Sunday, May 27, 2012

Investing and speculating in stocks

We discussed cash flow and appreciation in Real Estate, but what about the stock market? There are many strategies for picking undervalued stocks, but these are just that ‘strategies’… to figure out which stock is most likely to appreciate. That is nearly as ‘speculative’ as using horse statistics to bet at the races!

Whether you buy real estate or stock, if you only buy for the appreciation that may happen or not, you’re just speculating. The other side of the medal is investing for the dividends, which are a tax advantaged return that often also is inflation. Dividends from solid companies, not only represent cash flow today but such dividends tend to increase over time.

Dividends from stock and net cash flow for real estate are ‘the bird in the hand’ while the appreciation is the ‘many birds in the bush’.  Often, dividends constitute up to 40% of the total stock investment return and for a prudent investor they provide a live line during bad times as well as the means to build up cash for further investment creating a compounding return.

Dividends are that portion of a company’s earnings that its board of directors has chosen to return to the investor while the remainder goes to reinvestment in the company for expansion and/or acquisition. Often those dividend paying companies are perceived as mature companies that have ‘not much growth’ left and whose management does not see further investment opportunities. In reality nothing is further from the truth; research by experts such as James O’Shaughnessy backs this up plenty: companies that pay dividends and that regularly increase their dividend is, over the long term, one of the best performing categories in the stock market.

So, then how should you see your stock market investment?  Does this approach of investing in dividend paying companies provide a less speculative way towards financial independence and does it provide more confidence during a down turn helping the investor not to give in to the emotional urge to sell near the bottom of a bear market?

Well, as others have pointed as well, see investing in publicly traded companies as buying a piece of company ownership! Think about this in terms of the place where you are currently employed or even your place of ‘self-employment’. These companies do have good and bad years in terms of making money or selling their goods or services. There are good and bad quarters, but overall the company makes steady progress and that is reflected in growing revenue and profits.  Yes, a bad quarter may be frustrating but most other employees barely notice it.  Yet, you may work there day in and day out; month in and month out; and sometimes year-in and year out. 
How would you feel about quitting your job every time there is a bad quarter? Probably you would declare yourself nuts; so why would you not have the same attitude when you own that company’s stock?  You don’t sell a perfectly good business just because the stock is down, or because some guy on TV states that he doesn’t like your company.  Next month that same talking head may recommend that you buy its stock!

Again, the stock price is purely a speculative valuation that may incorporate that company’s growth prospects and current financial position; but mostly the market prices the company on how it feels!  The mass psychology of the market is a much stronger factor in evaluating a company’s stock than dividends and earnings or revenue growth. 

So from now on, see a stock investment firstly in terms of the cash flow it provides you and how reliable that income stream is. Then aim for appreciation, which especially in the short term is purely set by market psychology and you may preferred to wait selling your investment when you get the highest price relative to its earnings. But what are you going to do with the proceeds?  Invest in another high price company in a hot market?  In a later post, we’ll be looking at the numbers behind a possible stock acquisition

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