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By Mark Devcich
So you’ve decided you want to invest in the stock market. But what should you think about next? Mark Devcich shares six fundamental tips for budding investors.
1. Understand how the company makes money
Understand what products and services the company sells, who their customers and suppliers are, and how they get paid. Remember you are investing in a business and not a stock.
Stock prices are far more volatile than the underlying financial results of the business. By understanding the business you’re investing in, you are less likely to panic if the stock price falls. If you don’t understand how the company works then forget those investment plans and look for something you do understand.
You don’t need to invest in all companies on the stock exchange, so only choose those companies you think you know something about. If you feel this is too difficult, buy an index fund that tracks the market return.
2. Ensure the company is sustainable and doesn’t have too much debt
When a company has too much debt, it means shareholders’ options are limited. Banks can often withdraw their financial support too. During the Global Financial Crisis, many heavily indebted companies were forced to sell assets to repay debt. This wiped out any returns for investors.
Lower levels of debt supported by real assets — such as property or strong cash flows — mean a company’s destiny is in its own hands.
3. Make sure there’s sufficient diversity in your portfolio
As with any investment, it is dangerous to have all your eggs in one basket. It’s wise to spread risk by investing in at least three different industry groups. That way, if one industry is suffering a downturn, the other sectors you’ve invested in are less likely to also be impacted.
Research shows that a portfolio of 10 stocks will result in lower levels of volatility. While volatility continues to fall when more than 10 stocks are held, it does so at a lower rate. The more stocks you hold, the more your transaction (such as brokerage) costs increase. You also need to dedicate more time to adequately follow the companies in your portfolio.
4. Look for a company where the management team has ‘skin in the game’
Invest in companies where the management teams’ interests are aligned with those of external shareholders. For example, where management owns a significant shareholding in the company, or their remuneration structure incentivises shareholder wealth creation.
Research suggests that companies with more management share ownership tend to have a greater focus on the long term and achieve better shareholder returns.
5. Buy companies that are market leaders or have demonstrated a track record of wealth creation
Stocks that are market leaders often have characteristics that make it difficult for competitors to displace them. These characteristics are called ‘moats’. Moats restrict competitors from entering the market, which means the company can continue to generate higher profits.
Companies with these competitive advantages experience long periods of growth and produce good, sustainable returns for shareholders.
6. Buy stocks when they are out of favour — it’s often a good thing
Buy your stocks as you would buy your groceries — when they are on sale. You’re likely to achieve significant returns if you do the opposite of the crowd: for example, buying stocks in a market panic and selling stocks in a market bubble. Psychologically this is hard to do, but it is crucial to achieving above-average, long-term investment returns.