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

Posted on 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 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.

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

Posted on 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. 

Investing terms: Important terms every investor must know

Posted on by Jyothis George

Investing can seem intimidating, especially when you’re just starting out. Well, you’re not alone. We have made a list of investing terms for you, as you embark on your investment journey. Here is an introduction to the world of investing and the important investing terms.

General investing terms

Investing: Investing is the act of committing capital to an asset, expecting a profit. The profit could either be through capital appreciation; the increase in value of the asset with time, or it can be through active income from the asset; dividends (stocks), rental income (real estate), etc. In the stock market, investing is generally considered as buying and holding stocks over a period of time, at least 5 years.

Stock: An asset class that represents the partial ownership of a company. When you own a stock, you are owning a portion of the company. It is also known as equity. In investing, the stock is used synonymously with the underlying company. However, it is important to look into the underlying company, which will determine everything about the stock in the long run. For example, Amazon is the company, and the Amazon stock you own represents your ownership in the company.

Share: It is a portion of an asset or security like a stock. When you are buying a stock, you are buying a specific number of shares of the stock, it could be one, a hundred, a thousand, or whatever you want. Let’s take Amazon as an example; you can buy one or a hundred shares of Amazon stock (AMZN).

Ticker: A ticker symbol is an abbreviation used to identify publicly listed stocks on a stock exchange. Remember AMZN? That’s the ticker symbol for Amazon stock.

Portfolio: A portfolio is a collection of investments like stocks, bonds, funds, etc. Every asset you have currently invested in is a part of your portfolio, the investments constitute your portfolio.

Stock exchange: It is the place where stocks are bought and sold. Stock exchanges are institutions that host a marketplace for both buyers and sellers to come together to trade shares with one another. The transactions can only take place during business hours. Each country has its own stock exchange. The largest stock exchange, in terms of the value of companies listed, is the NYSE (New York Stock Exchange). A company must meet a certain set of requirements to be listed on a stock exchange.

Liquidity: The liquidity of an asset is the ease with which it can be converted into readily available cash. The most liquid asset is cash itself, as it can be exchanged for cash or any asset easily. Stocks on major exchanges are generally liquid in nature, so you can buy and sell them, at your time and price. You can also cash it, whenever you want. An example of an illiquid asset is a house, as you cannot easily convert it into cash. You would need to find a buyer who is ready to buy the house at your price, and the whole transaction could take a while to complete.

Market index: It is a hypothetical portfolio of stocks, that represents a section of the stock market. If you’ve heard people talking about how the ‘market’ is performing, they are talking about the index. Because often people see indexes as a representation of the stock market as a whole. The index tracks the prices of a set of stocks. The stocks might be selected based on their market cap, industry, or revenue. S&P 500 is the most followed index in the world. It tracks the largest 500 companies in the US, by market capitalization. The Dow Jones industrial average (DJIA) is another popular index in the US.

Bull market: A bull market is a market that is moving upward, that is rising in value. When someone says they are ‘bullish’ about a stock, it means they expect the stock price to rise.

Bear market: A bear market is a market that is declining 20% or greater. But investors generally use the term to describe a market that is declining in value. Also, when someone says they are ‘bearish’ about a particular stock, it means they think the stock will go down. A bear market generally occurs every six years or so.

Initial public offering (IPO): You might have heard of a company going public. That’s an IPO. It is when the shares of a company are made available for the public to buy for the first time. Once a private company becomes a publicly listed company through IPO, the shares will be available in the public market for investors to trade.

Capital gains: There are two ways by which investors hope to make a profit out of their investments. Capital gain is one of them. Also known as capital appreciation, it is the rise in the value of an asset (stocks) over a period of time. This allows investors to sell the stocks for a price that is higher than the price they bought the stocks for.

Dividend: This is the second way through which investors make a profit out of their investments. Dividends are cash payouts by companies at specific intervals, quarterly or annually (mostly quarterly). This is a way for companies to show their appreciation towards their shareholders (anyone who holds at least a stock share of the company). Shareholders will be paid a certain amount for each share they own. Dividends are an important part of investing as it provides an active income from your investments; you’re being paid just for holding the stocks. It is important to note that not all companies pay a dividend, particularly, younger and fast-growing companies.

Trading: Trading is the process of buying and selling stocks. Mostly, it is used synonymously with day trading. Day trading is the process of buying and selling stocks within a day. Day traders buy huge quantities of shares and hope to sell them within the day for a higher price than they bought them for, and pocket the difference. Day trading is a high-risk option, mainly due to the limited time frame, as they must sell the shares by the end of market hours.

Volatility: It is the degree to which the market fluctuates up and down. When someone says the market is moving up and down, they’re most likely referring to the rise and fall of the market index. The increase and decrease in stock prices are what cause these fluctuations. A volatile market will see constant fluctuations, as the stock prices will move up and down. The more frequent the fluctuations, the more volatile the market. It is to be noted that volatility is a short-term element and in the long term, the market tends to rise in value.

Stockbrokers: A stockbroker is an individual that buys and sells stocks on your behalf. They act as an intermediary between you and the buyer or seller. They often charge a commission for their services.

Full-service brokerages: Full-service brokerages are institutions that act as an intermediary between buyers and sellers and facilitate the transactions of stocks. They also provide services such as financial planning and money management. They often charge comparatively high fees.

Discount brokerages: These are generally online trading platforms that facilitate the buying and selling of shares. Unlike traditional brokerages, they only charge a small amount as commission. Some discount brokers provide zero-commission trades which means you don’t need to pay anything to buy or sell shares. Popular discount brokers include TD Ameritrade, Charles Schwab, E-Trade, etc.

Brokerage Account: You need a brokerage account to buy and sell stocks, bonds, funds, etc. It works similarly to a bank account. This is an account you open either with a full-service brokerage or a discount brokerage. This account will hold all your current investments. On opening a brokerage account, you can electronically transfer funds to the brokerage account, and use the fund to buy stocks. On placing orders to buy stocks, the brokerage will execute the order on your behalf, and deliver the stocks to your account.

Rate of return: It is the net gain or loss of an investment over a period of time that is expressed as a percentage of the initial investment. In other words, it is a measure of the profit or loss you have made relative to the money you invested. If you bought a stock at $50 a share and held it for a year, and the price rises to $80 in that time, you would have made a profit of $30 a share. If you divide the profit, by the initial investment, and multiply by 100 you get the rate of return of your investment. In this case that would be 30/50 multiplied by 100, which is 60. Hence for an investment of $50, you had a rate of return of 60% in a year.

Intrinsic value: Intrinsic value is a measure of how much an asset is worth. Intrinsic value takes into account tangible and intangible factors of the assets, to determine a value that accurately reflects its worth. In the case of stocks, investors study the fundamentals of the company; financial statements, corporate performance, management, industry, etc. to determine its intrinsic value. More often, it is different from its market value, as market value is more about how the stock market perceives the stock, which might take into account factors such as supply and demand from investors.

Ways of investing; terms you should know

Apart from individual stocks, you have plenty of ways you can invest in the stock market. From a low-cost index fund to a financial derivative, here’s everything you need to know.

ETFs: Exchange-traded funds (ETFs) are funds that track a market index, sector, commodity, or asset. But you can buy a share of an ETF, just like you buy a stock. Let’s say you want to invest in marijuana companies because you know they will make a lot of money. But you don’t know which marijuana company to buy nor have the time to research and study marijuana companies. So you can buy an ETF that holds shares of marijuana companies. Now, instead of one company, you have invested in several different marijuana companies.

Index fund: An Index fund is how you buy an index. Similar to ETFs, they track a particular index and attempt to mirror the performance of the underlying index (the index that it tracks), by buying shares of all the stocks in an index. Index funds are passively managed, which means there are no fund managers actively changing the holdings according to market conditions. Instead, the fund merely adopts the changes in the underlying index.

Mutual fund: Mutual fund is a fund that pools money from individual investors and invests in different assets like stocks, bonds, commodities, etc. A mutual fund is managed by finance professionals (generally referred to as Fund managers or Portfolio managers), who actively make changes in the investments in order to ‘beat’ the market. However, mutual funds tend to underperform the market in the long run. A 2018 report from S&P Dow Jones Indices suggests that more than 92 percent of active mutual fund managers in large companies were unable to beat the market over a 15-year period.

Hedge fund: Hedge funds pool money from rich investors. I say rich because there is a minimum investment amount, that is comparatively higher. Hedge funds use the pooled money to engage in a wide range of investment activities. They often use borrowed money to amplify their returns. Besides, the fund managers charge huge amounts of money in management fees. Due to the risky nature of hedge funds, the government has put in a number of regulations, which makes it hard for a regular investor to invest in hedge funds.

Expense ratio: It is a measure of how much of a fund’s assets will be used for administrative and operating expenses. Basically, it is the percentage of your money you need to pay when you choose to invest in a fund. For example, if you invest $10,000 in a fund with an expense ratio of 0.5%, you would need to pay $50 annually for the associated expenses. Generally, index funds and ETFs have a lower expense ratio compared to mutual funds, as index funds are passively managed. Remember, the higher the expense ratio, the less the returns.

Bonds: A bond is similar to a loan. When you invest in a bond, you’re lending money to the government or a company, with a promise that you’ll be returned the principal amount along with interest. The time period for which you’re lending money is the maturity date, on which the bond is matured and the borrower should give you back the money with interest. There are different types of bonds including Treasury bonds issued by the government and bonds issued by companies, known as corporate bonds. Bonds are generally considered to be a ‘safe’ investment as it promises a fixed rate of return.

Commodities: A commodity is a raw material that can be bought and sold. Commodities are generally categorized into two; hard and soft. Hard commodities are those which are mined or extracted; gold, oil, rubber, etc. Soft commodities are agricultural products such as coffee, wheat, sugar, etc. Investing in commodities can be done either through buying shares of companies that are directly involved in the commodities or by investing in commodity futures contracts.

Derivatives: A derivative is a financial security that derives its value from an underlying asset. The underlying asset could be stocks, bonds, commodities, etc. Derivatives are generally used to mitigate risk. Derivatives derive their price from fluctuations in the underlying asset. Consider an oil company that agrees to buy 100 barrels of oil at $50 a barrel from a supplier. Here the oil, a commodity, is the underlying asset and the futures contract between the oil company and the supplier is the derivative.

Asset management company (AMC): It is an institution that invests capital on behalf of its clients. They generally manage everything from high-net-worth individual portfolios to hedge funds and pension funds. They often create mutual funds and ETFs to cater to individual investors. Some famous asset management companies in the US include Vanguard Group and Fidelity Investments. AMCs charge their client a percentage of the assets the company manages for the client – assets under management (AUM).

Alternative assets: These are assets that do not come under the traditional asset classes like stocks, bonds, or commodities. It could be collectibles, antiques, rare stamps, or coins. These assets are traded infrequently and hence are illiquid. However, cryptocurrencies are another alternative asset that has high liquidity. These are digital currencies that can be used to make purchases. Bitcoin, the most popular cryptocurrency, is currently traded at $60,792.00 per coin.

Risk Management: It is the process of understanding, analyzing, and mitigating potential risks to your investment portfolio. As every investment involves a certain amount of risk, investors perform risk management to reduce risk as per their level of tolerance. Generally, investors do this by diversifying their assets, choosing stocks that are less volatile (blue-chip stocks), etc.

Asset allocation: It is the process of allocating your assets according to your risk tolerance (a measure of how much risk you can take on), investment goals, and time horizon (how long do you plan to stay invested). This is done to balance risk and reward by focusing on the overall portfolio. Diversifying assets across different asset classes, different geographies, companies of different scales (smallcap, mid-cap, and large-cap) is a method that is commonly used in asset allocation.

Financial advisor: A financial advisor is a professional who provides financial advisory services to their clients for compensation. Their services generally include financial planning, investment management, and tax planning. After understanding the client’s financial situation and goals, a financial advisor devises an investment strategy for their client that is tailored to their investment goals and horizon. Basically, they tell their clients what, when, and where to invest.

Investment terminology; companies

These are investment terms that are associated with a company and its business. Having a basic understanding of these terms will help you in finding the best company (stock) to invest in.

Outstanding shares: These are stock shares of a company that is currently held by all shareholders, including shares held by institutional investors and company insiders. Outstanding shares are used to calculate the market value of a company referred to as market capitalization.

Market capitalization: Commonly referred to as a market cap, it is a measure of how valuable a company is, according to the stock market. Market cap is the price of one share multiplied by the number of outstanding shares. Consider a company whose stock price is $100 per share, and it has 10 million shares outstanding, which means the company has a market cap of $1 billion. As per the market cap, companies are categorized into small-cap ($300 million to $2 billion), mid-cap ($2 billion to $20 billion), and large-cap ($20 billion to $200 billion), mega-cap ($200 billion or more). 

Enterprise value: While market cap is the value of a company as seen by the stock market, enterprise value is the total value of all assets and liabilities of the company. It is basically what you need to pay if you wanted to buy the company in whole and have 100% ownership. Apart from the market cap, it also takes preferred stock (a special class of stock that offers benefits such as larger dividends), debt, and cash reserves into the account. To calculate the enterprise value, add a market cap, preferred stock, and outstanding debt together and subtract cash and cash equivalents found on the balance sheet. You subtract the cash because once you acquire the company, the cash is yours.

P/E ratio: Price-to-earnings (P/E) ratio is the ratio of the company’s share price to its earnings per share (EPS). Earnings per share is the total profit of a company (earnings) divided by the number of shares outstanding. If a stock trades at $50 per share, and its EPS is $5, then its P/E ratio is 10.

P/B ratio: Price-to-book (P/B) ratio is the ratio of a company’s share price to its book value – which is the total value of all assets of the company. Typically, a ratio less than one is ideal. However, many newer companies (especially software/technology companies) have a higher P/B ratio, as more of their value derives from intangible assets which cannot be quantified on their balance sheet. Because if the stock price is lower than the book value of the company, the stock might be undervalued.

Free cash flow: Free cash flow is the cash left after paying for all the expenses including operating expenses and capital expenditures – which are used to purchase, maintain, or upgrade physical assets. If a company is generating free cash flow, it means the company has plenty of cash to invest in future business, pay off debts, or pay dividends to shareholders.

EBITDA: EBITDA stands for earnings before interest, taxes, depreciation, and amortization. It is a measure of the overall profitability of a company and often used as an alternative for net income. EBITDA can be calculated by adding net income, interests, taxes together with depreciation and amortization expenses.

Dividend yield: Dividend yield is a measure of how much a company pays its shareholders in dividends each year, relative to its stock price. If a company’s stock trades at $100, and they pay a dividend of $5 per share, then the dividend yield would be 5%. It is important to note that a higher dividend yield is not always ideal, as it might be a result of a decline in the stock price. While looking at dividend yield, you should ideally check whether the company has consistently paid dividends in the past.

EV/EBITDA: EV/EBITDA ratio is enterprise value (EV) divided by earnings before interests, taxes, depreciation, and amortization (EBITDA). It is also known as EV multiple. The ratio is used to compare the value of a company including money it owes, to its earnings less non-cash expenses.

Income statement: An income statement is a financial statement that shows you the financial performance of a company over a period of time – a quarter or a year. It is one of the three most commonly used financial statements (the other two being balance sheet and cash flow statement) that conveys the financial position of the company. The income statement shows you how profitable the company was during the reporting period. It shows the revenue, expenses, and profit of the company during the period.

Balance sheet: A balance sheet is a financial statement that basically shows what the company owns and owes, along with the amount invested by shareholders. The balance sheet reports the company’s assets, liabilities, and shareholders’ equities at a given point in time. Investors look at balance sheets to derive various financial ratios to understand the financial position of the company.

Cash flow statement: A cash flow statement is a financial statement that reports the movement of cash into and out of the company during a given period of time. It gives you an idea, of where the money comes from and how it is being used. Free cash flow in the cash flow statement, is a measure you can use to determine the profitability of a company. Because the more free cash the company has left, that can be used to expand the business, or return to shareholders, after paying dividends and paying off debt.

Form 10-K: It is a detailed report published annually by every public company. The Securities and Exchange Commission (SEC) requires every publicly listed company to publicly disclose all the information that surrounds the company, including the recent financial performance and the risks faced by the business. It is much more detailed than an annual report, which is a report that is sent to all the shareholders before the annual meeting. You can find all the information about the company in a Form 10-K; from how the company makes and spends money to the risks they currently face, everything you need to know about the company can be found in Form 10-K.

Fundamental analysis: Fundamental analysis is the process of studying business fundamentals and financial statements to determine the intrinsic value or ‘fair market value’ of a company. This is done to understand whether the stock is undervalued or overpriced. Investors and analysts look at the financial position of the company and other business fundamentals like overall industry, competitive advantage, management of the company, business model, etc. for fundamental analysis.

Brokerage terminology: buying a stock

These are investment terms you should know before you buy your first stock. It starts with the type of order you should choose when you buy a stock. Generally, there are two options; market and limit order.

Market order: A market order is selected when you want to get the stock as soon as possible for the current price. Market order puts no parameters on the share price, so the order will be fulfilled immediately. Since price fluctuations happen all the time, there might be a slight difference between the price you saw when you selected the stocks, and the price you paid. This price difference is negligible for an investor who plans to buy and hold these stocks for a long time. Investors generally use market orders as their priority is the completion of the trade.

Limit order: Limit order focuses on the price at which the trade should be executed. You have more control over the price with this order. Let’s say the stock Brookfield Asset Management (BAM) is trading at $50 per share. But you want to buy the shares at $48. With a limit order, you can set the price at $48, and the order will only be completed, once the price drops to $48 from $50. If you’re selling, you can set the price above the current price, say $52, and the trade will only complete once the price climbs to $52. Limit orders are mainly used by day traders, for whom even the slight fluctuations in the share price matter a lot.

Stop order: This is an order to buy or sell a stock, where you can specify a price, and on reaching the price, the trade will be executed at the next available price. The price you specify is referred to as the ‘stop price’. Consider Dell (DELL) trading at $100. If you think DELL is going to go up, but you want to buy it only, if and when it crosses $105, you can set the stop price to $105. Once it crosses $105, the order will be executed as a market order, which means the order will be fulfilled immediately at the available price. If you’re selling a stock, the same can be done, only you’ll set a price lower than the last traded price, and on crossing the price, the stock will be sold immediately. This is often used by investors to mitigate loss, hence it is referred to as a stop-loss order.

Trailing stop order: Similar to a stop-loss order, this type of order can be used to buy or sell a stock, the difference is the stop price moves when the stock price moves in your favor, and it stays at the stop price when the stock price moves against you. To explain this better, imagine you’re selling Dell (DELL) trading at $100, and you set trailing stop at $99. If the stock price goes up to 101, the trailing stop would move to $100. However, if the stock price lowers to $100.50, the trailing stop won’t move. If the price drops again to $100, the order will be converted to a market order and fulfilled immediately. A trailing stop order is mainly used by day traders as it helps them to lock in the profits while protecting them from any losses.

Bid and ask: Every time you want to buy or sell a stock, you can find the bid and ask the price for that particular stock. The bid price is the maximum amount a buyer is willing to pay for the stock share. The ask price is the lowest price at which a seller is willing to sell the stock share.

Margin: Margin refers to the amount of money you borrow from your brokerage firm to buy an asset. It is similar to availing a bank loan, only here, your investment portfolio will be the collateral, and your brokerage is the lender. Just like a bank loan, you’ll need to pay interest for the borrowed money. Leverage incurred from margin can amplify your losses and could lead to the brokerage acquiring your portfolio, without prior notification.

Retirement investing

Here you have terms that are related to investing for retirement.

Traditional IRA: It is a traditional Individual retirement account where you can save money for retirement. Anyone over the age of 18 with a job can open a retirement account, however, some retirement accounts have specific requirements. IRA offers tax advantages, and traditional IRAs are tax-deductible. That means the contributions you make to these accounts won’t be considered as your taxable income. If you earn $100,000 a year and contribute $20,000 to your IRA, you’ll only be taxed for $80,000. With a traditional IRA, you’ll only be taxed when you start withdrawing money from your IRA account.

401(k): This is a common retirement account offered by many employers to their employees. Similar to traditional IRA, contributions to 401(k) are also tax-deductible. Also, it allows you to invest money in stocks or mutual funds. Employers often match contributions, with up to 50%. The money is only taxed when you start withdrawing it, which you can only access when you are 59.5 years old.

Roth IRA: Roth IRA is a type of retirement account that offers some great tax benefits. Unlike traditional retirement accounts, you need not pay taxes on the money you withdraw from the Roth IRA. Also, the profit you make from the investments held within the Roth IRA, is tax-free, even when you withdraw those profits. You can invest in stocks, bonds, and other securities within the Roth IRA. Note that the contributions you make to the IRA are post-tax, which means you are already paying taxes for that money.

Conclusion

You’re right. Investing can be quite complicated at times. But we’ve got you. Understand all these terms, and you’re off to a great start. Even if you don’t understand everything in the beginning, it’s fine. Start small, buy your first stock, learn a little every day, and you’ll be good.

If you’re still not sure, whether or not should you start, it might be because you’re missing an investment strategy. Maybe you should try value investing. It is an approach where you buy stocks that are currently trading for less than their intrinsic value. Legendary investors like Warren Buffett used the value investing strategy that made him one of the richest men in the world. Learn more about value investing with our Amazon Bestseller The 8-Step Beginner’s Guide to Value Investing.