INVESTING IN STOCKS: A BEGINNERS GUIDE Module Two: ECONOMICS Lecture Two: Leading Indicators 7. DURABLE GOODS ORDERS Long-lasting manufactured goods are termed as Durable Goods. The data series called the Durable Goods Orders measures the delivery of these items as an indicator of current industrial activity. Conducted via a monthly survey by the U.S. Census Bureau, the Durable Goods Orders is a key leading economic indicator. The level of industrial activity can be measured via the level of orders for Durable Goods. The Survey measures the delivery of Durable Goods which are long-lasting manufactured goods. The orders for Durable Goods can be useful in understanding the level of strength in the manufacturing industries such as Machinery, Transport and Technology. If the orders for Durable Goods is a high number, this indicates a positive trajectory for industry and for the Economy and vice versa. It is a key indicator monitored by Equity Investors to see the current level of economic activity. WARREN WILLIAM WWW.SMARTEST-DATA.COURSES # 51
Module Three: INVESTING Lecture One: Investments Lecture Two: Stocks WARREN WILLIAM WWW.SMARTEST-DATA.COURSES
INVESTING IN STOCKS: A BEGINNERS GUIDE Module Three: INVESTING Lecture One: Investments 1. BENCHMARK INDEX For a Fund, the Benchmark Index defines the investment universe, the risks and potential returns. For a Stock it becomes a reference for performance measurement. In preparing to invest in the Stock Market, identifying and setting an appropriate Benchmark Index is critical in defining the investment universe, the risks and potential returns. There are many, many indexes, a Benchmark Index, could be either a broad market index, a market capitalisation index, for example Small Cap Stocks or a sector index, Financial Stocks. The critical issue is that it is the Index referred to when investing or measuring the relative performance of either a fund or a stock. For an index to be considered appropriate for the purpose of benchmarking, it must contain the stock being referred to or in the case of a fund, large portion of a fund’s holdings must be taken from the Benchmark index’s constituents. The less representative of a fund’s holdings to the Benchmark Index, the wider the Tracking Error. The Benchmark Index chosen in order to measure a Fund’s performance must not be swapped for another index. If the Benchmark Index changes, then this could change the characteristics of the Fund. WARREN WILLIAM WWW.SMARTEST-DATA.COURSES # 53
INVESTING IN STOCKS: A BEGINNERS GUIDE Module Three: INVESTING Lecture One: Economics 2. BETA Beta calculates the past relationship for stock’s returns compared to the Index. Above 1 indicates a stock price has moved more than the Index, less than 1 historically lower price movements. The Beta of a stock is the measure of the historical movements of the stock price compared to the Index of which it is a constituent. A stock’s Beta can be calculated based on anywhere from a 36 to 60-month regression analysis of the stock’s returns against the Index. If a stock’s Beta is 1 then over the regression period, its returns have been the same as for the Index. However, this does not mean the returns were always identical. A High Beta stock will have a Beta over 1, for example 1.25, a Low Beta stock less than 1, for example 0.83. Beta Formula Beta = Covariance (Rs, Rm) / Variance (Rm) Rm = average expected rate of return on the market Rs = expected return on Stock = S The interpretation of the Beta Formula is this. If the Index goes up by 100 points from 5,500 to 5,600, then a stock with a starting price of $46.50 and a Beta of 1.25 should go to $47.55. An increase of 2.3%. The stock’s Beta of 1.25 indicated that the price movement of the stock should be 25%, greater than the increase of the Index which was 1.8%. If a stock has a Beta lower than 1, for example 0.95 as the Index increases 1.8%, the stock’s price movement should go up but less than the market. In the previous example the end price should be $47.23 a 1.71% increase. WARREN WILLIAM WWW.SMARTEST-DATA.COURSES # 54
INVESTING IN STOCKS: A BEGINNERS GUIDE Module Three: INVESTING Lecture One: Economics 3. DUE DILIGENCE Due diligence can assist an investor in being more disciplined in their investment selections. It's critical to remember that there is always some risk associated with investing in stocks. Thus, even doing the required homework does not ensure success. To ensuring that an equity investment is sound and likely to generate a fair return, due diligence is crucial. Think of these areas of research an investor should take into account. Company fundamentals is key, it is the basis for valuing a stock. Thus, learn about a company's profitability, financial stability, and cash flow condition. A potential investor should study the financial statements, the income statements, balance sheets, and cash flow statements. The investor should assess the management team of the company, taking into account their track record and business management expertise. An understanding of any potential regulatory changes that may have an impact on the business's operations or profitability should be known to the investor. The investor should take into account how the market feels about the company, including what is said in news stories, social media posts, and analyst reports and ratings. A valuation as to the potential share price is essential. Based on indicators like the price-to-earnings ratio, price-to-sales ratio, and price- to-book ratio, among others, the investor should assess the company's valuation. WARREN WILLIAM WWW.SMARTEST-DATA.COURSES # 55
INVESTING IN STOCKS: A BEGINNERS GUIDE Module Three: INVESTING Lecture One: Economics 4. EFFICIENT FRONTIER If a Stock Portfolio lies on the Efficient Frontier, this offers the maximum return for the level of risk taken. In investing the concept of an Efficient Frontier, is the optimal risk return allocation for the specific asset allocation. In a Stock Portfolio, this means returns are maximized for the level of risk taken. A Stock Portfolio that lies on the Efficient Frontier is known as the Optimal Portfolio and it usually exhibits a higher degree of diversification. An Optimal Portfolio can be defined as either offering the lowest risk for a defined expected return or offering the highest expected return per a defined unit of risk. Sub-optimal Portfolios are portfolios that do not lie on the Efficient Frontier offering less returns per unit of risk taken. The Efficient Frontier concept can also be applied to a mixture of Asset Classes, Equities, Bonds and Funds. WARREN WILLIAM WWW.SMARTEST-DATA.COURSES # 56
INVESTING IN STOCKS: A BEGINNERS GUIDE Module Three: INVESTING Lecture One: Economics 5. FINANCIAL MARKETS Financial Markets provides buyers and sellers the means to trade a wide range of financial instruments. For a Financial Market to be successful this must be done in a transparent, secure and efficient process. A Financial Market refers to a market exchange where securities are traded. The Financial Markets have evolved, they can be physical locations, for example the NYSE on Wall Street or an electronic or virtual market. For a Financial Market to be viable they must offer price transparency and discovery between market participants, efficient settlements and in certain cases custodianship of the securities traded. There are 5 main types of Financial Markets based on the securities traded. Stock Market – The trading of share certificates in publicly listed companies. Bond Market – The trading of Bonds, Government or Corporate. Commodities – The trading of a wide range of Commodities from Agricultural commodities, Energy and Minerals. Derivatives Markets – Covering Futures and Options Currency Markets – The exchange of one currency for another at the current exchange rate. WARREN WILLIAM WWW.SMARTEST-DATA.COURSES # 57
INVESTING IN STOCKS: A BEGINNERS GUIDE Module Three: INVESTING Lecture One: Economics 6. LARGE-CAP STOCKS In the U.S, a stock is classified as a Large Cap Stock, when it has a total Market Capitalisation exceeds $10 billion. Market participants look to segment the Stock Market, to classify stocks by Market Cap is one method, into Large, Mid, Small and Micro-Cap Stocks. The level of a Company’s Market Capitalisation, {Stock Price x Number of Shares} is one way the Stock Market is segmented. Market Cap is an important measure as it is the correct measure to understand the value of a Company as perceived by Investors in the Stock Market. Segmentation by Market Cap, commonly starts with Micro-Cap Stocks under $300 million, then Small Cap from $300 million up to $2 billion, Mid Cap from $2 billion up to $10 billion. Then once a Company has a Market Cap over $10 billion, in the U.S. this is classified as a Large Cap Stock. The U.S. is by far the world’s largest Stock Market, so this classification can be relative, in other Stock Markets a Large Cap Stock could be a Stock with a Market Cap over $5 billion. The Large Cap Stocks represent the main percentage weighting of the Market Cap in the U.S. Several of Large Cap Tech Stocks, have a combined weighting of around 10% of the overall Market Cap. In any Stock Market, the Large Cap Stocks are the most widely held by Investors and they are the core holding for many broad-based Equity Funds which are not focused on more specialised strategies. They are also the most followed by the Analytical Community, issuing on a regular basis a deep library of Research and Earnings Estimates. The segmentation of the Stock Market is important for comparative Stock Valuations and Industry Analysis. Market Cap is one method, another way the Stock Market is segmented is by Industry and Sectors. WARREN WILLIAM WWW.SMARTEST-DATA.COURSES # 58
INVESTING IN STOCKS: A BEGINNERS GUIDE Module Three: INVESTING Lecture One: Economics 7. INDUSTRY CLASSIFICATION Industry Classification is when companies are grouped together based on the businesses that dominate Total Revenue. This assists in defining a competitive position and to compare valuations to similar companies. In the Stock Market, companies are classified together into Industries based on their primary business activity. Industry Classification is an economic taxonomy that classifies companies into Industrial groupings. In general, this is based on the dominate business by revenue, also taken into consideration is a similar style of industrial production, similar or competing products and a similar financial structure. Industry Classification can be further divided into Super Sectors, Sectors and Sub-Sectors. The Industry Classification of companies allow market participants to analyse companies operating in similar businesses. Hopefully, this offers a better understanding of the competitive forces a company is facing and the appropriate valuation metrics that could reasonably be applied. WARREN WILLIAM WWW.SMARTEST-DATA.COURSES # 59
INVESTING IN STOCKS: A BEGINNERS GUIDE Module Three: INVESTING Lecture Two: Stocks 1. ALPHA Alpha measures the excess return of a Stock above the return of its’ relevant Benchmark Index. Alpha is one of two coefficients (the other is Beta) in the Capital Asset Pricing Model (CAPM). In Stock investing the Greek Letter Alpha refers to the excess return on an individual Stock after adjusting for the price volatility which is related to the market and any random price movements. If the Stock’s Alpha is 2.5 this means the Stock has outperformed its relative Benchmark Index, which could be the overall Market or its Sector by 2.5%. Alpha generation describes an Equity Investor’s ability or edge in producing superior equity returns via a unique investment and trading strategy. The generation of Alpha in a Stock Portfolio refers to the ability of an Equity Portfolio Manager to generate excess returns. Alpha generation could be done by employing an investment strategy which the Manager has developed likely combining both Valuation techniques, quantitative or qualitative and Trading strategies. The aim is to consistently achieve better returns compared to a reference Equity market, which could be the overall Market or a Sector. The ability to generate Alpha is used to describe a Manager’s edge or ability to beat the Equity markets. Managers seeking to generate Alpha will focus on investing in specific Stocks. WARREN WILLIAM WWW.SMARTEST-DATA.COURSES # 60
INVESTING IN STOCKS: A BEGINNERS GUIDE Module Three: INVESTING Lecture Two: Stocks 2. INSIDER TRADING If someone provides or possesses inside information about a listed company, information not released publicly. Then with this information a trade is executed, is trading illegally. This is Insider Trading. Whether or not an insider who trades in a public company is acting legally or illegally, depends on when and how the trade is made. But if in doubt, do not trade. Let’s go through the six examples of Insider Trading, cases that have been brought by the SEC, listed on the SEC website. • Case One Company Executives, Directors and Employees who traded the Corporate Stock after learning about non publicly disclosed information. • Case Two Friends, family, or business associates tipped off to such information from company employees of any level. • Case Three Employees of brokerage, banking, law, or printing firms who traded based on information they obtained through providing services to the company. • Case Four Government employees who traded because of non-public information they learned due to the nature of their employment • Case Five Political intelligence consultants who trade or offer tips due to non-public data ascertained from government employees. • Case Six People who misappropriated and used non-public information from numerous sources, including family, friends, and employers The Six SEC Cases reveal that Insider Trading is not an exclusive domain of individuals who fall under the “Insider” definition. Central to the concept of Insider Trading is information and how WARREN WILLIAM WWW.SMARTEST-DATA.COURSES # 61
INVESTING IN STOCKS: A BEGINNERS GUIDE Module Three: INVESTING Lecture Two: Stocks it is used. Therefore, a person outside of a company can be equally guilty of Insider Trading as a corporate executive. The legal consequences of Illegal Insider Trading can be very severe, with a maximum fine of $5 million and a maximum prison sentence of 20 years, per the SEC regulations. WARREN WILLIAM WWW.SMARTEST-DATA.COURSES # 62
INVESTING IN STOCKS: A BEGINNERS GUIDE Module Three: INVESTING Lecture Two: Stocks 3. INITIAL PUBLIC OFFERING (IPO) An IPO is when a Private Company converts to a Public Company following the listing of its Shares on the Stock Exchange. A Listed Company will be analysed and will be able to raise capital in the future. An IPO is a major step for a Private Company, converting to a Public Company listing of its Share on the Stock Exchange. When a Company becomes a Public Company, it opens up to greater public scrutiny as it has the Investment Community and the Media gathering information on its operations and placing a valuation on its’ Shares. The main motivation for a Company to go through an IPO is the ability to access new sources of capital via the Equity Capital Markets. The owners can release some of their wealth previously tied up in the company thus providing them with liquidity. In the past an IPO was a young Company with a thirst for capital, listing on the Exchange. Now there is the invention of the Unicorns which are IPOs for over $1 billion. WARREN WILLIAM WWW.SMARTEST-DATA.COURSES # 63
INVESTING IN STOCKS: A BEGINNERS GUIDE Module Three: INVESTING Lecture Two: Stocks 4. PRICE RATIOS Price Ratios calculate the multiple of the current Share Price to Book Value and various P&L entries. Widely used to compare and contrast Stock, Sector and even Index Valuations. The Price Ratios are a series of ratios calculated by using the current Share Price as the Denominator and using various P&L entries and Book Value as a Numerator. The different items used as a Numerator taken from the Profit and Loss include, Sales, EPS (PE Ratio), Dividend per Share, Cash Flow per Share or Balance Sheet items, Book Value per Share or Tangible Book Value per Share. The Price Ratios are used as an historical comparison over a Stocks trading history, against the Sector Index or the major Index. For Sectors, Price Ratios can be aggregated for Intra Sectorial comparisons and against a major Index, such as the S&P 500. WARREN WILLIAM WWW.SMARTEST-DATA.COURSES # 64
INVESTING IN STOCKS: A BEGINNERS GUIDE Module Three: INVESTING Lecture Two: Stocks 5. INVESTMENT HORIZON Investment decisions matter, they matter a lot. An Investment is an asset that acquired to not for our daily lives, but to generate capital gain or income or a combination of the two. An asset which is purchased but is not part our daily needs, an asset with the specific objective of generating an income stream or capital growth or a combination of the two. This is an Investment. An Investment is a very basic term to define at the same time it needs to be put into perspective. When we receive a flow of income which could be a regular inflow such as our salary or from the sale of a property, we are faced with a choice of either spending it on our daily lives, so instant gratification or the cash can be invested. An Investment Horizon for Stocks indicates the time required to hold a position in a Stock to be adequately compensated for the Market and Stock Specific risks. The Investment Horizon is a critical part of the analysis, scenario evaluation and decision process, when investing in Stocks. An Investment Horizon covers from the short-term, within the next 12-months to a much longer- term, around 5 years. Investing in Stocks requires a realistic time horizon, 12 months is at least a start, more realistic is 2 to 3 years. A Stock Portfolio is dynamic, a 2-to-3-year Investment WARREN WILLIAM WWW.SMARTEST-DATA.COURSES # 65
INVESTING IN STOCKS: A BEGINNERS GUIDE Module Three: INVESTING Lecture Two: Stocks Horizon does not mean that positions and the weighting in a Stock Portfolio cannot change, they can change, they must change. Stock Markets are changing constantly, an avalanche of information arrives daily. Some short-term Stock trading strategies, based on graphs or technical analysis, may work. This is not Investing this is Trading and they are two different approaches. An Investment Strategy defines guidelines for Stock investing. Sets various investment limits, for example in Sector allocation or individual Stock weights. Most importantly gives discipline and direction. Investing in Stocks is not a sprint it is a journey, a Road Map is required. An Investment Strategy takes time and effort to put in place, but this piece of bureaucracy will give direction at critical points in investing in the Stock Market. An Investment Strategy for the Stock Market should start with an Investor’s Investment Objectives and must be documented. The Investment Strategy can be quite simple or detailed, as long as it imposes a discipline, and the Strategy is followed. Investment Strategies range from Conservative to an Aggressive Strategy. For example, a Strategy could guide Sector allocations, number of Stock positions, limits on Market Cap and maximum weights. Plan the Strategy, then invest the Strategy. WARREN WILLIAM WWW.SMARTEST-DATA.COURSES # 66
INVESTING IN STOCKS: A BEGINNERS GUIDE Module Three: INVESTING Lecture Two: Stocks 6. EQUITY RISK PREMIUM Think of the Equity Risk Premium, as a hurdle rate required in order to assume the extra risk involved in investing in Stocks. The premium demanded for stocks will depend on the current phase of the Equity Cycle. In order to justify the extra risk over and above the return offered on a “Risk-Free” Investment, a return premium is required. This is the Equity Risk Premium justifying the extra risk involved in investing in the Stock. The Risk Premium allocated to a Stock, then added to a risk-free rate of return, should over the long-term, indicate the possible return of a Stock. The estimated level of risk specific to a stock, earnings forecasts, price volatility, valuations will be factors in determining the specific excess Equity Risk Premium for an individual Stock. Therefore, the premium demanded will vary depending on the Equity Cycle and outlook for a specific Stock. WARREN WILLIAM WWW.SMARTEST-DATA.COURSES # 67
INVESTING IN STOCKS: A BEGINNERS GUIDE Module Three: INVESTING Lecture Two: Stocks 7. ILLIQUID STOCKS Illiquid Stocks cannot easily be sold on the Exchange. Market Cap is an indication, Nanocap or Microcap Stocks, Volume, Free Float and Price Spread are also factors. Limited Investor interest could be an issue. A Stock’s level of liquidity is one factor often overlooked by Stock Investors, at the point of investing, in monitoring a Stock holding often only discovered at the point of attempting to sell the Stock. The potential for a Stock to become illiquid is a major risk to the Share Price and is exacerbated as the Share Price falls. Illiquid Stocks are generally thought of or classified in terms of the size of their Market Cap, so Nanocap, Penny and Microcap stocks and this is certainly a good place to start. When Stocks become Illiquid Stocks, they cannot easily be traded in the Stock Market, thus carry greater risk in their Stock Price. Why or how Stocks become illiquid is more nuanced than simply looking at Market Cap. Any Stock, independent of Market Cap can become illiquid. The reality is that, in the worst-case scenario a Stock can become illiquid due to limited interest by other investors. Apart from limited investor interest, the level of volume traded is key to identifying illiquid stocks. Therefore, as part of the analysis a clear understanding of the following three points are critical. First, the level of volume traded as a percentage of Market Cap, which can be assessed by analysing the WARREN WILLIAM WWW.SMARTEST-DATA.COURSES # 68
INVESTING IN STOCKS: A BEGINNERS GUIDE Module Three: INVESTING Lecture Two: Stocks very recent volume compared to Average Daily Volume traded, calculated over the past 3 months. Understand the percentage volume traded compared to other Stocks with a similar Market Cap and the recent trend, if decreasing in Volume this is a concern. Second, the percentage Free Float, which is simply the amount in percent of the Stock’s Market Cap, which is freely floated on the Stock Market. The Free Float is the Shares not held by Management or “Insiders”. For example, in the January 2021 trading of GameStop, the short position was 130% of Market Cap. I believe around 14% of the GameStop shares were held by the new management. Thus, the short position of the actual Free Float was 50% above, further impairing the Hedge Funds ability to cover their short position. Somewhat subjective but be aware if the free float is lower than 50%, this is a concern. Third, the Bid-Ask spread must be taken into consideration. For Stocks with a high volume the Bid-Ask spread should or will be narrow. Then, if the spread between the Bid-Ask Prices is wide or starting to widen and the Price Volatility is increasing, this is also a concern. A quick way to assess if the Bid-Ask Spread is wide is to look at the range of the daily Price movements from high to low and if the Bid offered keeps dropping. Avoid illiquid stocks and monitor the liquidity trends of Stock positions currently held, in particular, for Stocks classified as Nanocap, Penny or Microcap Stocks. WARREN WILLIAM WWW.SMARTEST-DATA.COURSES # 69
SMARTEST DATA About the Author Warren William Meet the author behind Smartest-Data. Warren William has a career in Finance and Investments extending over 35 years, both on the Buy Side and Sell Side. His most recent roles include, developing Institutional Risk Management Programs for managing Equity and Fixed Income Risk. Prior to this Warren William work in Alternative Investments, in Investment Management and as a Buy Side Equity Analyst. Warren William brings a wealth of knowledge and expertise to the table, providing in-depth analysis and commentary on the latest trends in the Stock Markets. WEBSITES www.smartest-data.com www.smartest-data.blog www.smartes-data.courses
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