bad investment. Just that investing in companies with a moat increases the odds of substantial profits from the investment.

As a comprehensive continuation to this article, we’ll soon be releasing a book on Moats; how to identify a moat while it is being created, how to approach companies with an established moat, etc.

To make sure you don’t miss out on the book, join our newsletter here.

What is ETF? Meaning, function and why you need it

Posted on September 22, 2021November 17, 2021 by Jyothis George

The first exchange-traded fund (ETF) was launched in 1993.

Fast forward to date, and the global ETF assets stand at a whopping $9.1 trillion.

In 2020 alone, investors poured more than $730 billion into ETFs.

So what makes ETFs so popular among investors?

Exchange-traded fund (ETF)

Exchange-traded funds (ETFs) are tradable securities that track an index, commodity, sector, currency, or other assets. They are called exchange-traded funds, as they are traded on the stock exchange, just like stocks. And that allows investors to buy and sell ETFs, like stocks.

To understand ETFs better, imagine you’re grocery shopping. Now, you can either fill your basket with the essentials by walking down the aisles of the supermarket, finding each of the items, and adding it to your basket. Or you can simply buy one of those pre-filled baskets that have all the essential groceries.

ETFs are just like these pre-filled baskets, but for stocks. And unlike mutual funds, ETF shares can be bought and sold using your brokerage account, just like you would do with stocks.

ETFs can be structured to track anything from the price of a commodity to a collection of tradable securities. To do this, the fund will own the assets it is supposed to track. When it comes to tracking indexes, ETFs work almost the same way, as a low-cost index fund.

For example, if an ETF needs to track the performance of the S&P 500, the fund will buy stocks of all the companies in the S&P 500 and allocate them accordingly. So if you buy a share of this particular ETF, you’ll have invested in all the companies in S&P 500.

ETFs can have hundreds of assets in their holdings, to track stocks across various industries. Or it can focus on a particular industry or sector.

A very popular exchange-traded fund in the US is the SPDR S&P 500 ETF (SPY), which tracks the S&P 500 Index.

The popularity of Exchange-traded funds

As you can tell from the chart, the popularity of ETFs has risen rapidly over the years.

So what makes ETFs so popular?

Ease of use

ETFs are especially popular among newer investors. Most of them would start with a broad market ETF like SPY rather than picking individual stocks.

Why? It’s an easy choice.

Having to go through each individual stock deciding whether it’s the right choice for them, is intimidating to most newer investors. Whereas with ETFs, you’re instantly investing your money in the largest companies in the market.

ETFs trade on exchanges with ticker symbols similar to stocks. That makes it really easy to find them with a brokerage account.

Diversification

Investing in ETFs brings in immediate diversification.

As we’ve discussed earlier, ETFs are a basket of stocks. So buying a single ETF share will ensure that you’re investing in multiple companies. And if it is a broad market ETF, your investment will be spread across companies in different sectors and industries. That helps in decreasing volatility.

Because it’s highly unlikely that companies across all sectors will go down at the same time.

Also, for someone who picks individual stocks, ETFs can help in getting exposure to a certain sector, they might not be familiar with. For example, if you believe that the marijuana industry has significant room for growth, but you’re not quite sure which company to pick, choosing an ETF that focuses on marijuana stocks can save you time, and still make sure you don’t miss out on the industry winners.

Passive investing

Another advantage of ETFs is that you don’t need to frequently intervene with your assets. You can invest your money in a broad market ETF and forget all about it, and still grow your portfolio.

In many instances, these constant interventions and changes are the reason people lose money in the markets.

And the fund itself is passively managed. Meaning ETFs are generally automated to imitate changes in the underlying index/asset it tracks. Often, that results in having almost the same performance as that of the underlying index.

Having said that, there are also actively managed ETFs. These are run by professionals who make changes to the fund’s holdings more often. As a result, the fees tend to be higher when compared to passive ETFs. ARK Innovation ETF (ARKK) is an example of an actively managed ETF.

In general, most ETFs tend to be passively managed.

Low cost and commissions

This is a major factor in the wide popularity of ETFs. It’s cheap to invest in them.

The thing with investment vehicles is that they’ll charge you a substantial amount, for allowing you to invest in them. Actively managed mutual funds, for example, charge anywhere from 0.5% – 2% of your investment, annually.

But not ETFs.

On average, ETFs tend to charge anywhere between 0.02% – 0.75%.

You might wonder why we’re fretting over such a small percentage difference. After all, mutual funds are managed by finance professionals – they must know what they’re doing.

Well, think again.

A study by Vanguard found that only 18% of active mutual fund managers beat their benchmarks over a 15-year period. And, of these outperforming managers, 97% of them experienced at least five years of underperformance.

So basically, when choosing to invest in a mutual fund, you’re paying them huge sums of money every year, only to underperform the market.

With ETFs however, that’s not the case.

Sure, you might not beat the market. But you’ll likely match its performance every year. And believe me, you’ll be far ahead of most investors out there.

Different types of ETFs

As I said, there are ETFs for almost every asset, sector, and industry. Let’s look at some popular types.

Stock ETF

These are baskets of stocks that focus on a specific industry or sector. This also includes broad market ETFs such as SPY, which tracks the S&P 500, thereby tracking the performance of the 500 largest companies in the US. As illustrated before, stock ETFs have lower fees when compared to stock mutual funds.

Industry ETF

These ETFs are also stock-based. However, industry ETFs focus on a particular industry or sector (known as sector ETFs) rather than the broad market. This helps investors in getting exposure to an industry, which they might not be familiar. Especially with high-growth industries like technology, investors might be confused as to where they should invest.

So instead of looking for a specific company, they can invest in an ETF that focuses on major technology companies out there, making sure they don’t miss out.

Bond ETF

It’s what the name says – an ETF for bonds. Bond ETFs hold various kinds of bonds such as treasury bonds, corporate bonds, and municipal bonds. Their income distribution depends on the performance of their underlying assets. Investors generally choose bond ETFs, when they are looking for regular income from their investments.

Commodity ETF

These ETFs track the price of a commodity like gold or crude oil. These funds can be used to hedge your portfolio from downturns in the stock market. It is also far better than owning the physical commodity, as it involves a lot of complications. Commodity ETFs invest in all kinds of commodities.

For example, the popular coffee ETF in the US is iPath Dow Jones-UBS Coffee Subindex Total Return ETN (JO).

Inverse ETF

This is a different kind of ETF. While most funds are trying to capitalize on the price appreciation of underlying assets, inverse ETFs do the quite opposite. They aim to earn gains when the underlying asset goes down. This is done using something called shorting.

ETFs vs Stocks

ETFs and stocks are inseparably linked.

ETFs have lots of similarities with stocks; how they can be bought and sold, ticker symbols, etc. More importantly, the majority of the ETFs are made of stocks.

As for which of these is the better investment choice, I would say that’s entirely up to you.

ETFs can be helpful if you’re a complete beginner and don’t know where to start. Or if you do not have the time to spend picking individual stocks, ETFs might be the ideal choice for you.

You may also choose ETFs as a way of getting exposure to industries that are unfamiliar to you. Thereby enhancing your portfolio and ensuring diversification.

ETFs vs Mutual Funds

Cost

To iterate what we have discussed before, ETFs have several advantages over mutual funds.

ETFs are certainly cheaper. On average you’ll be charged anywhere between $75-$200 a year, for every $10,000 you invest in mutual funds. Whereas in ETFs, you’ll only be charged $2 – $20 a year, for the same investment.

This is because mutual funds are actively managed by a finance professional who is constantly in the pursuit of beating the market. Yet, over the past 15 years, only 1 in 13 managers have succeeded in doing so.

Tax Efficiency

And ETFs are more tax-efficient than mutual funds.

Generally, when you sell shares and realize the gains, you’ll incur capital gains taxes, which will be taxed depending on how long you’ve held the assets.

ETFs are passively managed. So buying and selling within the fund is less. However, as mutual funds are actively managed there are more buying and selling shares. This can incur taxes.

This means, even if you don’t sell any mutual fund shares, you might still incur taxes due to the nature of how mutual funds work.

Bottomline

ETFs are your go-to choice if you are a complete beginner, or if you don’t have the time to do due diligence in individual stocks. ETFs allow you to get started with investing. And for someone who has a portfolio of individual stocks, it helps you in diversifying your assets and getting exposure to different sectors.

However, it is important to know that your returns will be average. You might never beat the market.

But if you can put aside 20 mins a day, you could potentially generate substantial returns and beat the market year over year, by choosing individual stocks.

Check out the workshop to learn more.

Book value; What it means to investors in 2021

Posted on September 2, 2021November 17, 2021 by Jyothis George

When it comes to valuing a company and deciding whether it would be a good investment or not, things can get a little tricky. Of course, there are a lot of metrics you can look at, but it can be intimidating if you’re not sure what you’re looking at.

For instance, you’ve probably heard about the market cap of a company. Most investors look at this metric to understand how large a company is.

But there’s another metric you can look at, which gives you an exact picture, of what a company is worth. It’s called the book value of a company.

Let’s look at it in detail.

Book Value of a company

The book value (also known as net book value) of a company is, simply its assets minus its liabilities. It tells you how much the company is worth as per the company’s balance sheet.

Book value can also be seen as the amount left after paying off its liabilities, in the event of a liquidation.

Let’s say you invest in a company, and a year later the company closes down its business. As an investor, you have a right to claim a portion of the company’s assets. Instead of giving you your share of assets, they’ll sell off all the assets first. The company’s assets will be liquidated (sold off) and using the money, all the liabilities the company has incurred will be paid off. What’s left will be distributed to the shareholders, including you.

This total amount the shareholders will receive after paying off the liabilities is referred to as the book value of the company. In other words, a company’s book value is its basic net worth.

To easily calculate the book value, deduct the total liabilities a company has, from its total assets.

Book Value Formula: Assets – liabilities

For example, Apple Inc. (AAPL) has total assets of $323.88 billion and total liabilities of $258.54 billion. So their book value is $65.33 billion ($323.88 billion – $258.54 billion).

In the company’s balance sheet, you find the same number listed as shareholders’ equity.

Market value and Enterprise value

Now, book value is different from market capitalization or enterprise value. Market cap is the total value of a company’s outstanding shares. It is the perceived value of the company by the investors. For example, Fiverr has a current market price of $174.65, with 35.84 million shares outstanding. So that makes Fiverr’s market cap around $6.26 billion ($174.65 * 35,840,000).

Whereas enterprise value will be calculated in a different way. Enterprise value is the theoretical takeover price of a company. So it is calculated by adding its market value, and liabilities together and subtracting cash the company has. So in the case of Fiverr, that’s ($6.26 billion + $380.21 million) – $441.84 million. That gives Fiverr an enterprise value of $6.28 billion.

Now you see how these metrics are all about the value of the company still have entirely different values.

Components of Book value

A company’s book value is the value of the business according to its accounts (books). It is the net asset value of the company. This is seen from the perspective of what would the investors get if the company was liquidated. So that’s after liquidating all the assets and paying off the liabilities.

Total Assets

Assets include short and long-term investments, cash and cash equivalents, and all other kinds of financial assets. It also includes physical assets such as plants, equipment, and machinery.

Intangible assets such as patents, copyrights, and other intellectual property are also considered under total assets, but most often due to their intangible nature, cannot be represented in the company’s balance sheet.

Total liabilities

Liabilities include short and long-term debt, accounts payable, deferred taxes, and other obligations.

In a healthy balance sheet, the assets should be more than liabilities.

Using Book Value in valuations

All of this information wouldn’t mean anything unless we can use it in valuing companies.

So, let’s take a look at how we can do that.

Book value per share

Book value per share is calculated by dividing the book value of a company by the number of shares outstanding. So in the case of Fiverr, the book value per share would be $9.52.

Price-to-Book ratio (P/B ratio)

This is one of the oldest metrics used by investors in valuing a company. The price to book ratio is calculated by dividing a company’s stock price by its book value per share. So if a company has a share price of $50 and it has a book value per share of $25, then the P/B ratio would be 2.

Limitations of using Book value

Like I mentioned above, book value is one of the oldest metrics used by investors. It was more suited for those days when most of the company’s assets could be accounted for on its balance sheet.

Today, however, that’s not the case.

Especially with modern companies, a lot of their assets are intangible in the form of brand value (Apple), patents (Qualcomm), data (Google), etc.

So when calculating ratios such as the Price to book ratio, the company might seem significantly overvalued. And that can often discourage investors, when in fact, a lot of their assets just cannot be quantified.

Another factor that should be considered while valuing a company is its profitability. A company with an excellent product and a growing business is most likely a good investment. The stock might be trading above its book value, but that’s just because profitability and future growth are taken into account by the investors.

This is the reason you should look at more metrics when valuing a company, and not restrict yourself to one specific metric.

Value investing and Book value

Value investors are in constant pursuit of undervalued stocks. P/B ratio used to be the guiding light for value investors, as the metric immediately revealed whether a stock was undervalued.

But not anymore.

Value investing has evolved over the years, and what exactly constitutes value investing has been a topic for discussion in the investing community. In a time where most companies have high valuations even before they are profitable, checking the book value to see whether the stock is undervalued, might not be a smart move. Especially when you considered the increasing importance of intangible assets.

Value investors, today, look at more relevant metrics and they look at the sector in which the company is. Because companies in certain industries can have high P/B ratios compared to other industries. For example, internet companies.

Bottomline

There’s no doubt that book value is an important metric in a company’s valuation. But it should not be considered as the key to unlocking undervalued stocks. It’s always better to look at more metrics before you arrive at a conclusion. As for comparison, look for companies in the same sector, that’ll give you a better idea.

And remember, it’s better late than never. So if you haven’t started investing yet, start today. Meanwhile, here’s a guide to help you do that – The 8-Step Beginner’s Guide to Value Investing.

Why do we need the stock market? Function and importance

Posted on August 25, 2021October 29, 2021 by Jyothis George

The answer is simple.

The stock market provides companies access to money.

That is the primary reason we need stock markets.

But that’s not the only reason.

Let’s take a look at what constitutes a stock market and why do we need it.

What are stocks?

Before we dive deeper into the stock market, it’s essential to understand stocks. Thankfully, it’s not that hard.

Let’s say four friends wanted to start a company, so they put in equal amounts of money for the initial capital. All of them will be given shares that represent the ownership of the company.

The number of shares each person will receive depend on the amount of money they put in. In this case, they all will receive the same number of shares as all of them put in equal amounts of money.

Owning shares means you have a chance of receiving a portion of the profits the company might make in the future. Now, this is not guaranteed. Because the company might never make profits, and even if they do, they might decide not to distribute profits among shareholders.

But if the company decides to distribute profits, each shareholder will receive a portion of the profits, in proportion to the number of shares they own.

The company always keeps track of who owns its shares and how many. So that if in future they decide to pay out profits as dividends they’ll know who to pay.

And the stock is transferable. Why is that so important?

Because it means that if you own stock shares of one company, you can hand them over to another individual or organization, in exchange for money. You can also gift your stock shares to your friends or family, or your children could inherit them.

The stock market exists because the stock is transferable.

Why would someone buy stocks?

Individuals invest in companies (by buying shares) to make profits.

When you invest in a company, there are two ways you can potentially make a profit. The first one is through capital appreciation. That means selling shares for a price, more than you bought them for, and pocketing the difference.

Over time, stocks tend to rise in value. The S&P 500 – an index that tracks the performance of the stocks of the 500 largest companies in the US – has a produced an average annual return of 13.6% in the last 10 years. And investors make money off of this price appreciation.

The second is through cash payouts called dividends.

Like I mentioned earlier, companies might distribute a portion of their profits among shareholders. The amount each shareholder will receive will be relative to the number of shares he/she owns. These payouts can act as an active income from your investments.

There are many more reasons why people buy stocks, but these are the most common.

What is the stock market?

The stock market serves as a marketplace for stocks.

The stock market refers to financial institutions that facilitate the transfer of shares from one party to another. The stock market makes it easy for people to buy and sell stock shares.

Why is this so important?

Every transaction – whether it’s goods, services, or money, involves a certain level of uncertainty. The buyer might be uncertain about the quality of the goods, whereas the seller might be worried whether the buyer will pay in time.

The same goes for transactions of shares. The stock market lowers that uncertainly surrounding the buying and selling of shares, by providing a common marketplace for all participants – known as stock exchanges.

If you would like to know more about how the stock market works, read this article.

Stock exchange

A stock exchange is where the trading (buying and selling) of the shares happens. Market participants (individual and institutional investors) use the stock exchange to place orders to buy or sell. All the orders (to buy or sell shares) are processed at the stock exchange, and the shares and the cash is delivered to the respective participant.

New York Stock Exchange (NYSE) is one of the oldest and largest stock exchanges in the world. Stock exchanges in the US are regulated by the Securities and Exchange Commission (SEC). The institution oversees the smooth functioning of exchanges.

The stock market makes sure that you are free to buy and sell shares whenever you want. Institutions like the SEC lowers the uncertainty around investing in companies and protect investors from fraud and manipulation.

What if there was no stock market?

Buying and selling stocks won’t be easy

To begin with, investors would have a hard time buying and selling stocks. The whole investing process will be complex and expensive. You would need to approach the companies directly to buy shares. And every time you want to sell shares you will need to find a buyer on your own.

As a result, people will be very unwilling to invest in companies as they are not sure whether or not they can get their money back, let alone profits.

Funds will be hard to access

It’s worse for companies.

An initial public offering (IPO) is when a company’s shares are made available to the public to buy for the first time. An IPO has the potential to bring in a lot of funds to a company. And if the company is already well known at the time of its IPO, the company will be able to raise a significant amount of money.

But this won’t happen if there is no stock market.

And companies might decide to issue new shares in the future to raise capital. This opportunity gives them access to funds from the public, and they can access them as and when it seems necessary.

Needless to say, if there is no stock market, companies can forget about these funds.

So they’ll need to find and approach investors who would be willing to provide funds in exchange for money. It will be time-consuming and expensive. And companies won’t have access to large amounts of money. So they’ll be forced to look at alternate sources for capital.

This means they’ll have to take on debt; they’ll need to borrow money – large amounts, to grow the business. And that could be a burden later on, especially for newer businesses.

And due to the lack of sufficient capital, company growth will substantially slow down. As it would be hard for them to expand their business, introduce new products/services, or invest in R&D without enough money to spare. Also, if it’s a competitive market, the company might end up losing its customers and could potentially go out of business.

Now, let’s talk about the overall economy.

Economy and the stock market

Many of the largest publicly traded companies we see today grew their businesses using the funds they raised from the public through the stock market. And these companies might not exist today if it wasn’t for an active stock market and a large number of enthusiastic investors.

When these companies grow, naturally there will be more revenue, which means they’ll hire more people, which will grow the business. All of this means that the government will receive more money in taxes.

Don’t believe me? Check this out;

The US government received $230.2 billion in corporate taxes, in FY2019. Most of that money could disappear if there was no stock market.

So no stock market means fewer jobs, less income, fewer taxes, all of which will result in a weaker economy.

Bottomline

Financial markets are viewed as an indicator of the overall economy of the country; an active stock market shows a robust economy and vice versa. An active stock market can help individuals grow their wealth and companies grow their businesses.

To know more about how you can grow your wealth through investing, check out our bestseller The 8-Step Beginner’s Guide to Value Investing.

Enterprise value; Definition, importance, and calculation

Posted on August 15, 2021October 29, 2021 by Jyothis George

What is enterprise value (EV)?

In its simplest form, enterprise value (EV) is the theoretical takeover price of a company. Meaning, it is the company’s market value, which you need to pay for acquiring it.

A company’s enterprise value is seen as a comprehensive alternative to its market cap and is mostly used in Mergers and acquisitions, as it gives an estimate of how much the buying entity must pay to take over the company. Enterprise value is a better alternative to market cap since it considers both the debt and the cash on the company’s balance sheet.

This is is how you can calculate enterprise value –

Enterprise Value = (Market cap + debt) – cash

Market capitalization (also known as equity value) is the company’s perceived value by the stock market participants. It is calculated by multiplying the company’s stock price by the number of outstanding shares (shares that are available to the public to trade). And that is basically the total value of all the shareholder’s stakes in the company. So if you want to take over the whole company, that’s what you need to buy first.

Second, comes debt. Once you acquire the company, whatever debt the company has, is your responsibility, and would need to pay that off eventually. So that’s is added to the total cost of acquisition.

The next is cash. And that’s deducted from the total cost. Because whatever cash the company has, it’s yours once you take over the company. That cash can be used to repay some of the debt. So it makes sense to deduct it from the total amount you need to pay for the company.

Components of Enterprise value

Market capitalization

Market capitalization can be calculated by multiplying the number of outstanding shares by the share price.

For example, if a company has 50 million shares outstanding, and the share price is $100, then the market cap is $5 billion (50 million shares x $100 per share).

Preferred stock

Preferred stock is technically equity. But depending on how it is issued it can also act as debt. For example, a preferred stock that must be redeemed at a future date at a certain price is, by all definitions, debt. And in most instances, preferred stockholders are entitled to a larger fixed dividend compared to common stockholders. They also have a higher priority in asset and earnings claims.

Since the preferred stock has a larger claim on the business, the holders must be repaid in a takeover. So similar to debt, it is taken into account when calculating the enterprise value.

Debt

Acquiring a company equals, acquiring everything the company owns and owes.

This includes both long-term and short-term debt. So once you’ve taken over a company, it is your responsibility to pay it back to the creditors. Let’s say a company is worth $50 million, and the company has $10 million in debt. So even after you pay $50 million to buy the company, you still need to pay off the debt, which is an additional $10 million. So your total cost is $60 million.

This is the reason debt is added to the enterprise value of a company.

Cash

When you acquire a company, the cash is yours to use, just like the debt is yours to pay.

This includes cash in the bank and other cash equivalents, like short-term debt and marketable securities. Cash reduces the acquisition price. As cash is the most liquid asset the company owns, it is assumed that the buyer will use it immediately to pay off a portion of the debt. So cash is deducted from the enterprise value.

What is the use of Enterprise value?

Enterprise value in investing

Enterprise value is used by investors to value a company. Especially investors who follow the value investing strategy, often use enterprise value as a metric to compare companies in the same industry.

Investors also use the EV/EBITDA also known as the EV multiple, in valuing a company. EBITDA stands for earnings before interest, tax, depreciation, and amortization. EV multiple is often used as an alternative to the traditional P/E ratio.

Unlike the P/E ratio, EV/EBITDA takes into account debt and the cash the company has.

Enterprise value in Mergers and Acquisitions

Enterprise value is very useful in mergers and acquisitions. In fact, enterprise value is considered a more accurate measure of the value of a company compared to its market cap. The reason being, enterprise value takes debt into account, which must be paid by the buyer when acquiring a company.

Because two similar companies with the same market cap can have different enterprise values.

If a company has a market capitalization of $100 million and $10 million in cash and no debt, its enterprise value will be $90 million ($100 million + zero debt – $10 million cash).

Meanwhile, an identical company that has a market cap of $100 million and $20 million in debt, and $5 million in cash, will have a market cap of $115 million ($100 million + $20 million – $5 million).

In this scenario, we can see that the first company is cheaper to acquire, since it does not have any debt to pay off, and they have spare cash.

Consider the examples of Advanced Micro Devices (AMD) American Airlines (AAL). AMD has an enterprise value of $130 billion which is less than its market cap ($134 billion). Whereas in the case of AAL, the company has a market cap of $12.8 billion and an enterprise value of $43.19 billion – almost 4x its market cap!

The reason is American airlines have a lot of debt and as a result, you need to pay a lot more than its market value in order to acquire the company. AMD, however, has very little debt, and as a result, has an acquisition price (enterprise value) that is less than its market cap.

And as you can see, enterprise values can also be used to compare companies with different capital structures. Capital structure is the combination of capital that is used to fund a company. That includes shareholder equity, debt, and preferred stock. And a difference in capital structures can affect the enterprise value.

There are some downsides to using enterprise value in the valuation of a company. When using enterprise value, a company with a relatively high amount of debt might be seen as less of a prospect than a company with less debt. What many fail to realize is that their competitors also have similar levels of debt.

A better way to use enterprise value when valuing a company is to look at other companies in the same industry.

How can you use Enterprise value?

Even if you don’t want to take over a company, you can use EV multiple in valuing companies. Remember, it is a more accurate representation of what a particular company is worth. And you can use it to identify whether the company is overvalued or undervalued.

A low ratio relative to peers might indicate that the company might be undervalued, and a higher ratio means the company might be overvalued. Then again, companies in high-growth industries tend to have a higher ratio compared to companies in slow-growth industries.

Ideally, when using EV multiple, you should compare the ratio of a company with similar companies in the same industry.

Key Takeaways

Enterprise value is the total takeover price of the company. It includes the equity and debt capital of the company.
It is mostly used in Mergers and acquisitions as it provides an accurate cost of acquiring a company.
Enterprise value can also be used by individual investors in comparing companies within an industry.

To learn more about valuing companies, check out our bestselling book The 8-Step Beginner’s Guide to Value Investing.

Invest in index funds; A complete beginners guide for 2021

Posted on July 26, 2021October 29, 2021 by Jyothis George

“Don’t look for the needle in the haystack. Just buy the haystack!”

That’s John Bogle, on the importance of index funds.

John Bogle was the founder and Chief Executive of The Vanguard Group. Most of all, he was the biggest proponent of index funds.

To understand how big of a deal this introduction was, you need to know what an index fund is, and how they have helped individuals invest, over the years.

What is an index fund?

An index fund (also known as an index mutual fund) is a fund that tracks a market index. A market index is a hypothetical portfolio of stocks that represent a certain section of the stock market. Often market indices represent the stock market as a whole. For example, S&P 500 is the most popular index in the US. It tracks the 500 largest public companies in the US. When you hear people say the market was down today, they’re likely to be referring to a broad market index.

So an index fund that tracks the S&P 500 will have shares of all the 500 companies in the index. By doing so, the index fund is trying to replicate the performance of the market index.

Index mutual funds are passively managed. The funds are automated to make adjustments according to the shifts in value in the underlying companies.

Since the funds are not actively managed, the fees tend to be lower than actively managed funds. On the other hand, actively managed funds usually have a fund manager and a team of analysts, who are constantly trying to find new opportunities, in an attempt to beat the market. As a result, they usually have higher fees associated with them.

Traditionally, there are two types of index funds – Stock index funds and bond index funds. As the name goes, stock index funds track a stock market index (like S&P 500), a bond index fund tracks a bond market index (a market index that tracks the price of bonds, like the Bloomberg Barclays U.S. Aggregate Bond Index).

Why are index funds popular?

These are some of the reasons why index funds are so popular.

Easy to invest

Most individuals put off investing because they don’t have the time to do the research that is essential in making informed investment decisions. Also, many have a hard time understanding all the jargon that comes with the stock market. So people put off investing altogether. This is where index funds come in.

Index funds provide you a hands-off approach to investing. Even if you have no clue how the stock markets work, you could invest in index funds and still get around 8%-10% return annually. Because that’s the average annual return of the S&P 500, during the last 10 years. And since the index funds by definition are the market average, that’s the return you will receive.

Low-cost index funds

This is another aspect that makes index funds so great. Index funds are less expensive compared to other funds. On average, low-cost index funds annually charge 0.02% – 0.2% of your total investment. Whereas mutual funds charge 0.5% – 2.5% of your investment.

You must be wondering why we’re losing our heads over some fractions of a percentage. Do they really matter?

You bet they do.

In fact, these small fractions can have a massive difference in the long run. Consider this; assume you invest $10,000 in two funds that charge 0.5% and 2.5% of your investment, respectively. Assuming you get an annual return of 10%, this is how your investments will look like in 20 years.

As the table illustrates, the $10,000 invested in the fund that charges 2.5%, will be worth $46,022 in 20 years. Not bad, right?

Actually, it is bad.

Not in itself, but compared to the other $10,000 invested in an index fund that charges 0.5%. After 20 years, it would be worth $61,159 – a 33% improvement over the more expensive fund.

There’s another reason why passively managed index funds are the better option when compared to actively managed funds. A 2018 report from S&P Dow Jones Indices suggests that more than 92 percent of active fund managers in large companies were unable to beat the market over a 15-year period.

This means with actively managed funds, you’re paying more money, only to underperform the market.

Diversification

A major advantage of investing in index funds is that you are diversifying your investments. As I mentioned, market indices usually consist of several companies that belong to different industries and sectors. So with index funds, you’re diversified from the get-go. For example, SPY is an exchange-traded fund (ETF) that tracks the S&P 500. ETFs work basically the same way an index fund does. So when you buy one share of SPY, you own shares of 500 companies.

This immediate diversification leads to less risk. As your investment is sprawled across companies from different sectors, you’re less likely to suffer losses. And even if you do, your losses should be balanced by your gains from other stocks in the fund.

Remember the quote at the beginning? That’s another reason why investors choose index funds. Instead of looking for the next big winner among thousands of stocks (needle in hay), you can buy an index fund (the hay), and make sure that you don’t miss out on the winners.

Disadvantages of index funds

Since we talked about all the good things that make index funds a popular form of investment, I feel like we should look at the other side of the coin too.

When it comes to the demerits of index funds, these are what I can think of;

Average returns

With index funds, you’ll only ever make average returns. That is because the performance of the market index is considered the market average. Since that is the performance your index fund tries to match, you’ll end up with the same returns. So it’s unlikely that you’ll ever beat the market.

Less choice with stocks

When you invest in an index fund, you’ll be investing in several different stocks; you might be interested in some of those, not so much with other ones. Your choice is limited with index funds. You’ll likely end up owning stock you’d rather not own.

Moreover, you might miss out on certain stocks that may not be a part of any index, but you believe has a huge potential.

How to invest in index funds?

The first step to investing in an index fund is choosing one.

A couple of things to be kept in mind while choosing an index fund are expense ratio, tracking error, and the index that it tracks.

Underlying index

When you’re investing in an index fund, you’re basically investing in the underlying index. So it’s important to identify which index is worth investing in. Generally, people go with index funds that track a broad market index such as the S&P 500, or the Dow Jones Industrial Average (DJIA). You also have the option to choose indices that focus on specific sectors. Even better, you have index funds that track the index of global stocks – like Vanguard Total International Stock Market (NASDAQ: VXUS).

Expense ratio

It is the amount you’ll be charged annually, for investing in the fund. It is expressed as the percentage of the amount you invest. For example, if you invest $10,000 into a fund with an expense ratio of 0.02%, you’ll be charged $2 every year. Like I mentioned earlier, the average annual expense ratio for index funds is around 0.02% – 0.2%.

As illustrated earlier in the article, the more the expense ratio, the less the returns.

Tracking difference

Basically, tracking difference is the difference in the index fund’s performance to that of the underlying index. If a market index produces an annual return of 10%, and the index fund produces 9.8%, the tracking difference is -0.2% (9.8% – 10%).

The negative value indicates that the index fund is underperforming the market index it tracks. So when the tracking difference is positive, the index fund is outperforming the market. Usually, the tracking difference tends to be marginal.

Once you decide which index fund you want to invest in, you can open a brokerage account with, either a broker or the mutual fund company that issues the index fund. Since you’ll likely make more investments in the future, it’s better to go with the broker. Once your brokerage account is up, you can transfer funds electronically and invest in the index fund.

Bottomline

If you are looking to grow your money, but don’t have the time to do the necessary research, index funds are the way to go. You can also choose index ETFs because it also works pretty much the same way. Index funds are certainly a lot better than mutual funds, as index funds charge lower fees and over the long run, they generate better returns.

That being said, there is something I would like to bring your attention to.

As it turns out, most index fund investors seem to be individuals who’d rather invest in individual stocks but don’t have the time nor the resources to do so.

Well, the truth is, if you can spend just 20 mins a day, you can achieve market returns substantially higher than the market average – just by using what you already know. To know more, check out our bestseller The 8-Step Beginner’s Guide to Value Investing.

Differences between stocks and bonds; A complete guide

Posted on July 19, 2021October 29, 2021 by Jyothis George

Most individuals when they are starting with investing, tend to have a lot of questions. And one of the most common questions of them all is – should I invest in stocks or bonds, or if I invest in both, how much should I allocate to each one?

For a lot of people, their investment journeys end right at that point. Because they look into stocks and bonds but can’t seem to decide which is a better investment, so they put off investing altogether. And they think they’re better off putting their money in savings accounts.

Here’s the thing – savings accounts with their 0.04% interest are not going to make you any money – in fact, they don’t even save your money when inflation rates are around 2%.

The point is, you should get started with investing as soon as you can. And we’re here to help you do that.

In this article, we’ll talk about the difference between stocks and bonds and which might be the better investment option for you.

Stocks and the stock market

Stocks are securities that represent partial ownership in a company. When you buy a share of stock, you’re buying a portion of the company. Hence stocks are also known as equity securities. For example, if you buy 10 shares of Microsoft stock, you are buying a portion in the company that is equivalent to 10 shares. Because Microsoft has more than 7 billion shares, your stake might be insignificant. Nevertheless, you’re still a shareholder of Microsoft.

A stock market allows companies to raise money from the public. Companies exchange a small stake in the company for cash. This allows them to raise huge amounts of cash that can be used for expanding the business and grow the company. For investors, it is an opportunity to be a part of the company and get rewarded.

A stock exchange is where individuals come together to trade in stocks. Stock exchanges act as an intermediary between companies and investors, where the company can list their shares and the individuals can trade them. New York Stock Exchange is one of the largest stock exchanges in the world and lists some of the biggest companies in the US.

Stock markets in the US are heavily regulated. The Securities and Exchange Commission (SEC) oversees the activities of stock exchanges and has set strict rules to ensure the smooth and transparent functioning of the market.

Bonds and the bond market

With bonds, you’re lending money. When you invest in a bond issued by a company, you’re basically lending them money with a promise that the money will be returned to you along with interest. It’s almost the same way a bank pays its debtors.

Assume you invest $1,000 in a bond that pays 2% interest for the duration of 5 years. During this holding period, you’ll be paid $20 (2% of $1,000) every year. And at the end of the duration, you’ll be paid back the initial investment i.e. $1,000, so you end up with a total of $1,100.

The bond market does not have a centralized location like a stock exchange. Bonds are mainly sold over the counter (OTC). Bonds are also given an investment grade by credit rating agencies like Moody’s and Standard and Poors. These ratings help investors understand how risky a particular bond is.

Generally, there are three types of bonds;

Corporate bonds
Municipal bonds
High yield bonds

Corporate bonds are the ones that are issued by private and public companies. These generally have a high credit rating, meaning that they’re likely to pay you back your money along with interest.

High-yield bonds, on the other hand, offer higher yields but have a low credit rating. So they’re more likely to default, and hence offer higher yields for the increased risk.

Municipal bonds are the ones issued by states, cities, and other government entities. US Treasury securities are an example of it. Treasury bonds are considered the safest form of investment, as they are backed by the US government, making them a popular choice.

Difference between stocks and bonds

By now you have a decent idea of the differences between stocks and bonds. Anyway, we’ll take a closer look at how they are different.

Making money; bonds vs stocks

Capital gains and dividends

When it comes to stock investments, there are two ways you can make money; capital gains and dividends. Capital gains are when you make money from the price appreciation of stocks over time. In simpler terms, you sell the stocks for a higher price than you bought them for. Capital appreciation occurs when the underlying company performs well; the company generates more revenue and profits, expands the business, enters new markets, etc. When a company performs well, investors will be willing to pay more for its stock, and you capitalize on that.

The second way to make money from stocks is through dividends. These are cash payouts paid by the company to its shareholders. A portion of a company’s earnings is distributed to shareholders in the form of dividends as a token of appreciation for investing in the company. These payouts are made at frequent intervals, usually annually or quarterly, although some stocks pay a monthly dividend. So you invest in stocks that pay a dividend and get paid frequently.

Notice I said ‘stocks that pay a dividend? That’s because not all stocks pay a dividend. Instead of paying shareholders, the company might reinvest those earnings into R&D, expansion, or acquiring businesses. And that can drive up the price – which ultimately benefits the shareholders.

And both capital gains and dividends can be reinvested into equities which will compound your returns over time.

Interest payments

Similar to stocks, investors can make money from bonds with capital gains or interest payments. Bonds, just like stocks, can be sold on the market for more than you bought them, and pocket the difference. However, the primary source of income from bonds is through interest payments.

Generally, interest payments will be paid every year, distributed throughout the year. This predictable regular income is what attracts most investors to bonds. Hence bonds are considered as fixed income securities. Also, with bonds, the initial capital is guaranteed, as long as the bond issuer is solvent. As for government bonds, they are backed up by the US government, so it is considered the safest form of investment.

Ownership; equity vs debt

When you own stocks, you become a shareholder in the company. That means you own a small portion of the company. Depending on how well the company performs, that portion could be a lot more valuable in the long run. And you can hold on to it, as long as the company exists, and get rewarded all the while. As a reason, stocks are the most popular liquid financial asset in the US.

With bonds, however, you don’t own anything. When you lend money to a company, you’re not given a stake in the company. Instead, you’re merely promised that you’ll be returned the capital along with interest.

Risks and rewards

Whether you invest in stocks or bonds, there are risks and rewards involved in both these. Let’s look at it in more detail.

Stocks

The risk with stocks starts with the returns. For stocks, returns are not guaranteed. If anybody tells you that a certain stock is a ‘guaranteed’ ten-bagger, run for your life. Because stock price can move up, down, sideways – pretty much in all directions. This is especially true in the short term. You can invest in a promising company and still lose money in the short term.

If you would like to know more about how a stock market works, check out this article.

A lot of factors can affect stock prices. It could be issues within the company in question, or the industry, or the economy in general. Remember March 2020? Between March 4 and March 11, the S&P 500 index dropped by 12%. On March 12, the S&P 500 plunged 9.5%, its steepest one-day fall since 1987. This was due to the outbreak of the global pandemic.

But if you take a step back and look at the markets, you’ll see that the markets rise in the long run. The S&P 500 for instance, was back on its feet, and by January 2021 it had reached a new record of 3,849.62. And as of the time that I am writing this, it’s at 4,352, up 88.83% from its lowest in March 2020.

The point is – investing in stocks can be extremely rewarding. Especially if you hold on to your stocks for a longer period of time, say more than 20 years. Consider this for example; if you had invested $8,000 in the S&P 500 index in 1980, your investment would be nominally worth approximately $783,086.76 in 2021, despite several market crashes and downturns along the way.

And this is only the market average. You could have achieved this just by passively investing, using an index fund, or a broad market ETF. Also, when it comes to stocks, there is virtually no limit to the returns you can generate. Using a proven investment strategy such as value investing can bring returns substantially higher than the market average.

There are also dividends, which can provide a steady stream for as long as you hold the stocks. And if you can reinvest those dividends, your returns will compound over the years, and it can bring massive returns to your investment portfolio.

Let’s assume you invested $100,000 into an ETF that tracks the S&P 500 and remain invested for 20 years. Also, you chose to reinvest your dividends using a dividend reinvestment program (DRIP).

Assuming a steady dividend yield of 2% and an average annual return of 8%, this is what your investment will look like in 20 years, compared to the one where you did not reinvest your dividends.

As you can see, there is a big difference in the value of the investment after 20 years. In fact, you earned 48% more by reinvesting your dividends for 20 years, than the one where you did not reinvest.

Bottomline – dividends or no dividends, in the last 15 years stocks have outperformed every other asset class with an average annual return of 9.88%.

Bonds

Bonds help you preserve capital and earn a steady income. You get an additional stream of income with the regular interest payments from the bond. And these payments are generally tax-deductible, which is an added benefit. On top of that, certain bonds such as the Treasury bonds can be the safest investment during bear markets.

Having said that, there are downsides to bonds as well, the most important one being that the returns are limited. The returns from bonds are guaranteed, but they are limited and lower compared to other asset classes. In fact, bond yields are so low that when accounted for inflation, the returns might be marginal or in some cases – none.

Liquidity is another important factor when it comes to bonds. Bonds can also be bought and sold like stocks, but they are less liquid, meaning they cannot be easily converted into cash. Bonds are traded on over-the-counter (OTC) markets, which means regular investors like me and you are less likely to participate in trading bonds.

Rising interest rates add to this issue. When interest rates rise, bond prices fall. Because the newer bonds will be more appealing to investors, as they offer a higher rate of interest. And when you try to sell a bond with a lower interest rate, you might have to do so with a loss.

Which is best for you; stock or bonds?

It depends.

Your investment goals, timeline, and risk tolerance are some of the factors that need to be considered before deciding what’s best for you.

You might be investing with a specific goal in mind that needs to be achieved within a specific timeline-like buying a house. Or you might be investing for retirement. Also, how much risk are you willing to take; are you okay with your investments going down 10-15% at times? What about your timeline – are you flexible with your timeline, or do you have a timeline that must be met at all costs?

All of these need to be considered, before deciding whether to invest in bonds or stocks or both. But as a rule of thumb, when you are looking for the capital appreciation you should go for stocks. On the other hand, if you are looking to preserve your money, and get low but consistent income from your investments, maybe you should go with bonds.

You can also mix it up with stocks making up the majority of your portfolio. This is applicable when you’re looking to limit your downside, or simply put, protect your investments, rather than trying to grow it substantially.

Bottomline

Stocks and bonds can be beneficial to your portfolio, whether to go all-in on one of these, or have a mix of both depend on your goals, timeline, and risk tolerance.

When it comes to growing your money, stocks have the upper hand, as it has historically outperformed all other assets. However, if you’re hesitant about going all-in on stocks, you can go with a mix of both, with allocations such as 70% stocks, and 30% bonds or similar.

The important thing is that you invest in the market, rather than depending fully on savings accounts to save your money. Have a long-term view when it comes to investing in stocks, and also investing in general, and do your homework when investing in any asset, and you’ll be good.

While this is enough to get started, you’ll need more information as you sail through your investment voyage. Here is The 8-Step Beginner’s Guide to Value Investing to help you.

PS: The book features the 20 best stocks & ETFs to buy and hold for the next 20 years that can give you a jumpstart.

How do stock markets work? Understanding the basics

Posted on July 12, 2021October 29, 2021 by Jyothis George

When you start planning your finances, you’ll see that personal finance essentially comes down to this; earning, saving, and investing. The first two, earning and saving are pretty straightforward. You get a job, and you track your expenses and save as much as possible. But the third, investing- is not that simple.

At least that’s what it feels like for most individuals when they come across investing for the first time.

If the idea of investing in the stock market seems absurd and it scares you a little, you’re not alone. Even after people get to know about investing, many put it off, since they don’t feel comfortable or confident about it. That’s understandable – you don’t want to risk your money on something that you’re not sure about.

But the truth is, investing in the stock market is one of the most effective ways to grow your money over the long term. Studies show that stocks generate investment returns over long periods of time superior to those from every other asset class.

Source: NovelInvestor.com

Is it risky? Yes, there are risks involved.

Is it worth taking the risks? Absolutely it is.

Before I go into the details of why you should invest, let’s address the elephant in the room – the stock market, and how does it work?

In a nutshell, the stock market is a place to buy and sell shares of publicly traded companies. Individual or institutional investors come together in the stock market to trade shares of stock.

Let’s break it down one by one – starting with the company.

Why do companies sell shares?

Any company – small or large – needs capital to thrive. There are capital expenses, R&D, marketing, operations – all of which must be well-financed for a company to grow. And a company can access capital by borrowing money from banks (debt) or selling shares. Raising capital using borrowed money has limits, as there is the burden of paying interest. And for a smaller company, they might only have a few assets to borrow against. Eventually, you need to pay back the money borrowed along with interest.

The second option – selling shares, is more viable, as you are not obliged to pay back money to investors. Having said that, most early-stage investors (Angel investors and VCs) might want to have a say in the company’s administration and management, especially if they own a relatively higher stake in the company.

Another way to raise capital is by selling shares to the general public through an initial public offering (IPO), so individuals like you and me can be a part of the company. For companies, this allows them to access large amounts of capital that can be used to expand the business, improve products, and grow the overall business. As for individuals, this is a chance to be a part of a promising company, and to get rewarded in the process.

How do you invest in a company?

So when a private company goes public, that is through IPO, the company is required to allot share certificates or simply – shares, to the public. These are certificates that represent partial ownership of the company. The more shares you own the more stake you will have in the company. Each share will have a face value (FV). If a company is valued at $500 million, it can either have 50,000,000 shares with a face value of $10 per share or have 5,000,000 shares with $100 per share. It is up to the company to decide how they want to allow the shares to the public.

More often than not, companies will try to increase the number of shares and decrease the face value, to increase participation from investors. However, keep in mind that the company won’t sell all the shares to the public, meaning that the company valued at $500 million will choose to retain some shares within the company, and only the remainder will be issued to the public.

So once the company successfully goes through an IPO, investors will be able to buy and sell shares of the company daily. And that’s where stock markets come into play.

What is a stock market?

The stock market is a marketplace where buyers and sellers can come together to trade stocks. Stocks or equities are tradable securities (meaning they can be bought and sold) that represent a portion of the ownership in a company. So when you buy Apple stock, you are buying a portion of the company. As Apple has 16.69 billion shares that are available to the public (this known as outstanding shares), your personal stake might be insignificant. But still, you are a shareholder of the company and you have certain rights within the company including voting rights.

The stock market exists for two reasons; the first one – it gives companies easy access to capital that can be used to expand their businesses. The second – it allows investors to be a part of companies and share in their profits.

I’ll be talking more about how investors make profits from buying stocks, later in the article.

It is important to note that when someone uses the term ‘stock market’, they might refer to stock exchanges or market indices. Stock exchanges are places where people come together to trade the shares they own. Because when you buy or sell a stock, you’re not directly trading with the company, instead you’re trading with other existing shareholders.

Stock exchanges act as an intermediary between buyers and sellers and help them in completing the transaction. So it’s no wonder when people use stock exchanges synonymously with the stock market. Today these exchanges exist as electronic marketplaces, even though there is a physical location attached to them. New York Stock Exchange (NYSE), one of the oldest and the largest by market cap of listed companies, is situated in Lower Manhattan, New York City. Stock exchanges are regulated by government agencies. The Securities and Exchange Commission (SEC) oversees the stock market in the US, ensuring the smooth functioning of the markets.

On the other hand, a market index is a hypothetical portfolio comprising some of the largest public companies in the country. It is used as a performance indicator of the overall market, even though it represents only a small portion of it. So when you hear people talking about how ‘the market is doing, they’re merely referring to a market index. The Dow Jones Industrial Average (DJIA) and S&P 500 are the most popular indexes in the US. While Dow Jones tracks the performance of 30 prominent companies, S&P 500 tracks the stock performance of the 500 largest public companies in the US.

How do stock markets work?

Now we know how companies issue shares to the public to raise capital, through an IPO. So once the shares are available to the public, they’ll start buying and selling shares. To understand how the stock market works, you need to look at the participants involved, starting with the investment banks.

Market participants

Investment banks

These are some of the largest banks in the world. They handle the IPO of companies. They help the company with valuations and usually buy most of the shares and resell it to the public through IPO.

Institutional investors

These are large financial institutions that play a major role in the market. During the IPO of a company, these institutions buy most of the shares from investment banks, and later they sell it to the public while retaining a portion of the shares. Hedge funds, pension funds, and mutual funds are examples of institutional investors.

They buy and sell shares in larger quantities, and therefore their actions can influence the price of a particular stock in the short run.

Individual investors

These are investors like you and me, and millions of others. Also known as retail investors, they use brokerage accounts for buying and selling stocks.

Brokerages

These are financial institutions that allow investors to buy and sell shares. In fact, they act as an intermediary between buyers and sellers. Nowadays, online brokerage platforms allow investors to transfer funds, buy and sell shares – electronically.

Note that these are only the major participants in the stock market, there’s more. But this is enough for a head start.

Now that you know who all are in the market, let’s see how trade will take place.

Take Apple Inc. for example. As of the time I’m writing this, the stock is trading at $136. Let’s assume that today, the NY Times reports that Apple is going to launch the Apple Car in a few weeks. Now, two traders, Ben and Peter saw the news; Ben believes that this is going to be a huge source of earnings for the company, and the stock price is going to rise. So Ben decides to buy 10 shares of Apple.

Meanwhile, Peter is not happy about the news. He thinks that Apple might be risking its earnings by entering an unknown market, and he believes that the stock price will eventually go down. So Peter now wishes to sell the stock, of which he has 10 shares.

So Ben will place the order to buy 10 shares of Apple with his broker, and Peter who uses a different broker will place the order to sell the 10 shares of Apple stock he owns. The brokers will redirect both of these orders to the stock exchange where Apple stock is traded, and in this case NASDAQ. Once the stock exchange receives the orders, they’ll match Ben’s order with Peter’s, and the trade gets executed.

This is the primary function of the stock market – act as a marketplace between buyers and sellers of stock shares. And the buyers and sellers don’t have to be individual investors, they could be any of the stock market participants mentioned above. And it doesn’t have to a single seller or a buyer; Ben’s order to buy 10 shares could be met by sell orders from Cathy (who is selling 6 shares) and Lauren (selling 4 shares). Stock exchanges take care of these aspects and they ensure that all the orders placed are executed and the shares are delivered accordingly.

Thus, the stock market allows market participants to access any public company, and trade their stock.

What moves stock prices?

To understand the price movement of a stock, let’s go back to the example of Apple stock and the news that came out.

Let’s assume that most traders saw the news in good light, and they believe this is going to increase the stock price. So what do they do? They try to buy the stock. But there’s a problem – there are only a few sellers but a lot of buyers. And when buyers outnumber sellers, the laws of supply and demand play out.

You see, when there are more buyers than there are sellers, buyers will be willing to pay the price the seller asks for. Once buyers buy the stock at a higher price, that becomes the latest stock price. Then the sellers will ask for more, on top of the last traded price. Why? Because they can. Buyers are looking to acquire the stock as soon as they can, and they’re willing to pay whatever price the seller asks.

You see, buyers are willing to pay because they believe they’ll be able to sell it in the future, for a price higher than they bought it for. As a result, the price increases. If you look at the example above, the price went up about 3% in less than an hour. Even though this is a fictional situation, the reality isn’t far from this. Price movements can occur very quickly, and they can be quite significant.

And if this was the other way around – there are more sellers than buyers, the seller will be willing to accept a lower price as they want to cash in as fast as possible. As a result, the stock price will go down.

The point is – price changes in the stock market are simply a matter of supply and demand from investors.

So naturally, you ask. What if there was no news – would the price stay constant?

Well, yes and no.

In the case of a rather unknown company, the stock price might not move, and even if it does, it would be marginal. But with most stocks, there will be significant price movements throughout market hours. The reason is, market participants are always looking for information; they’ll act based on the information they have, or they’ll simply act on the expectation of information. For example, traders might sell a particular stock if they believe bad news regarding the stock is going to be out.

Speculations and assumptions are abundant in the stock market, and so are price movements.

Why do people invest?

Good question.

Why do people buy stocks in the first place?

Before I answer that question, let me talk about the different ways individuals participate in the stock market. Broadly speaking, there are two kinds of individuals in the market; traders and investors.

Traders are looking for opportunities to initiate a trade and profitably exit at the earliest possible time. Traders have a short-term view of the market. They are constantly analyzing price movements and other indicators in an attempt to predict the short-term price movements of stock to successfully execute a trade.

Investors, on the other hand, have a long-term view of the market. They are looking to gain from the capital appreciation of stocks over the long run. They are willing to hold stocks for years or even decades. Because they understand the power of compounding and the significant price appreciation it can bring to your investment.

Back to our initial question – why do people buy stocks?

Even though each individual has his/her own reason for investing, the idea remains the same – grow your wealth. Traders try to profit on the short-term price movements thereby taking up more risk, whereas investors capitalize on the long-term price appreciation of stocks, thereby mitigating risk.

How do you make money from stocks?

By this point, you have a good idea about how people make money from stocks. Nevertheless, let me reiterate.

There are two ways to make money from stocks; capital appreciation and dividends.

Capital appreciation is the increase in the price of an asset, in this case – stocks, over time. Simply put, if you select the right stock and buy it at the right price, you’ll be able to sell it later for a higher price and pocket the difference.

A dividend is a cash payout by the company to its shareholders. A portion of a company’s earnings is distributed to shareholders in the form of dividends as a token of appreciation for investing in the company. The payouts are made at frequent intervals, usually annually or quarterly, although some stocks pay a monthly dividend.

Basically, you get paid just for holding the stock.

So a lot of investors look to buy dividend-paying stocks as it provides additional returns to your portfolio, on top of capital appreciation. Since 1956, dividends have contributed nearly one-third of total equity return while capital gains have contributed two-thirds.

Contrary to what many individuals like to believe investing is not gambling. It is rather a proven way to build wealth over the long term. Consider this – if you had invested $8,000 in the S&P 500 index in 1980, your investment would be nominally worth approximately $783,086.76 in 2021.

Now you know how stock markets work and how powerful they are in building wealth.

Bottomline

The stock market can be a little intimidating at times, but this is everything you need for a headstart. And if you haven’t started investing in the stock market, yet, I suggest you start today. Meanwhile here’s a book to help you in your investing journey – The 8-Step Beginner’s Guide to Value Investing.

Value trap; How it works and how to avoid in 2021

Posted on July 7, 2021October 29, 2021 by Jyothis George

Value investing is one of the most popular investment strategies. The stock market has rewarded value investors with exponential returns. No wonder why so many new investors are intrigued by this successful strategy.

However, there is one aspect that many investors look over and fall prey to – the value trap.

Let’s see what it is.

What is a value trap?

It is precisely what the name says – a trap.

Value traps are stocks that seem like value stocks but are actually traps in disguise. These stocks will be trading at low stock prices relative to what is considered as their fair value (or book value), and will also have valuation ratios in lower multiples. This will trick an investor into thinking that it is a value stock available at a discount.

Value traps appear to regular investors as potential winners, especially for value investors who are looking to buy stocks on a bargain. But in reality, these stocks often have very little promise, and possibly no future. Investors on seeing this ‘opportunity’ rush to buy these stocks end up losing their money.

The catch here is that the stock price is low not because it is trading below its intrinsic value. It’s just because the company doesn’t have much potential and is likely to be on its way to bankruptcy.

How does a stock become a value trap?

To understand this, let’s first look at how a regular stock becomes a value stock. This happens when a stock that has strong fundamentals and huge long-term potential trades below its intrinsic value. This might be because the market hasn’t realized the stock’s true value, and when it does, the stock price rises above its intrinsic value, and the investor makes money.

However, in the case of a value trap, the stock might be trading at a low price because of different reasons. It might be the case that the company’s long-term outlook has changed, or is about to change due to reasons that are not immediately apparent. The stock might appear to have good fundamentals, but there are underlying issues that could potentially affect the long-term prospects of the company.

For example, a company losing market share to a strong competitor might be at the risk of losing out revenue and profits – which could have a negative impact in the long run. But this might not be obvious in the income statement or balance sheet.

Value trap indicators

There are various instances where a stock might end up being a value trap. A factor that indicates that a particular stock might be a trap is referred to as a value trap indicator.

Let’s look at each in detail;

Earnings and cash flow

Income and cash flow statements are something every investor looks at when analyzing a company’s fundamentals. However, an income statement or a cash flow statement doesn’t tell you the whole story. A company can have good earnings and still go bankrupt.

Consider the case of some investment banks at the time of the financial crisis during 2008-2009. These institutions were funding long-term liabilities with current assets. So their financial statements looked healthy, but they were hanging by a thread. Soon enough, most of these institutions went bankrupt, and the shareholders were wiped out overnight.

Business model

This is something that many investors neglect and as a result, can lead you right into a value trap.

In a nutshell, understanding the business model involves finding the answer to three questions; a) how do they make money, b) how do they spend their money, and c) and what makes them any different from a competitor.

If there’s a company whose business model is hard to understand, and you can’t find a path to profitability, it might not be worth investing in it. Another question to ask – is the business model sustainable? Meaning can it withstand a recession, technological advances, etc.

Walmart is a great example of a company that can withstand a recession and technological disruption.

Major changes in the industry

Changes are inevitable, and they happen all the time – some of them are obvious, while some aren’t. Major changes in an industry can change the long-term outlook of a company, in a short period of time. More importantly, these changes won’t be reflected in the financials of the company until a few quarters or years later. Meanwhile, investors will rush to buy the stock as it seems cheaper compared to its previous prices.

Airlines are a good example of this. The global pandemic brought a lot of change to the airline industry – because people stopped flying. And then people found a way to reach one another without traveling hundreds of miles – using Zoom and other video conferencing platforms. If you were an investor who has been waiting to own airline stocks, you see the price decline the pandemic has caused, and you jump at the opportunity.

Guess what, you’ve just fallen prey to a value trap.

Peak earnings or cyclical industries

Then some companies belong to cyclical industries. A cyclical industry is an industry that is dependent on business cycles for revenue generation. So their profits rise and fall predictably. The businesses in cyclical industries, expand and contract, and expand and contract again – in cycles. Their ability to make money largely depends on the overall economic conditions. Hotels, textiles, and construction are some examples of cyclical industries.

When they go through a favorable period in the business cycle, their earnings might shoot through the roof. This results in a significantly low P/E ratio, which makes the stock appear largely undervalued. Now given the fact that most investors look at the P/E ratio to find undervalued stocks, suddenly these stocks might seem like a lucrative investment. However, investors fail to realize that this might be the first time they’ve had such results in years or even decades.

Management

This is another aspect of a company that gets lost in the world of numbers, ratios, and whatnots. Good management can build the company from the ground up and keep it growing, and a bad one can drive it right into the ground. The management makes strategic decisions that decide the long-term potential of a company. So be well aware when they are giving out signals.

Are the insiders buying shares? Or are they selling them? Do they have skin in the game – how much of the shares do the executive team members own? These are some questions you need to ask yourself, before jumping into a value stock – to make sure you don’t end up in a value trap.

Chewy – one of the stocks that we recommended has insider ownership of 21.99%. It means that about 22% of all the outstanding shares are owned by the company’s management, directors, promoters, etc. basically people who know best about the future of the company. Significant insider ownership ensures that they have skin in the game – they are accountable for their actions that drive the company.

Companies without a moat

Okay, you have checked all of the boxes above – they have a good business model and management, they’re not in a cyclical industry – it all seems good. But are they any different from their competitors? More importantly, is there anything that sets them apart from their peers in the industry? What if a new competitor comes in – can they imitate what our company does – what if the competitor does it in a better way?

The point is – if they don’t have sustainable competitive advantages (also known as moats), that can set them apart from their competitors, they’re unlikely to survive competition over the long run. And they could just be another value trap.

Consider Apple for example. If you’re an iPhone user (or any Apple products for that matter), you know best about the edge Apple has over its competitors. Their brand value is just one of their sustainable competitive advantages that just cannot be imitated by their competitors – new or old. And if you’re not an Apple user, you know how the prices seem ridiculously high – but still, people line up outside their store whenever they launch a new product. That’s because of the pricing power that they have; they can charge higher prices than their competition and still get away with it, without losing market share.

How to use value investing to avoid value traps?

Now that we know the characteristics of a value trap, let’s see how you can avoid them.

Do your homework; thoroughly

I can’t stress this enough.

You need to do due diligence on any stock that you buy, and you need to do it thoroughly.

That means not just looking at the numbers, but doing a deep dive into their 10-K form, investor presentations, etc. When they hear about a stock for the first time, most investors quickly jump onto a platform like Yahoo Finance and take a look at all the numbers available – P/E, P/B, P/S, ROE, ROA, ROIC, etc. and decide whether its a good or bad investment.

Don’t get me wrong here; it’s a good idea to look at numbers, and Yahoo Finance is a great place to start – as it gives you a detailed look without being intimidating. But you shouldn’t make an investment decision solely based on that. Because that might just be the easiest way to end up in a value trap.

You see, the numbers only tell you one side of the story. There might be underlying issues that pose a risk to the future of the business – the company might be facing a lawsuit from their biggest customer, they might be losing market share, or their products are getting outdated, etc. Therefore, wait for a while to make sure you’re not buying on ‘instinct’. And in the meanwhile, take a look at their investor presentation – it is usually short and easy to understand. And if you’re still interested, take a look at their Form 10-K. That will give you a detailed look at the business and operations.

And always remember, if you can’t find some sort of negative information about the company, you haven’t looked deep enough. Now, this information needn’t necessarily be bad enough to sell the stock, but more like the kind of information that gives you a fair picture of the risks of investing in the company.

Bottomline

Investors should be well aware of the risk value traps pose. This is especially applicable for value investors, as they’re the ones who are more exposed to these. There is also the risk of buying stocks by looking only at dividend yield, only to end up in value traps.

It is important to note that, Warren Buffett, however, had the audacity to identify false value traps (which is nothing but a value stock) and make a lot of money. The important part is being able to tell the difference between a value stock and a value trap.

To know more about value investing and the 20 stocks you should buy for the long term, check out our bestseller The 8-Step Beginner’s Guide to Value Investing.