Investor Education
Investment Choices-Stocks
Stocks When used as part of a well-diversified portfolio, common stocks can play an integral role in your quest to achieve your financial goals. Historically, stocks outperform most other investments in achieving long-term capital growth, and may help minimize the negative, long-term effects of inflation. But the market risk with common stocks can be substantial. While an interest-bearing account might earn two percent over a year's time, the price of a stock can rise or fall by that amount or more in just minutes. And while there may be a certain appeal to making decisions on the fly (or trying to time the market as though you were a "trader"), there is no substitute for a long-term, well-thought-out financial strategy.
Your stock choices should be the result of extensive research. Take the time to sift through the securities available to find those that match your risk/return parameters, rather than chasing after short-term trades. This "investor" approach will help you avoid the volatility associated with day trading. Use H&R Block Financial Advisors' Research Center for timely information online.
Your stock choices should be the result of extensive research. Take the time to sift through the securities available to find those that match your risk/return parameters, rather than chasing after short-term trades. This "investor" approach will help you avoid the volatility associated with day trading. Use H&R Block Financial Advisors' Research Center for timely information online.
Your Search
Look for investments that have fundamental strengths. Stocks in companies with capable management, growing markets, and strong financial positions make sense for many investors. Once identified, examine the individual stocks for a closer analysis.
In addition to their risk, stocks may be volatile. A variety of factors contribute, including company performance; economic factors, such as changes in interest rates or in the rate of unemployment; political news; and events of national or international importance.
Our Research Center gives you the ability to analyze both companies and industries by the topic discussed. To continue, scroll down the page or choose a topic from the drop-down list.
Diversification
It's also important to learn about the different types of stocks. Each stock possesses its own unique risk/return characteristics. Generally, the greater the desired return, the greater the risk of loss. Some stocks offer greater stability, while others that are more volatile offer more opportunity for a greater return.
As you consider your investment in stocks, remember the importance of diversification-- not only among different stocks but also among industries.
- Cyclical stocks. These are stocks in industries that go up and down with the economy. Cyclical stocks belong to companies that may report strong earnings in one cycle, yet in a downturn, turn around and post losses in the next. Cyclical industries include automotive, paper, chemical, steel and housing.
- Defensive stocks. These stocks are typically less volatile than average and thus provide a more conservative return on an investor's money than do the cyclicals. Defensive stocks can be found in sectors whose goods are in demand regardless of the economic environment, including the beverage, pharmaceutical, food and tobacco sectors.
- Interest-rate-sensitive stocks. These stocks, which include banks and utilities, fluctuate in value with interest rates since such companies tend to borrow large amounts of money. They typically perform well during times of declining interest rates but poorly during times of rising interest rates. Companies that typically perform better when interest rates are rising, such as those engaged in oil production or the mining of precious metals, are often sought as a hedge against inflation.
- Growth stocks. These stocks are in companies that have exhibited faster-than-average gains in revenue over the last few years and are expected to continue to show high levels of profit growth. They may offer investors opportunities for capital appreciation. Many of these stocks are found in the software, telecommunications, semiconductors or biotechnology industries. However, growth stocks tend to have greater volatility because the stock may often be selling at a higher price in the market in comparison to the stock's intrinsic value.
- Value stocks. Value stocks typically sell with relatively low valuation as determined by price/book, price/sales, and price/cash flow ratios, implying that their market value may be closer to their book value.
Measuring Risk
Investment risk can never be entirely eliminated, but many of the risks associated with stock investments may be reduced with proper industry diversification.
Diversification can mitigate the effect that a particular stock's decline in value will have on your overall portfolio. While diversification, through mutual funds for example, can protect against risks from a single investment or a single type of investment, it will not protect you against market and inflation risks.
Any investor seeking higher returns must be willing to assume additional risk. As a general rule, the higher the potential gain, the greater the risk.
To get a clearer picture of the degree of risk involved, carefully analyze the historical volatility of each stock you're considering.
A traditional way to measure risk when considering volatility is by comparing "betas." A beta represents the volatility of a given stock vs. the market as a whole. In general, stocks with high betas are deemed to be aggressive, while those with lower betas are usually considered defensive. For example:
- A stock with a beta of one would be expected to move in tandem with the market averages.
- A stock with a beta of 1.3 would be 30 percent more volatile than the market as a whole.
- A stock with a beta of 0.5 would be expected to have half of the market's volatility (i.e., advancing 5 percent if the market advanced 10 percent or declining 5 percent if the market declined 10 percent).
Unsystematic Risk vs. Systematic Risk
Unsystematic risks are associated with a given company or industry. Examples include product delays, competitive issues, margin deterioration or weakening financial conditions within either a single company or an industry.
Systematic risks are associated with the stock market in general. While proper diversification can help eliminate much of the unsystematic risk from your portfolio, diversification with other stocks will not eliminate systematic risks. But diversification among different asset categories -- cash, bonds, real estate, etc. -- can reduce a portfolio's systematic risk below that found in stocks alone.
Identifying Buying Opportunities
Major events can dramatically change stock prices. But what makes day-to-day stock prices rise and fall during relatively calm periods?
There's no single answer because daily stock prices are affected by various factors. The short-term direction of a stock's price can be influenced by investor psychology, political events, international developments, quarterly earnings reports and even institutional trading activity.
Thus, over the short-term, there may be very little correlation between a company's fundamental performance/prospects and its stock price. Over the long-term, however, there is a very strong correlation between a company's fundamental performance and its stock price. Moreover, while stocks can be volatile over the short term, history has shown that swings in the market "balance out," thus favoring stocks for investors with a long-term investment horizon.
Stock Evaluation
Here's what you should consider as you evaluate a company's stock:
- Income Statement. By examining the income statement, you can see how much revenue the company generated from selling its products or services, where it was spent, and how much the company earned or lost for the reporting period. Public corporations typically report their earnings once each quarter.
- Revenue Growth. This is a good indicator that a company is producing and selling a product in demand by customers. If revenues are growing, consumers are most likely buying more of the company's products or services.
- Gross Margins. This is revenue minus the direct cost of producing the product or service stated as a percent of revenues. The formula is revenues minus the cost of goods (services) sold, divided by revenues.
By looking at gross margins, you can see how efficiently a company produces its goods and also whether the company produces a product that competes on price alone or on the basis of other attributes (quality, technical innovation, service contracts, global distribution networks, etc.)
For example, a grocery store sells commodity products with little variation in quality, thus making price a primary focus. However, a specialty medical company produces a complex product sold on the basis of quality and innovation. As a result, price may not be such a primary concern. Hence, it would not be uncommon for health care companies to post gross margins of 50 to 70 percent while commodity-type companies post gross margins well under 10 percent.
- Valuation. Investors use a number of valuation tools to screen stocks. Many factors influence the valuations placed on stocks, including the company's operating history, consistency, financial structure, gross margins, future growth potential and market psychology. Here are a few of the valuation tools used:
- The price/earnings (P/E) ratio. This perhaps is the best-known measure of valuation. It's the price per share divided by the amount of earnings per share over the trailing 12 months. Investors are willing to pay a premium price for companies consistently posting above-average growth.
- The price/book ratio. This tool is typically used when investors are seeking value stocks. Value stocks are those that typically sell with relatively low price/book ratios, which imply that their market value is close to their book value.
- The price/sales ratio. First used by venture capitalists, this ratio is often a barometer of a company's potential. It's particularly useful for companies that currently do not have earnings or are experiencing operating difficulties and are reporting depressed earnings.
- Research and Development. Expenses committed to research and development are indicators of investments in the future. It wouldn't be unusual if a growing technology company were to commit 10 percent to 20 percent of gross profit to research and development.
- Economies of Scale. This is the theory that as the volume of production increases, the cost of producing each unit decreases. Therefore, a large factory will be more efficient than a small factory because the large one will be able to produce more units at a lower cost per unit than the smaller one.
As a company grows, such economies may occur, allowing a company to increase its earnings by a greater percentage than revenues. For example, once a company's infrastructure is in place, a 30 percent revenue increase may be achieved without hiring 30 percent more employees or opening 30 percent more offices. If these operating expenses were to grow by only 20 percent, the incremental difference then falls to the "bottom line," enhancing profitability. - Net Income. This is the amount of money left after all operating expenses, interest, and taxes are paid. Earnings per share, or "EPS," is equal to net income divided by the number of company shares outstanding. This represents the amount of earnings allocated to each share.
- Balance Sheet. This lists a company's assets, liabilities, and shareholder equity. A sound balance sheet is needed to support future growth or to help the company weather difficult transitions. While financial structures vary from industry to industry, look at such factors as cash reserves; amount of debt requiring periodic payment; equity; receivables and inventory.
When analyzing a company's financial structure, you should compare it not only with previous statements for internal changes but also with its peer group. Companies in capital-intensive industries, such as airline transportation, manufacturing or utilities, may have more debt than companies that are not as capital intensive, such as software.
Technical Analysis
Unlike fundamental analysis, technical analysis is not concerned with things such as revenue growth or new products. Instead, the focus is on the actual supply and demand dynamics of the market.
Technical analysts aren't looking at the strength of a company's balance sheet or its prospects, but at the company's stock prices and sales volume. They look at price and volume trends, and consider factors such as market psychology by examining what investors are actually saying through their buy and sell decisions.
Since such technical factors can have a profound effect on stock prices, technical analysis can be an important tool for investors. Our Research Center can provide you with the ability to create charts that will make it easier for you to analyze either individual companies or an overall industry.