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The art and science of stock market investment
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Evidently, the Nigerian stock market has undergone unprecedented surge in activites in recent times and has been adjudged one of the fastest growing in the world. Unlike most developed countries where capital market investment is almost a culture, the investing public in Nigeria is yet to fully explore the immense opportunities offered by the stock market for maximum returns and wealth benefits. But for many potential investors, the procedure of investing in the stock market is rather tedious and complex. They are afraid it is quite complicated and wearisome for the average investor. Nothing can be further from the truth as the process and requirements for trading in the stock market is quite simple and straightforward.
First of all you need to have an understanding of what stocks are. A stock certificate is a unit of ownership in a company. By owning a stock or a share in a particular company you actually own part of that company. There are two kinds of stocks you should be familiar with. First of all, there is common stock or ordinary share popularly called EQUITY. This is the most common type of stock that is traded and held by the public. If you own common stock you have voting rights along with the right to share in dividends. Preferred stock on the other hand, gives the owner fewer rights except in one important area. Those who own preferred stock usually receive consistent dividends before the ordinary stockholders get theirs. In fact investors buy preferred stocks for the income from dividends.
The Markets for stocks:
Generally, shares can be bought from either the primary market or the secondary market window. Basically, the primary market exists for new issues or for raising fresh funds. Fresh funds are mostly raised through Public Offers and Private Placements.
As the name connotes, Public Offers are made accessible to the general public. The primary advantage a company stands to gain through an Initial Public Offering (IPO) of its shares is access to capital. Banks and insurance companies in the post-consolidation era succeeded in raising sufficient funds to meet or even surpass minimum required standards. In addition, the capital does not have to be repaid and does not involve an interest charge. The only reward that IPO investors seek is an appreciation of their investment and possibly dividends and bonuses. Another advantage IPOs hold for businesses is increased public awareness, which may lead to new opportunities and new customers. Parts of the biggest disadvantages involved in going public are the costs and time involved. The small business owner and other top managers must prepare registration statements for the NSE and SEC, consult with investment bankers, lawyers, accountants, stockbrokers and take part in the personal marketing of the share. Many people find this to be an exhaustive process and would prefer to simply run their company.
Other disadvantages involve the public company's loss of confidentiality, flexibility, and control. The Securities and Exchange Commission (SEC) regulations require public companies to release all operating details to the public, including sensitive information about their markets, profit margins, and future plans. An untold number of problems and conflicts may arise when everyone from competitors to employees know all about the inner workings of the company. By diluting the holdings of the company's original owners, going public also gives management less control over day-to-day operations. Large shareholders may seek representation on the board and a say in how the company is run. If enough shareholders become disgruntled with the company's stock value or future plans, they can stage a takeover and oust management. The dilution of ownership also reduces management's flexibility. It is not possible to make decisions as quickly and efficiently when the board must approve all decisions. In addition, SEC regulations restrict the ability of a public company's management to trade their stock and to discuss company business with outsiders. Private Placement occurs when a company makes an offering of securities not to the public, but directly to an individual or a small group of investors. Such offerings do not need to be registered with the Securities and Exchange Commission (SEC) and are exempt from the usual reporting requirements.
Private Placements are generally considered a cost-effective way for companies to raise capital without "going public" through an initial public offering (IPO). Most times, private placements offer companies especially small businesses a number of advantages over IPOs. Since private placements do not require the assistance of brokers or underwriters, they are considerably less expensive and time consuming. With loan criteria for commercial bankers and investment criteria for venture capitalists both tightening, the private placement offering remains one of the most viable alternatives for capital formation available to companies.
A private placement may also enable a company to hand-pick investors with compatible goals and interests. Since the investors are likely to be sophisticated business people, it may be possible for the company to structure more complex and confidential transactions. Of course, there are also a few disadvantages associated with private placements of securities. Suitable investors may be difficult to locate, for example, and may have limited funds to invest. In addition, privately placed securities are often sold at a deep discount below their market value. Companies that undertake a private placement may also have to relinquish more equity, because investors want compensation for taking a greater risk and assuming an illiquid position. From the investors' side, some of the problems associated with using the private placement window often may sometimes outweigh the benefits. Often, the lack of stringent regulatory control usually shrouds Private placements in secrecy thereby undermining transparency and accountability. Sometimes, share certificates are unduly delayed and there is much uncertainty about when such shares will be listed.
The Value of a Stock: Real Worth vs. Market Price
It is important to distinguish between the real worth and market price of a stock. Much like a rational buyer would do for any commodity offered for sale, a trader will be willing to buy a stock at the lowest possible price. No buyer considers all shares equally attractive at their present market prices whatever these prices happen to be. On the contrary, he seeks "the best at the price." He picks and chooses among all the stocks in the market until he finds the cheapest issues. Even then he may not buy at all, for fear that everything is too high and nothing will give him his money's worth. If he does buy, and buy as an investor, he holds for income; if as a speculator/trader, for profit. But speculators as a class can profit only by trading with investors, to whom they can sell only for income; therefore in the end all prices depend on someone's estimate of future income.
A very important metric in determining the real value of a stock is the P/E ratio. For example, if stock A is trading at N24 and the Earnings Per Share (EPS) for the most recent 12 month period is N3, and then stock A has a P/E ratio of 24/3 or 8. Put another way, the purchaser of stock A is paying N8 for every Naira of earnings. Companies with losses (negative earnings) or no profit have an undefined P/E ratio. All things being equal, (especially in earnings growth, the P/E ratio determines the attractiveness of a stock. For instance, if the PE ratio of a stock is twice another, it is relatively less attractive.
Trading in shares: Between speculating and investing.
Traders in the capital market are inherently categorized into speculators and investors. Although, everyone wants to make a profit on the stocks they buy but there is a big difference between speculation and investing.
We shall define an investor as a buyer interested in dividends and principal, in other words, they are interested in capital accumulation and a speculator as a buyer interested in resale price for capital appreciation. Thus the usual buyer is a hybrid, being partly investor and partly speculator. Clearly the pure investor must hold his stock for long periods, while the pure speculator must sell promptly, if each is to get what he seeks. To gain by speculation, a speculator must be able to foresee price changes. Since price changes coincide with changes in marginal opinion, he must in the last analysis be able to foresee changes in opinion. Successful speculation consists in just this. It requires no knowledge of real value as such, but only of what people are going to believe real value to be. Now opinion, when it changes, need not change for the right; it may change for the wrong, and the probability of a change for the wrong is about as great as of a change for the right. How to foretell changes in opinion is the heart of the problem of speculation, just as how to foretell changes in dividends is the heart of the problem of investment. The investor looks at the logical value that may accrue over time as the particular stock price is affected by the ongoing business, the industry, economy and so on.
When Investors become Speculators…
A switch from investment to speculation reveals an attitude of purchasing a stock with the sole purpose of selling it to someone else at a higher price. The speculator does not care about the inherent value of the stock. He or she only cares about whether or not they think it will go up in price as more and more speculators accumulate the stock. When speculation becomes rampant, as we are experiencing currently in the Nigeria stock market, it creates a situation that is impossible to perpetuate. One of the most difficult things for most investors to understand is that in the investment markets, often the opposite of what you feel is actually the reality!
This means that when everyone is certain of a particular outcome, the odds of it happening are remote and this is why investment markets ultimately cannot exceed their borders. When investors become speculators they lose the rare privilege of using fundamental analysis, reason, long-term ownership, and patience to create wealth. Any change in investment attitude has profound implication for the market as stock prices become more volatile and close regulation becomes key to the avoidance of financial crises. Excessive speculation thus seems to put undue pressure on stock price movement as the market becomes over-heated.
Beating the Market or following the crowd:
It is natural human instinct to follow the crowd, but when trading stocks that may not always be the best thing to do. One argument states that if everyone else is selling, then you should be buying, and if everyone else is buying, then you should be selling. A successful trader knows how to see a trend before it begins and therefore can sell / buy before the masses do. However, some people find it difficult to break away from the crowd- they find safety and comfort in numbers.
However, if you have chosen to be an investor, it is sometimes useful to follow the crowd. If you are a long-term investor, it is usually beneficial to put your money in stocks that do not have high levels of instability (i.e. stocks with relatively low beta). The stocks should have indicators that the masses will continue to push it forward for the coming years. It is usually a safe investment if you put your money in the stocks of companies that the masses believe in popularly referred to as Blue Chip Companies. If you do not feel comfortable taking risks, follow the crowd. If you follow the crowd, you will usually still be able to make a profit. Choosing to stick with the herd or not should be dependent on how big of a risk you are willing to take. You should however note that the bandwagon sometimes becomes unsafe when you are a trader looking for a big profit. In this case, you may want to guess what the crowd will do next and benefit from it by being one step ahead of everyone else. The biggest profits often come when doing this, but that is also where the biggest losses are found.
This may result into Greater Fool Theory phenomenon.
Preparing for the worst (or the best!):
In order to trade against the herd and beat the market, you cannot be afraid of risk. A trader who can successfully operate on their own course needs to be self confident and not need any outside assurance in order to succeed. They must believe that their plan will work and be willing to put their money on the line. Being afraid of losing is not advantageous to success. Trading against the herd takes a lot of experience and thought. You need to study the market for years in order to develop potent plans. Gaining expertise of the market and perfecting trading skills is the only way that traders can move away from the masses and still trade with a consistent profit. It is not an easy task. An experienced trader knows how to foresee the trends and act before the masses do. For someone that is experienced and understands the markets, trading against the masses is the best way to make a large profit. But for a naïve trader or one who does not want to take a major risk, it might be best to stick with the herd. This will help minimize losses and maintain a safe profit. Whatever your stance might be on buying stock, be prepared and do your homework before any decisions are made. Do not shoot with your eyes closed.
First of all you need to have an understanding of what stocks are. A stock certificate is a unit of ownership in a company. By owning a stock or a share in a particular company you actually own part of that company. There are two kinds of stocks you should be familiar with. First of all, there is common stock or ordinary share popularly called EQUITY. This is the most common type of stock that is traded and held by the public. If you own common stock you have voting rights along with the right to share in dividends. Preferred stock on the other hand, gives the owner fewer rights except in one important area. Those who own preferred stock usually receive consistent dividends before the ordinary stockholders get theirs. In fact investors buy preferred stocks for the income from dividends.
The Markets for stocks:
Generally, shares can be bought from either the primary market or the secondary market window. Basically, the primary market exists for new issues or for raising fresh funds. Fresh funds are mostly raised through Public Offers and Private Placements.
As the name connotes, Public Offers are made accessible to the general public. The primary advantage a company stands to gain through an Initial Public Offering (IPO) of its shares is access to capital. Banks and insurance companies in the post-consolidation era succeeded in raising sufficient funds to meet or even surpass minimum required standards. In addition, the capital does not have to be repaid and does not involve an interest charge. The only reward that IPO investors seek is an appreciation of their investment and possibly dividends and bonuses. Another advantage IPOs hold for businesses is increased public awareness, which may lead to new opportunities and new customers. Parts of the biggest disadvantages involved in going public are the costs and time involved. The small business owner and other top managers must prepare registration statements for the NSE and SEC, consult with investment bankers, lawyers, accountants, stockbrokers and take part in the personal marketing of the share. Many people find this to be an exhaustive process and would prefer to simply run their company.
Other disadvantages involve the public company's loss of confidentiality, flexibility, and control. The Securities and Exchange Commission (SEC) regulations require public companies to release all operating details to the public, including sensitive information about their markets, profit margins, and future plans. An untold number of problems and conflicts may arise when everyone from competitors to employees know all about the inner workings of the company. By diluting the holdings of the company's original owners, going public also gives management less control over day-to-day operations. Large shareholders may seek representation on the board and a say in how the company is run. If enough shareholders become disgruntled with the company's stock value or future plans, they can stage a takeover and oust management. The dilution of ownership also reduces management's flexibility. It is not possible to make decisions as quickly and efficiently when the board must approve all decisions. In addition, SEC regulations restrict the ability of a public company's management to trade their stock and to discuss company business with outsiders. Private Placement occurs when a company makes an offering of securities not to the public, but directly to an individual or a small group of investors. Such offerings do not need to be registered with the Securities and Exchange Commission (SEC) and are exempt from the usual reporting requirements.
Private Placements are generally considered a cost-effective way for companies to raise capital without "going public" through an initial public offering (IPO). Most times, private placements offer companies especially small businesses a number of advantages over IPOs. Since private placements do not require the assistance of brokers or underwriters, they are considerably less expensive and time consuming. With loan criteria for commercial bankers and investment criteria for venture capitalists both tightening, the private placement offering remains one of the most viable alternatives for capital formation available to companies.
A private placement may also enable a company to hand-pick investors with compatible goals and interests. Since the investors are likely to be sophisticated business people, it may be possible for the company to structure more complex and confidential transactions. Of course, there are also a few disadvantages associated with private placements of securities. Suitable investors may be difficult to locate, for example, and may have limited funds to invest. In addition, privately placed securities are often sold at a deep discount below their market value. Companies that undertake a private placement may also have to relinquish more equity, because investors want compensation for taking a greater risk and assuming an illiquid position. From the investors' side, some of the problems associated with using the private placement window often may sometimes outweigh the benefits. Often, the lack of stringent regulatory control usually shrouds Private placements in secrecy thereby undermining transparency and accountability. Sometimes, share certificates are unduly delayed and there is much uncertainty about when such shares will be listed.
The Value of a Stock: Real Worth vs. Market Price
It is important to distinguish between the real worth and market price of a stock. Much like a rational buyer would do for any commodity offered for sale, a trader will be willing to buy a stock at the lowest possible price. No buyer considers all shares equally attractive at their present market prices whatever these prices happen to be. On the contrary, he seeks "the best at the price." He picks and chooses among all the stocks in the market until he finds the cheapest issues. Even then he may not buy at all, for fear that everything is too high and nothing will give him his money's worth. If he does buy, and buy as an investor, he holds for income; if as a speculator/trader, for profit. But speculators as a class can profit only by trading with investors, to whom they can sell only for income; therefore in the end all prices depend on someone's estimate of future income.
A very important metric in determining the real value of a stock is the P/E ratio. For example, if stock A is trading at N24 and the Earnings Per Share (EPS) for the most recent 12 month period is N3, and then stock A has a P/E ratio of 24/3 or 8. Put another way, the purchaser of stock A is paying N8 for every Naira of earnings. Companies with losses (negative earnings) or no profit have an undefined P/E ratio. All things being equal, (especially in earnings growth, the P/E ratio determines the attractiveness of a stock. For instance, if the PE ratio of a stock is twice another, it is relatively less attractive.
Trading in shares: Between speculating and investing.
Traders in the capital market are inherently categorized into speculators and investors. Although, everyone wants to make a profit on the stocks they buy but there is a big difference between speculation and investing.
We shall define an investor as a buyer interested in dividends and principal, in other words, they are interested in capital accumulation and a speculator as a buyer interested in resale price for capital appreciation. Thus the usual buyer is a hybrid, being partly investor and partly speculator. Clearly the pure investor must hold his stock for long periods, while the pure speculator must sell promptly, if each is to get what he seeks. To gain by speculation, a speculator must be able to foresee price changes. Since price changes coincide with changes in marginal opinion, he must in the last analysis be able to foresee changes in opinion. Successful speculation consists in just this. It requires no knowledge of real value as such, but only of what people are going to believe real value to be. Now opinion, when it changes, need not change for the right; it may change for the wrong, and the probability of a change for the wrong is about as great as of a change for the right. How to foretell changes in opinion is the heart of the problem of speculation, just as how to foretell changes in dividends is the heart of the problem of investment. The investor looks at the logical value that may accrue over time as the particular stock price is affected by the ongoing business, the industry, economy and so on.
When Investors become Speculators…
A switch from investment to speculation reveals an attitude of purchasing a stock with the sole purpose of selling it to someone else at a higher price. The speculator does not care about the inherent value of the stock. He or she only cares about whether or not they think it will go up in price as more and more speculators accumulate the stock. When speculation becomes rampant, as we are experiencing currently in the Nigeria stock market, it creates a situation that is impossible to perpetuate. One of the most difficult things for most investors to understand is that in the investment markets, often the opposite of what you feel is actually the reality!
This means that when everyone is certain of a particular outcome, the odds of it happening are remote and this is why investment markets ultimately cannot exceed their borders. When investors become speculators they lose the rare privilege of using fundamental analysis, reason, long-term ownership, and patience to create wealth. Any change in investment attitude has profound implication for the market as stock prices become more volatile and close regulation becomes key to the avoidance of financial crises. Excessive speculation thus seems to put undue pressure on stock price movement as the market becomes over-heated.
Beating the Market or following the crowd:
It is natural human instinct to follow the crowd, but when trading stocks that may not always be the best thing to do. One argument states that if everyone else is selling, then you should be buying, and if everyone else is buying, then you should be selling. A successful trader knows how to see a trend before it begins and therefore can sell / buy before the masses do. However, some people find it difficult to break away from the crowd- they find safety and comfort in numbers.
However, if you have chosen to be an investor, it is sometimes useful to follow the crowd. If you are a long-term investor, it is usually beneficial to put your money in stocks that do not have high levels of instability (i.e. stocks with relatively low beta). The stocks should have indicators that the masses will continue to push it forward for the coming years. It is usually a safe investment if you put your money in the stocks of companies that the masses believe in popularly referred to as Blue Chip Companies. If you do not feel comfortable taking risks, follow the crowd. If you follow the crowd, you will usually still be able to make a profit. Choosing to stick with the herd or not should be dependent on how big of a risk you are willing to take. You should however note that the bandwagon sometimes becomes unsafe when you are a trader looking for a big profit. In this case, you may want to guess what the crowd will do next and benefit from it by being one step ahead of everyone else. The biggest profits often come when doing this, but that is also where the biggest losses are found.
This may result into Greater Fool Theory phenomenon.
Preparing for the worst (or the best!):
In order to trade against the herd and beat the market, you cannot be afraid of risk. A trader who can successfully operate on their own course needs to be self confident and not need any outside assurance in order to succeed. They must believe that their plan will work and be willing to put their money on the line. Being afraid of losing is not advantageous to success. Trading against the herd takes a lot of experience and thought. You need to study the market for years in order to develop potent plans. Gaining expertise of the market and perfecting trading skills is the only way that traders can move away from the masses and still trade with a consistent profit. It is not an easy task. An experienced trader knows how to foresee the trends and act before the masses do. For someone that is experienced and understands the markets, trading against the masses is the best way to make a large profit. But for a naïve trader or one who does not want to take a major risk, it might be best to stick with the herd. This will help minimize losses and maintain a safe profit. Whatever your stance might be on buying stock, be prepared and do your homework before any decisions are made. Do not shoot with your eyes closed.
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