by Marc Lichtenfeld, Investment U's Senior Analyst Wednesday, December 1, 2010: Issue #1398
"Dad, can you teach me about the stock market? I want to buy a stock."
It was music to my ears, given that my nine-year-old son had never taken much interest in his old man's job before, or asked how the market and stocks work.
It had been a while since I'd given a "Stock Market 101" lesson, but no matter your level of expertise, stock analysis doesn't have to be complicated. Like many things in life, keeping it simple is often the best way. Especially for a novice nine-year-old!
Here are a few timeless tips that apply to all investors in their research...
Stock Market 101: The Only Two Kinds of Analysis You Need
When you buy stocks, there are basically two approaches you can take to your investment research:
- Fundamental Analysis: When I research a company's fundamentals, I look at sales and earnings growth, cash flow growth and the balance sheet. I certainly do a lot of digging to confirm or reject my investment thesis, but generally speaking, if a company is financially stable and is growing its earnings and cash flow, then there's a solid chance that the stock will rise over the long-term.
- Technical Analysis: The mere mention of this form of research scares some investors, as they picture all kinds of complicated-looking chart patterns and formations. But again, just keep it simple. When I look at stock charts, I look for trendlines, support and resistance, and basic patterns like head-and-shoulders. I don't worry about cycle analysis, Gann Wheels, or other arcane indicators. The reason? Because the simple stuff works. After years of study, I'm not convinced that the more complex indicators are any more reliable than a crystal ball.
Like Father, Like Son
Now, Junior doesn't read Investment U (although he should), so he had no idea that I wrote a positive review of Costco just one week ago.
His reasoning was that when we go to the store, it's always crammed with people and that there are many different things to buy there. (Plus, he's a huge fan of their hot dogs, which are fantastic, by the way.)
But as I mentioned last week, it's Costco's excellent management team that sets the foundation for the company's success. It maintains tight control over its margins and ensures that its employees are happy - and therefore motivated. Not to mention the fact that Costco offers everyday household products at excellent prices.
We pulled up Costco's five-year stock chart...
To see the chart in its original size, click here.
I asked him what he thought would happen to the stock next. His answer: "No higher than $75." I asked him why and he said, "Because when it gets close, it stops there."
Without realizing it, he'd just noted one of the most basic elements of technical analysis - upward resistance. Simply put, this level acts as a barrier to a stock's continued rise if it hasn't broken through it in the past.
Conversely, support levels work on the downside, providing a "floor" that a stock shouldn't fall through before rebounding higher. (Note to self: Add John Murphy's Fundamentals of Technical Analysis to my son's holiday gift list.)
Tune Out the Crowd
We looked at other successful businesses, including Whole Foods (Nasdaq: WFMI) and Starbucks (Nasdaq: SBUX). But perhaps unsurprisingly, we zeroed in on a company that most kids love - Walt Disney (NYSE: DIS).
In this case, I mentioned the fundamental aspects of the stock to him, including the fact that it pays a small $0.35 per share annual dividend. But given my contrarian nature, I also told him that the analysts aren't overwhelmingly positive on the stock and explained that the best way to make money in the markets is not by following the crowd. Instead, going against analysts that are "late to the party" is often the path to profits.
Then it was on to more speculative stocks, given that I spend much of my time researching them...
If You're Going to Gamble, Make Sure it's Educated Risk
I explained that with these slightly riskier stocks, the research process is more time-consuming, as you need to be much more rigorous with your analysis.
However, since we're only investing a few hundred dollars, he can afford to take a little more risk at his age without worrying about a lifestyle-affecting loss. The rest of his money is invested in various mutual funds, so he'll still go to college!
You never want a loss, of course, but even if one of your speculative, small-cap names takes a dive, make sure you haven't over-extended yourself on the position. It's okay to take an educated gamble as long as most of your money is invested in more stable investments, so you can handle any losses.
All investors - whether new or experienced - need to remember that there's always more to learn about investing. Even if you score a big gain, or enjoy a long winning streak, always stick to disciplined money management.
As for my son's first stock pick... he wasn't interested in airlines, pharmaceuticals, or automakers, so we're still on the prowl. (Perhaps I have a perma-bear in the making.) Your suggestions are welcome in the "Comments" section below. If we use your idea, while I can't give you a cut of the profits, I can promise that when he starts his hedge fund, you'll be first on the list. However, he'll only return client calls after he finishes his homework.
Hoping your longs go up and your shorts go down,
Disclosure: No Position