Is there an easy way to invest in stocks?

Question: I am a newbie in stock investing. Just a few weeks into investing and I am already overwhelmed by the number of things people say I need to take into consideration. I would like to know if there are simple ways to invest in the stock market.—Posted in the “Ask a Friend, Ask Efren” service of www.personalfinance.ph

Answer: George Soros, who is known as the one who broke the Bank of England, was once quoted as saying, “It’s not whether you’re right or wrong that’s important, but how much money you make when you’re right and how much you lose when you’re wrong.”  The best way to maximize earnings and minimize losses is to do a lot of hard work on your homework.

There is a tendency not to see the forest for the trees. Too much attention is paid to details at the risk of losing sight of the big picture. But the opposite is also not good, especially for stock investing.

Nobody is brilliant in a bull run because most stock prices would be moving up. But not all prices will move up, particularly those that are already expensive. If people will focus just on the broad market indicators, they can get trampled upon by the bulls.

Consider two actual stocks, whose names we will mask, that represent firms that are leaders in the same industry. Stock A is priced at P7 per share while stock B is priced at P32 per share. The stock market is in a bull run. Would you buy stock A in the hope that its price will catch up with that of stock B? As my mentor used to say, this is where we separate the men from the boys.

A closer look at the two stocks show that the price-earnings (P/E) multiple of stock A is already at 19x trailing 12 months earnings (TTM) versus 11x for stock B. As a general rule, the higher the P/E multiple, the more expensive a stock is. In other words, stock A is already expensive while stock B is cheap, correct? Not necessarily.

As an investor, you would want to see returns on your investment or equity. Stock A has return on equity (ROE) on TTM of 14.17 percent while stock B has only 10.09 percent. Let’s use the Du Pont model to break down ROE to see why the ROE for stock A is higher than that of stock B.

The Du Pont model interprets ROE as the product of three ratios: profit margin, asset turnover and equity multiplier (i.e. by how much power debt multiplies to a company’s equity to create its assets).

Stock A’s equity multiplier is only 0.98x TTM, which means the company it represents has practically no debt. Stock A also just has a 0.99x TTM asset turnover. However, stock A more than makes up for these low numbers by displaying a tight control over costs and, therefore, a high profit margin of 14.64 percent TTM. The answer to 0.98 x 0.99 x 14.64 percent is approximately the ROE for stock A.

In contrast, stock B’s equity multiplier is a high 2.54x TTM. But stock B has a low asset turnover of just 0.61x TTM and a low profit margin of 6.5 percent TTM. Part of the reason for the lower profit margin could be the high level of interest expense from being highly leveraged vis-à-vis stock A. The answer to 2.54 x 0.61 x 6.50 percent is approximately the ROE for stock B.

The dividend yield for stock A is 2.94 percent, higher than the 1.19 percent of stock B.

It seems that while stock B is inexpensive P/E-wise, stock A produces the higher ROE and dividend yield, which perhaps explains the higher P/E multiple.

There is also a need to look at expectations on future earnings before a final judgment is passed.

All too often, the unsophisticated investor would only see the forest and not the trees. That is, such investors focus on the general indicators too much at the risk of overlooking the details. Examples of this attitude are focusing on the level of the composite index and being fixated on just the broad economic numbers.

Warren Buffet once said, “I never attempt to make money on the stock market. I buy on the assumption that they could close the market the next day and not reopen it for five years.” That is why he does a lot of research before buying anything.

There are no simple ways to stock investing.

Learn more about effective wealth, cash, debt and risk management by visiting www.personalfinance.ph. Attend the EnRich™ personal finance training on Oct. 26, 2013, in Quezon City, Nov. 9, 2013 in Davao City and Feb. 8, 2014 in Baguio City.

(Efren Ll. Cruz is a registered financial planner of RFP Philippines, personal finance coach, investment adviser and author. Questions may be sent by SMS to 0917-5050709 or e-mailed to [email protected].)