Beginner Investors
If you have recently started investing directly in stocks, or are still preparing to do so, you probably need to know some important information first:
Relationship
When you buy a company's stock, you are becoming a shareholder in a business, and in the vast majority of cases a shareholder with a small stake, known in the market as a minority shareholder. Here it is worth highlighting the "business" and the "minority" aspects of the relationship.
Many people invest in the stock market in companies that they know little or nothing about (sometimes they don't even know exactly what the company does). If a friend of yours asked you to become an investor in a business he is starting now, most people with a modicum of common sense would first try to understand the business well before investing, trying to answer questions like:
- What are the products/services that this company is selling and what is the prospect of demand for them in the future? Are these products/services unique in the market (i.e., do they have what is called a “competitive advantage”) or are they the same or very similar to a thousand others that are already being offered by other companies?
- What is the sector of activity of this company and its most direct competition in particular? Is the industry made up of a dominant and competent company that will do everything to stay that way, or is it made up of a couple of "backyard" companies that don't work well and can't meet customer demands?
- What are the chances that my friend will be the best manager in this specific industry? Does he have the necessary experience and skills, along with the company's team, to meet customer expectations, or is it much more likely that a competing company will?
Equally important, this sensible person would analyze whether the “price” at which that share is being sold makes sense, analyzing items such as:
- if the current profit of the business is maintained in the future and is completely distributed among the shareholders, how long will it take me to recover my invested capital? and if it is necessary to make a large reinvestment of the profit in the business (and therefore cannot be distributed to the shareholders, at least initially), what are the prospects for growth of the business and appreciation of its shareholding?
- if I compare this investment with an investment with much lower risk, for example in federal government fixed income bonds, am I being duly compensated with a sufficiently greater possibility of future gain to offset all the additional risk I am taking?
- if I compare this business with other similar businesses, in Brazil or abroad, am I “buying” this share for a similar, higher or lower value? If higher, is there any objectively strong reason to pay more? If lower, is this investment really the “bargain” it seems to be, or should I even pay much less because some specific characteristics make it actually worse than other “comparable” businesses?
In investments in publicly traded companies, there is no reason for the analysis to be done in a less rigorous manner.
The “minority” aspect of the relationship means, in a very simplified way, that your influence on the company’s decisions will be extremely limited (if not none at all). In the extreme case, this means that, for example, if the company is changing the course of its business in a direction that you do not agree with, there will not be many alternatives other than simply selling the shares you bought. Obviously, there are minority investors in the market who have other options available. Normally, despite being minority shareholders, they manage to “accumulate” a percentage of participation, either individually or together with other important minority shareholders who think the same way, which allows them a certain influence on the company’s strategic decisions. However, this case is the exception and not the rule. Therefore, to really protect yourself from falling into this situation, it is important to also analyze the controlling shareholder and the company's executive management (board of directors):
- Does the controlling shareholder have a “fair” attitude toward its minority shareholders? Have there been situations in the past in which minority shareholders felt harmed by the actions of the controlling shareholder in this company (the same applies to the same controlling shareholder in another company)?
- Is the compensation of the company’s board of directors in line with “normal” standards or does it seem excessive? Is the compensation aligned, as far as possible, with the interests of the shareholders in general?
Risk
When you buy a company’s stock, you are taking a reasonable but limited risk. The maximum risk is losing 100% of your investment, a situation that is certainly not common, but is possible in cases of bankruptcy or judicial recovery (see, for example, what happened in 2008 during the American crisis involving the shareholders of Lehman Brothers, and the numerous cases that occurred when the Internet bubble burst between 2000 and 2002).
It is worth noting here that there are investments in which the risk is greater than losing all the capital that was invested (in “leveraged” investments it is possible to lose all the capital and still be in debt, for example). On the other hand, the possibility of losing 100% of the invested amount is certainly very risky compared to, for example, the security of a fixed-income investment. If you invest in federal government fixed-income securities, the chance of losing your entire investment is practically non-existent.
Return
The return on a specific variable income investment in a stock is not known a priori, as is the case with a fixed income investment (even if it is post-fixed). It is known, however, that this return will come from two main components: income and appreciation (or depreciation) of the stock price. The most common income is dividends and interest on equity. Just to simplify the explanation, we will limit ourselves here to considering only dividends.
Dividends are the direct distribution of a portion (or in some rarer cases, the total) of the company's profits to shareholders. The companies that distribute the most dividends are usually those that need to reinvest less of their profits in their own operations, and for this reason they tend to be "more mature" companies in their life cycle. Companies that need to use their profits to reinvest in their operations, usually to sustain growth, obviously pay fewer dividends. Because of these characteristics, it is very common for companies that provide public services, such as electric power, sanitation and telecommunications companies, to be good dividend payers. In this type of company, the large investment was made in the initial stage of providing services, when their networks had to be set up and most of their customers were served. Later, they only need to invest to renew assets that are being worn out or to make technological updates, an investment that is usually small compared to what was initially necessary to set up the business. Perhaps the great exception to this rule today are telecommunications companies, which, due to technology renewal, sometimes need to make large investments even after serving almost all customers in a certain concession area.
The value of dividends is directly related to the company's operational performance in the period, since they are taken from the company's profits. Ultimately, even a company that traditionally pays dividends, if for some exceptional reason it does not have sufficient profits in a certain period, may not make dividend payments as it would in more “normal” conditions.
The appreciation (or depreciation) of a share price is also closely linked to the company's operational performance, at least over long periods of time. It is worth noting here that over short, or even medium, periods of time, the price fluctuation of a share may have little to do with the operational performance of the company in question. The price of a share, as well as that of any asset (or commodity) that is subject to the laws of supply and demand and has a market for these forces to act, is subject to numerous factors that sometimes have little to do with its intrinsic value: general market "mood", exaggerated reaction of buyers/sellers to positive or negative news about that company, herd behavior of investors exaggerating price drops or rises, etc. In this regard, it is very difficult to predict price fluctuations over short periods of time. (*1)
At the same time, price fluctuations over long time intervals are directly related to the company's performance. Investors who know how to choose companies that will perform well in the future in relation to their current situation and in relation to their competitors, and who pay a reasonable price for the share, will most likely be rewarded with a return on price appreciation. The opposite is equally true. This concept is known internationally as Value Investing and several major investors have applied it or are applying it in one way or another. A short list of the best-known value investors would certainly include: Warren Buffett, Benjamin Graham, Seth Klarman, Martin Whitman, and Joel Greenblatt.
(*1) The school of investment analysis known as Technical Analysis or Graphical Analysis aims to predict price fluctuations over short time intervals, as short as intervals of a few days and in some cases even within the same day. No study has conclusively demonstrated that profitable and consistently replicable strategies can be produced using this type of analysis after accounting for transaction costs. However, there is also no conclusive study proving the opposite. There is much debate among different schools of thought on the subject. At the end of the day, at this point in the evolution of the study of finance, there are only opinions from different schools. We do not intend to add anything to this debate here, but we do want to make it clear that this is not a site about technical analysis. We believe that there are already many sources of information on technical analysis and at the same time very few on fundamental analysis. Our intention here is to contribute only to closing this gap by providing a good source of information for the latter.