How To Invest Initially With Limited Capital

| About: Juniper Networks (JNPR)

Summary

Use of capital is key initially. You don't want to go all in on one stock.

Juniper is a prime candidate for a smaller account in that it's liquid, undervalued and trading for just over $20 a share.

Selling put options on stocks that have been fundamentally dissected is a good way to achieve diversification in a portfolio with limited capital.

This is a question I get asked a lot. How does a newbie with limited capital get started in the stock market? For example, an investor starting out with $2k. How does this person invest his or her capital? It's a really important question. Like think of the commissions one has to pay before even making a trade. If the investor in question is paying a standard rate of $9.99 per stock trade, the balance has gone down immediately by $20 to $1,980 when buying and selling a stock (down 1% already). Therefore, instead of buying a stock outright and waiting for the price to appreciate or a dividend to be paid, let me give another slant on how I believe small accounts could be traded.

The problem with investing in an established undervalued dividend aristocrat for example is that:

  1. It may take a while before the stock returns to its average valuation ratios. This would mean a long wait for your position to show good returns especially if equity markets entered a long-term secular bear market.
  2. My experience with newbies is that it is essential that they see gains early on in their investing career. Simply making a profit or collecting strong dividends early on can motivate the investor especially if they spend a long time underwater in some position(s).

Therefore, I would suggest finding quality liquid stocks, which have excellent fundamentals and are undervalued compared to their industry and historic averages. One such example would be something like Juniper (NYSE:JNPR) where current fundamentals stack up in my opinion.

Price To Earnings Ratio 14.13
Price To Cash Flow 10.8
Price To Sales 1.9
Price To Book 1.9
Debt To Equity Ratio 0.46
Current Ratio 2.16
Quick Ratio 2
Dividend Yield 1.72%
Free Cash Flow 630 million
Click to enlarge

Although the company's earnings history has been patchy over the last 10 years, Juniper's earnings multiple is still much lower that its 5-year average of 32.6. Furthermore, earnings and revenues are growing and debt levels are well under control. Its current and liquid ratios illustrate there is plenty of liquidity and the company has increased its cash balance to $2.25 billion on its balance sheet and there is twice as much equity as interest bearing debt.

When doing your due diligence on a stock, 3 metrics are critical. Look for positive earnings, plenty of cash and low debt. If these elements stack up plus the stock is undervalued (and earnings expectations are robust for forthcoming quarters), then you are looking at a high quality candidate for positive returns going forward. Furthermore, comparing the company against fundamental metrics in its industry is another way to see if really the market has this stock undervalued.

Juniper is down over 16% year to date and is now trading at $23 a share. In spite of this, revenue was actually up in its last quarter despite suffering a serious decline in its security division by probably moving too early with its "end of life" initiatives. Nevertheless, its services industry grew nicely and I believe it won't be long until its enterprise segment improves from the transitioning taking place there at present. Many investors underestimate the switching costs in this industry. I acknowledge that market share in certain segments has been lost in recent years, but I still see Juniper as an established player in this sector.

Click to enlarge

So why should a stock like Juniper suit an investor with a smaller account? Well, it's pretty liquid and cheap relative to other stocks, which is a huge help for the following strategy. What I would recommend for a newbie to do would be to sell a put option in the money instead of buying the stock outright. By selling the July 29th - 22 put option for $0.60, you are bringing your break-even for the trade to $21.40 which is 7% below where the stock is currently trading. Furthermore (and this is key), the put option will only use about 20% of the buying power you would have used if you bought the stock outright - a necessity in small accounts

All we are doing here is improving your probability of success and reducing the capital needed to trade in the markets. I'm aware that some people will state that selling the put will mean that could miss out on a potential rally and this very well may be true. However, what I know is this. Any time you pull the trigger on any stock purchase, there is a 50-50 shot of the stock going up or down.

No matter how attractive the fundamentals or valuation are, the stock could get taken down in a steep market decline especially if you do not have a hard stop loss in place. Why not improve your odds by selling a put option, which will give you a lower break-even? Furthermore, and what I have seen in this industry is that if the respective investor has the due diligence done on the stock, he or she will hold it as a paper loss until it comes right.

All a put option does here is enable you to get the stock at a better price if this scenario were to play out. Alternatively, if the trade goes your way so profits can be taken, all you do is find more stocks will similar set-ups (valuation, fundamentals, liquidity, etc.). Rinse, wash, repeat.

Selling put options gets a bad name but it's the same as being long the stock. It's all about the fundamentals of the company in question. The strategy comes second. The put option is only another vehicle one can use to get long the respective stock by using much less buying power.

To sum up, I'm going to be adding a few good dividend and growth stocks to the Elevation Portfolio over the next several weeks, when I see value. In order to ensure that income is brought in every month, it's imperative that they are not correlated and all don't have similar valuations. You can follow along by pressing the "Follow" button above.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.