Stock investing explained : A beginner's guide
Updated on November 05,2022
I would love to sit back, watch my money grow, and collect dividend checks as money rolls in.
Would you?
I get it. It sounds like I am building castles in the air.
The claim, however, is more substantial than you might think. And the money-rolling thing? That is true too ( this, of course, would continue as long as the market allows-which most often, it does unquestionably).
As most have already guessed (on mentioning of dividends), am talking about STOCKS.
Stock is undoubtedly one of the greatest tools and financial instruments ever built for creating wealth. Very lucrative and equally risky.
Allow me to take you through some history classes.
History of Stock Investing
In the 1990s, many American investors went for the rage of investing in stocks, Yet they didn't know exactly what they were investing in.
Perhaps they could have avoided some expensive mistakes if they had a rudimentary understanding of what stock really is.
They watched as their stock portfolios and their stock mutual funds skyrocketed (the bull market), and by 1999 about half of the country's households were in the stock market.
Raar!! like a bolt from the blue, millions lost money when the stock market( actually the dot-com market) suddenly fell big time (t the bear market) in 2000-2002.
Importance of research and ForeKnowledge in stock investment
Knowledge is, therefore, prudent even for the self-proclaimed know-alls before venturing into this lucrative but risky market.
Unfortunately, even after a decade of wound healing and fresh regrowth, many investors do things in reverse; they buy the stock first and learn "some lessons" afterwards.
Your success depends on doing your homework before investing your money in stocks. Most investors don't realize that they should be scrutinizing their own situations and financial goals at least as much as they scrutinize stocks.
But how else can you know which stocks are right for you?
Too many people risk too much simply because they don't take stock of their current needs, goals, and risk tolerance before they invest.
The bottom line is that the first thing you do in stock investing is not to send your money to a brokerage account or go to a Web site to click "buy stock."
You should learn as much as possible about stocks and how to use them to achieve your wealth-building goals. The winning techniques are tried and true but how you assemble and apply them is what makes the difference.
That's exactly why a series of stock market learning has been created for you. It is, however, for the open-minded. In the first part, you will learn just what stock is. Stay anxious but learn and apply. I wish you luck throughout the series.
What is stock?
Whether you call it shares, equity, or stock, plain and simple, it means a share in the ownership of the company. That is, you get to own a part of a company. Acquiring more stock means you get more stake in the company's ownership.
You own", I know. Holding a company's stock means that you are one of the many owners (shareholders) of a company, and, as such, you have a claim (though usually tiny) to everything the company owns. It overwhelms.
That might technically mean you own a portion of the company's compound( the grass included), a tiny sliver of every piece of furniture, every trademark, and every contract of the company. As an owner, you are entitled to your share of the company's earnings and any voting rights attached to the stock.
My grandfather would have to prove his stock ownership using a stock certificate during their time. But not anymore. Your brokerage keeps these records electronically, which is also known as holding shares. This is done to make the shares easier to trade.
Now, trading with a click of the mouse or a phone call. Compare it with the past, when a person wanted to sell their shares, that person physically took the certificates down to the brokerage.
Details an investor/shareholder should understand.
- it does not mean you have a say in the day-to-day running of the business. Instead, one vote per share to elect the board of directors at annual meetings is the extent to which you have a say in the company. You can't walk into the Toyota Company and pick your right choice of Toyota-Harrier and drive away just because you hold a share or ten of the same. It would be weird, don't you think?
- It has a limited liability, which means that, as an owner of a stock, you are not personally liable if the company cannot pay its debts. Other companies, such as partnerships, are set up so that if the partnership goes bankrupt, the creditors can come after the partners (shareholders) personally and sell off their personal assets like houses, cars, furniture, etc. Owning stock means that, no matter what, the maximum value you can lose is the value of your investment. Even if a company of which you are a shareholder goes bankrupt, you can never lose your personal assets. But you can lose all of your savings.
- You don't quite have much material influence in big decision-making. Rather, the large investors do. Actually, you went there to earn profits and let the managers do their work. But if work is done poorly, shareholders can vote them out together.
- Being a shareholder is important because you are entitled to a portion of the company's profits and have a claim on assets. Profits are sometimes paid out in the form of dividends. The more shares you own, the larger the portion of the profits you get. Your claim on assets, however, is only relevant if a company goes bankrupt. In case of liquidation, you'll receive what's left after all the creditors have been paid.
Hmm... I am satisfied with the introduction, are you? Check out the next article on the same subject. We will discuss the following; debt and equity-what differentiate a bond from a stock and the types of stocks. You will also get to know how stocks to trade.
Debt Financing vs Equity Financing
As I might have guessed, you might wonder why a company would sell some part of it to be owned by other people ( outsiders) and why share profit with them.
Well, there are two major ways a company can use to generate capital when the need arises: borrow it from somebody else, or raise it by selling some part of it, which is known as issuing stock.
The former can either be achieved by borrowings from a monetary institution like a bank, or the company can issue bonds. Both are part of debt financing.
However, the company does not have to pay for any borrowings when it comes to issuing stock. Instead, it shares its profits with its financiers (the shareholders). This is termed equity financing.
Bond vs Stock
When you buy a debt investment such as a bond, you are assured of getting your money back(the principal) and the promised interest returns. Whereas in equity financing, this isn't the case. You assume the risk of the company not being successful.
As an owner, your claim on assets is less than that of creditors. This means that if a company goes bankrupt and liquidates, you, as a shareholder, don't get any money until all the creditors, i.e., the banks and bondholders, have been paid out; we call this absolute priority.
Shareholders earn a lot if a company is successful, but they also stand to lose their entire investment if the company isn't successful.
Understand this also. Some companies pay out dividends, but many others do not. And there is no obligation to pay out dividends even for those firms that have traditionally given them.
Without dividends, an investor can only make money on a stock through its appreciation in the open market. On the downside, any stock may go bankrupt, so your investment is worth nothing.
Types of Stock
When investors talk about stocks, they usually mean “common stocks”. A share of common stocks means a share of ownership of the company that issues it.
The company's price fluctuates depending on its performance and how investors predict it. The stock may or may not pay dividends which usually come from profits. If the profits fall, dividend payments may be cut or eliminated.
Many companies also issue “preferred” stock. It's similar to common stocks as it also pertains to a share of ownership. The difference is that preferred stockholders get the first dibs on dividends in good times and on assets if the company breaks and liquidates.
Theoretically, the preferred stock price can rise or fall along with the common stock. In reality, however, it doesn't move nearly as much because preferred investors are interested in dividends, usually fixed when stocks are issued. Preferred stock is more comparable to a bond than to common stocks.
It's difficult to find a compelling reason to buy preferred stocks. They generally pay slightly lower than the company's bonds and are unsafe. The chance for their price rising along with that of common bonds has been largely illusionary.
Stock Markets
Stocks are bought and sold on one of the many stock markets like the Nairobi Securities Exchange (NSE).
The following link gives you a list of all African stock exchange markets.
Stocks sold on an exchange are said to be listed there. These are also called exchanges, which are places where buyers and sellers meet and decide on a price.
Some exchanges are physical locations where transactions are carried out on a trading floor. In which traders are wildly throwing their arms up, waving, yelling, and signalling to each other. The other type of exchange is virtual, composed of a network of computers where trades are made electronically.
The purpose of a stock market is to facilitate the exchange of securities between buyers and sellers, reducing the risks of investing. However, we should distinguish between the primary market and the secondary market.
The primary market is where securities are created (using an IPO), while, in the secondary market, investors trade previously-issued securities without the involvement of the issuing companies.
The secondary market is what people are referring to when they talk about the stock market. It is important to understand that the trading of a company's stock does not directly involve that company.
When should I invest in stock?
Opportunities to make money in the stock market will always be there, no matter how well or poorly the economy and the market are performing.
There’s no such thing as a single magical moment, so don’t feel that if you let an opportunity pass you by, you’ll always regret that you missed your one big chance. Furthermore, it's purely a risk- there is no such thing as a sure thing.
One of the largest stock market investors, Warren Buffett and Carl Icahn, placed their biggest bets on companies when the market was under stress . Knowledge of the stock dynamics is therefore necessary.
How to choose a company to acquire a share from.
Stocks represent ownership in companies.
Before you buy individual stocks, you want to understand the companies whose stock you’re considering and find out about their operations.
Taking Kenya, for example, the link provides a list of companies that have been listed by the Nairobi securities exchange.
It may sound daunting, but you’ll digest the point more easily when you realize that companies work similarly to how you work. They make decisions on a day-to-day basis just as you do.
You need to know that the company you’re investing in is financially sound and growing, offering products and services that consumers demand and in a strong and growing industry (same for the general economy).
How to determine the value of a company
You can determine the value of a company (and thus the value of its stock) in many ways.
The most basic way to measure this value is to look at a company’s market value, also known as market capitalization (or market cap).
Market capitalization is simply the value you get when you multiply all the outstanding shares of a stock by the price of a single share.
Calculating the market cap is easy. It’s the number of shares outstanding multiplied by the current share price. If the company has 1 million shares outstanding and its share price is Ksh.20, the market cap is Ksh.20 million. Small cap, mid cap, and large cap aren’t references to headgear but references to how large the company is as measured by its market value.
The following basic economic principles are essential to understand the value of a company.
Assets minus liabilities equal net worth.
Take what you own(assets) and subtract what you owe (liabilities) the difference is what you're worth.
A company’s balance sheet shows you its net worth at a specific point in time (e.g. As of June 1st).
A company's net worth is the bottom line of its asset and liability picture, and it tells you whether the company is solvent (can pay its debts without going out of business).
The net worth of a successful company is regularly growing. To see whether your company is successful, compare its net worth with the net worth from the same point a year earlier, usually at the end of every fiscal/financial year.
Income less expenses equal net income.
Take what you make (your income), subtract what you spend (your expenses), and the remainder is your net income (or net profit or net earnings — your gain).
Why invest in stocks if it were not for the company's profitability? As it is through profits, the company becomes more valuable, and in turn, its shares and dividends value follow suit.
To discover a company’s net income, look at its income statement. Try to determine whether the company uses its gains wisely, either reinvesting them for continued growth or paying down debt.
Do a comparative financial analysis.
How a company is doing now, compared with something else (like a prior period or a similar company).
If you know that a company you’re looking at had a net income of Ksh. 6M for the year, you may ask, “Is that good or bad?” Obviously, having a net profit is good, but you also need to know whether it’s good compared to something else. If the company had a net profit of Ksh.4.5M the year before, you know that the company’s profitability is improving. But if a similar company had a net profit of Ksh.8M the year before and in the current year is making Ksh.5.6, you may want to either avoid that company or determine what went wrong.
Knowledge about the general economy, the real driver of the stock market, is also vital. A stable economy means a stable stock market and vice versa.
Gross domestic product (GDP)
This is roughly the total value of output for a particular nation, measured in the currency value of the amount of goods and services.
GDP is reported quarterly, and a rising GDP bodes well for your stock. When the GDP rises 3 per cent or more annually, that’s solid growth.
If it rises at more than zero but less than 3 per cent, that’s generally considered less than stellar (or mediocre).
GDP under zero (or negative) means the economy is shrinking (heading into recession). Kenyan 2016 full-year GDP report downloads are here.
The Kenya Bureau of statics website downloads page also provides essential downloads that would aid in understanding this matter.
The index of leading economic indicators (LEI)
The LEI is a snapshot of a set of economic statistics covering activity that precedes what’s happening in the economy. Kenyan LEI January 2017 and a download link are found in the links.
Each statistic helps you understand the economy in the same way barometers help you understand what’s happening with the weather.
Economists don’t just look at individual statistics; they look at a set of statistics to get a more complete picture of what’s happening with the economy.
Observe Politician and Government bureaucrats
See what the politicians and government bureaucrats are doing because government actions significantly affect your investments.
National, county, and local governments pass literally thousands of laws yearly; monitoring the political landscape is critical to your success.
So always ask yourself, “How does a new law, tax, or regulation affect my stock investment?”
Take market news seriously as an investor. The news flow driving day-to-day gyrations in the market should be taken as interesting reading rather than a reason to make or change strategy.
Understand your environment perfectly and clone it, not someone else's environment.
Get familiar with company fillings.
Some investors might think they have a sixth sense of finding good companies, but the rest of us have to do our homework.
There's no better starting point than the following sites if Nairobi securities exchange and Systems day for records of registered companies to find out more. In your search for information, consider the following:
After identifying a stock with a high yield, you first want to check its debt load. Companies that borrow heavily often find it difficult to sustain their dividend when the economy turns sour, and interest rates rise. This is what happened to Kenya Power in 2013. Interest charges on its debt more than doubled when it borrowed to finance the electricity grid extension, and management was forced to nix its dividend payout. To minimize this risk, only consider stocks with debt levels lower than 70% of their book value.
We calculate this debt-to-equity ratio by dividing all of the company’s interest-bearing debt by its total equity. Companies with low debt-to-equity ratios are generally resilient enough to weather tough times without immediately cutting dividend payments to their shareholders.
The next thing to look for is growth potential. One would choose to buy high-valued shares from an already-grown company, just as one would consider buying from one that is just a newbie in the market. But wisdom has it that a seedling will have to grow, as the growth potential is the only gift it possesses. This is a great opportunity for growth in the value of dividends.
What of the old tree, value stagnation, if not slight value increases, and of course, an overwhelming potential of a fall? Haha! Consider that. If a company isn’t growing, then it’s unlikely that it will be able to consistently increase its dividend. And if a company isn’t consistently boosting its dividend, you might as well invest in a bond.
Companies often reveal their potential for growth by the percentage of their earnings they pay out in the form of dividends. If a company pays out just 10% of its earnings, then it is likely investing the remainder in expansion. Therefore, it stands a good chance of increasing its dividend in the next year. If, however, the company pays out 90% of its earnings, management is essentially saying that it doesn’t have many good ideas about growing the business, so it’s likely that dividend growth will soon stagnate.
Finally, check out for consistency. If you find a high-yielding company with low debt and a low payout ratio, check out its dividend payment history. Avoid companies that slashed their dividend at any time during the past five years. Inconsistency is the mother of inconsistency; there’s a good chance that they’ll be tempted to do it again.
Walking into the market
Kenyan high-interest rates and instability in the banking sector have left many Kenyan stocks trading at multi-year lows, offering investors a great entry point for exceptional long-term returns.
And now that you have the nitty-gritty of the stock market at your fingertips, you are ready to walk into the market with heads held up high (though as a starter).
In this part of the series, we will cover the process of buying stocks from the market. The Nairobi Securities Exchange (NSE) will be our guinea pig.
Ways to buy a stock
There are two ways to buy stocks from the market, which are discussed below.
Using a Brokerage
It's the most common method to buy stocks. Brokerages come in two forms:
(a) Full-service brokerages: offer you (supposedly) expert advice and can manage your account; their fee is also higher (there is nothing for free here).
(b) Discount brokerages: they offer very little in the way of personal attention, and they are much cheaper.
Chose the shoes that fit you.
Using Dividend reinvestment plans (DRIPs) and Direct investment plans (DIPs).
These are plans by which individual companies, for a minimal cost, allow shareholders to purchase stock directly from the company. DRIPs are a great way to invest small amounts of money regularly.
I will discuss the former, for it is the most common way for many, especially beginners.
Opening a Brokerage account
Before you can start putting your money to work on the NSE, you must open an account with a licensed stockbroker.
There are many brokers trading on the NSE. Click on the link to see the list.
The non-travellers type, like me, would prefer everything done online, including brokerage services. The following list provides those stock brokers that offer online services.
You can check all of them out to make an informed decision but consider this; if not all, the above brokers will charge an account opening fee, an account maintenance fee, or both.
The amount of these fees varies from broker to broker, but it is roughly about Ksh1,200.00 (US$12.00) to open the account and about Ksh100.00 (US$1.00) per month to keep it active.
So the account can also die?
You must buy at least 100 shares on the first trade, but no minimum amount is required to fund your account.
As per the writing of this article (10th March 2017), the least expensive share listed on the NSE was Home Africa selling at KES 0.83, Mumias sugar at KES 1.05, Atlas Development and support services at 1.05, followed by Uchumi Supermarkets at 2.38. at the same time, the current big guys are British American Tobacco Kenya at KES 856, Limuru tea company at KES 550, and Jubilee insurance at 485. A share from Safaricom limited goes for KES 16.25.
Always check the current prices before leaving your house with money to buy. Sites like Wazua can give you the current listings of prices per share. For example, if you needed 100 shares of Mumias Sugar company, you would only spend about( stock prices are sometimes dynamic) KES 105. Whereas for 100 shares of Safaricom, you will need X. (find out the value of X on your own).
In addition to the account maintenance fee, your stockbroker will charge commissions and fees on every trade you execute. The commission rate is the same across all stockbrokers and is equal to 1.78% of the total value of transactions less than KES 100,000 or 1.50% of the total value of transactions more than KES 100,000.
Documents Required to open an account.
The following documents are needed by your broker to open an account:
- Two coloured passport-size photos Your national ID document or passport (a notarized copy is acceptable for investors living outside Kenya)
- A signed Central Depository System(CDS-1) Form. A Sample is available for you.
- You might also want to carry the following with you; a copy of a recent utility bill, the first page of your bank statement, or your PIN certificate, as most brokers often ask for them.
Central Depository System (CDS) account
After opening your account, you will own a Central Depository System (CDS) account. This is an electronic account that stores all of the shares you own. It is your portfolio. You can move it from stockbroker to stockbroker, and all of the shares you have accumulated move along with it.
This might be necessary if you aren't satisfied with the level of service from your current broker. You can always easily take your business elsewhere. After the account is set up, your broker should instruct you on how to fund it and how to place an order to buy shares.
A nominee account is available for non-Kenyan Investors, allowing the broker to collect dividends on your behalf and deposit them directly in your trading account. The reason is that Kenyan companies deliver dividends via direct deposit into a specified bank account or by cheque denominated in Kenya shillings.
This being the most anticipated part by many, I wanted to keep it precise and to the point. In the last part, I will give you the necessary knowledge to monitor stock trades. I will highlight how you can always read the stock table and know how various stocks perform. I will also let you know what causes the stock market prices to fluctuate so that you may always be on the listening ear.