Individual Stocks—Section 6

 

Many of our clients have the ability to purchase individual stocks and bonds through their 401k plans. This section will be helpful to those already investing in individual securities and for those thinking about doing so. It will also provide a useful background for the great majority of our clients who have no intention of ever investing in individual stocks but who wish to learn more about how and why the stock market moves and how to keep their mutual fund investments on the right side of major market trends.

Stocks represent an ownership interest in a corporation. For example, if a company has 1,000 shares of stock and you own 100 shares you own 10% of the company. Most publicly traded companies that you would be interested in owning have millions of shares outstanding. So if you bought 100 shares of General Electric, your ownership interest would be very small. It still, however, would be an ownership interest. You would have the right to share in any dividends, vote for board members and the value of your shares would increase or decrease according to the fortunes of GE.

Stocks move up and down for only one reason, supply and demand. When supply exceeds demand, sellers must lower the price that they are willing to accept for their stock in order to attract buyers. This causes the stock’s price to fall. When demand exceeds supply, buyers must increase the amount that they are willing to pay for a stock in order to attract sellers. This causes prices to rise. If supply and demand are equal, the stock’s price remains the same or almost the same.

The factors that influence the supply and demand for a particular stock include:

·Company fundamentals

·Investor perceptions

·Technical factors

·News

·Sector and industry conditions

·The overall trend of the market

Fundamental analysis is a method of measuring the internal conditions of a company through the use of a variety of accounting measurements and ratios. Items such as earnings, profitability, sales, prospects for growth and debt are analyzed and compared to the same measurements obtained from other companies. This is the traditional method of stock analysis and is practiced by most financial institutions including mutual funds.

A profitable company with consistent earnings growth is likely to be purchased and held by large financial institutions. This increases demand for the stock and reduces supply. The institutions probably won’t sell the stock unless they realize a substantial profit or unless the company’s fundamentals change. New investors who wish to purchase the stock may have to increase the amount that they are willing to pay in order to obtain it; pushing the stock’s price higher.

Investor perceptions, which are often clouded by the emotions of fear and greed, also play a major role in creating supply and demand for a stock. If fundamentals represent the facts about a company, perception is how these facts are interpreted. Because of the emotional component of perceptions, they are not always accurate or, for that matter, rationale. This is particularly true in the short run. A classic example is the tech bubble of 1999 and 2000. Untried companies, with little in the way of earnings and no profits, were trading at multiples of projected earnings that would be almost impossible to achieve in the real world. Yet due to the combined effects of ignorance and greed, these stocks continued to rise. At the time, many new players had entered the market with little understanding of market dynamics, whose only concern was not to miss out on further profits.

Eventually the tech bubble, like all bubbles, burst and fear replaced greed as the dominant emotion, dragging the NASDAQ from a high of over 5000 to a low of a little over 1000.

Another method of analysis that effects stock prices is Technical Analysis. Technical Analysis attempts to measure the forces of supply and demand directly. It involves the study of price and volume patterns in conjunction with many mathematical tools to predict the probability and extent of a future price move.

Technical analysis is used by professionals and non-professionals alike as a method of timing stock exit and entry points. Because technical analysis is so widely used, I believe that it acts as a self-fulfilling prophecy. That is, many people see the same buy and sell signals on their charts simultaneously and act accordingly.

More than other markets, the stock market is news driven. When unexpected news is released about a company, the professionals act with amazing speed, driving the stock price up or down many points. Some times in a matter of seconds. The most common form of news that drives stock prices are earnings reports which are released each quarter. If a company’s earnings beat the analyst’s expectation, the stock is likely to rise. If earnings fail to meet expectations, the stock price will probably fall. Take over announcements have an even more dramatic effect on a company’s stock price. If the news of the acquisition is released when the market is closed, the stock of the company being acquired can open 20 points or more above the previous day’s close.

Other news that can impact a company’s stock price include developments concerning a major lawsuit, obtaining a new patent, financial irregularities, the death of a well known CEO or a delay in SEC filings.

When it comes to news, you should be aware that it is not always distributed in a uniform manner. The institutions and professionals sometimes have access to important news before it is released to the general public. Most of the time there is nothing illegal about this, they just have better research capabilities than you. They are also usually in a better position to interpret how this news will impact a company’s stock price. Because of this, news may already be factored into a stock’s price. I believe that this is the origin of the Old Wall Street adage “buy on the rumor and sell on the news.”

As we discussed in (section 3) and (section 4) overall sector and industry conditions also impact individual stock prices. Again the logic behind this is straight forward. If economic forces cause an industry to become more or less profitable, it will affect all companies within that industry in a similar way. There will, of course, be variations in the degree that these economic forces effect particular companies but everyone in the industry is essentially in the same boat.

The overall trend of the market (see section 12) has a profound impact on individual stock prices. As I mentioned, the majority of stocks increase during a bull market and decline during a bear market. The reasons for this are both logical and irrational. Bear markets typically begin in anticipation of an economic slowdown. When business activity decreases, company earnings and profits also decrease. This is reflected in declining stock values. This is the logical part of the process. As a bear market unfolds, optimism turns to concern, which turns into fear and ends in panic. During the fear and panic stages the stocks of even very strong companies are sold at fire sale prices.

Occasionally I am asked about the advisability of the average investor trading individual stocks. My answer, is that if you’re not prepared to devote several years to serious study, don’t do it. It is very difficult to consistently earn money trading stocks, while it is very easy to lose it. It has been my experience that someone who dabbles in stocks, may without knowing it, assume a host of asystemic and systemic risks (see section 3). If that person doesn’t know how to protect him or herself from these risks, they stand an excellent chance of experiencing a catastrophic loss.

If you intend to purchase individual stocks, please take the following precautions:

  • Keep your positions small. Never invest more than 5% of your total account balance in any particular stock.
  • Always, and without exception, use stops. A stop is an automatic sell order that will be triggered when a stock declines to a specified price. For example, if you buy a stock at $50 and you place a stop at $45 your position would be automatically liquidated if the stock declined to $45. Stops prevent small manageable losses from becoming large disastrous ones.
  • Stops don’t always work perfectly. In a fast moving market, your stop may be executed well below your stop price, so keep your positions small.

If a stock moves in your direction, gradually increase your stops. There are many different methods of placing stops. The key is to decide on your maximum acceptable loss in advance and to stick with it regardless of subsequent price action.

To sum up. Individual stocks are subject to a variety of asystemic and systemic risks. Stocks move up and down for a variety of reasons, some of which are rationale while others are not. Individual stocks are not suitable for the casual investor.

Quiz—Section 6

1. Stocks are:

A) An ownership interest in a corporation

B) A certificate of corporate debt

2. If the supply of a stock exceeds the demand for a stock, in order to sell a stock, you may have to:

A) Increase the price that you are willing to accept

B) Reduce the price that you are willing to accept



3. Factors that influence the price of a stock include the following.

Select all that apply.

A) Company fundamentals

B) Investor Perception

C) News about the company

D) The overall trend of the market



4. The emotions of fear and greed:

A) Always result in the market behaving in a rationale manner

B) Always result in the market behaving in an irrational manner.

C) Sometimes result in the market behaving in an irrational manner.

D) Are unimportant in terms of a stock’s price.



5.When it comes to news about a company, the following is true:

A) Because of strict insider trading rules, news is always distributed in a uniform manner.

B) Everybody on Wall Street is a crook and the insiders always know in advance about changes in stock prices.

C) News has no effect on the price of stocks

D) Large institutions have better research capability than the average investor and news is often factored into a stock’s price.



6.The overall direction of the market:

A) Has no effect on the price of an individual stock

B) Has profound effect on individual stock prices



7.When you purchase an individual stock, you assume which of the following risks. Select all that apply.

A) Business risk

B) Valuation Risk

C) Industry Risk

D) Market Risk



8.With individual stocks _____________. Check all that apply.

A) It is very easy to be consistently profitable

B) It is very difficult to lose money

C) It is very difficult to be consistently profitable

D) It is very easy to lose money

 

Securities offered through Registered Representatives of Cadaret, Grant and Co., Inc., Member FINRA and SIPC, 239 New Rd, Parsippany, NJ  Registered Representatives are licensed to conduct securities business in NY, NJ, PA, MA, CA and FL.  Bauman, Noonan and Associates and Cadaret, Grant and Co., Inc. are separate entities.