Investing in Stocks

Farm Business Management Update, October 1998

By Benjamin Kyle Burkhart and David M. Kohl of the Department of Agricultural and Applied Economics, Virginia Tech

In recent months, the stock market has seen substantial declines. People who have been investing in the market over the last few years may be reluctant to open their statements for fear of seeing how much their portfolios have declined. For the beginning investor, this perspective can result in procrastination in stock investing.

If you are about to begin investing in stocks, understanding the financial markets may be as confusing as the cockpit on a 767 airliner. All of the financial and market information that is available can leave you feeling overwhelmed by data, but lacking relevant information.

A tremendous amount of information is available; you can choose from many stocks; and multitudes of "experts" offer advice. How can you discern the good from the bad? If you're like the average beginning investor, picking a stock can be intimidating.

Reports show that if you had invested $1,000 in the stock market in 1958, you would have doubled your money 5 times. If you had invested in Microsoft in the early 1980s, today you would have made 50 times your initial investment. Hindsight is 20/20. But with a few tips, you can begin to focus on picking a stock.

Develop a Game Plan

Before starting an investment portfolio, analyzing your short-term and long-term goals and developing a plan is critical. You need to decide why you want to invest. Do you desire to make money quickly? Or are you planning for retirement? You need to match your goals and objectives to various classifications of stock. High-tech and new company (called small-cap) stocks generally earn or lose money quickly, because of the nature of the industries. Blue Chip stocks, however, have a long track record of steady performance for investors. By analyzing how you handle risk and what you want to do with your money, you can begin to narrow the selection of a stock.

Part of being successful is to establish a schedule for analyzing your portfolio. Stocks will move up and down, but avoid making long-term changes based on daily performance. Very few people can predict the direction of the market, so avoid making quick moves. Plan ahead to keep the stocks that make money for you over time and drop those that do not.

"In order to consistently make money in the stock market, you have to have some discipline," says Morgan Stanley-Dean Witter broker Mark Wigginton. "And you have to be in the market for the long haul. One of the biggest traps people fall into is overreacting to a swing in the market. The market goes up and down by nature, and if you want to make money, you have to be disciplined enough to stay with your investments even through a little swing." A study at the University of California-Davis found that the most active traders on a daily basis generally made about 10 percent. Those who bought and held their investments over a full year period made almost 18 percent.

Find a Broker

Full-service brokerage firms provide you with their perception on a company. They may send you information or put you on a mailing list at no cost. Full-service brokers have instant access to up-to-the-minute information, which they will discuss with you. If you want to get some expert advice on a particular stock, call three different brokers and ask for their opinions. Discounters, on the other hand, don't offer the same personal touch and information as full service brokers; they simply trade stocks. If you are sure what stocks you want to trade, discounters may be the best route.

An enormous amount of information is available about stocks, but be careful of the information you find. Magazines make money from selling advertising space. The advertisements will give you the positive information on a company and shy away from its weaknesses because their goal is advertising. Much information is also available on the Internet, but look for hard facts. Don't fall prey to free-lance journalists' opinions. Lots of people talk about the stock market, but beware of information gathered through word-of-mouth. The stock market is very fast and very efficient, and chances are the hot tip you get from your neighbor has already been incorporated into the trading.

Choices, Choices

When investing in stocks, purchase stock from companies with which you have some familiarity. For example, if you are familiar with computer technology and high-tech stocks fit your investment goals, then computer stocks should be a high priority investment. Invest in stocks of companies that you use in everyday life. If you are an agricultural producer, firms such as John Deere, Case International, or Monsanto may offer possibilities. If you are just getting your portfolio established, search for companies with proven track records. Coca-Cola, Wal-Mart, and Gillette all have been consistent in their growth and profit even though they experience short-term fluctuations. Seek companies with increasing market share, both nationally and globally, and with strong financial positions needed to weather economic downturns. For example, food stocks such as Kraft and Sara Lee are generally strong performers in recessionary times.

One tool to use in determining the value of a stock is to analyze its price/earnings (P/E) ratio. This ratio is simply the price of a stock divided by the annual earnings or profit of the company on a per share basis. So if a company has earnings of $10 million, with $1 million outstanding shares, it has earnings of $10 per share. If the stock is selling at $80 per share, its P/E ratio is 8 (price per share of 80 divided by earnings per share of 10). You can compare the P/E ratio with predicted growth rate of the company plus its dividend yield percentage. A P/E ratio of 20 may appear high, but if a company is growing at a rate of 25 percent each year and has a dividend yield of 3 percent, the P/E ratio may be insignificant. If growth percentage plus dividend yield is higher than the P/E ratio, generally the stock has a sound basis. You can obtain all this information from your full-service broker or in The Wall Street Journal and other financial publications that track stocks.

In summary, selling at the highest price and buying at the lowest price can rarely be achieved in the stock market. A strategy that includes discipline and finding good information is critical to a healthy portfolio. Selecting stocks from companies with strong histories of growth and healthy capitalization and management is the foundation upon which to build your growing portfolio.

Contact David M. Kohl at Sullylab@vt.edu.

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