There is no sure-fire way to ensure trading success but there are plenty of common pitfalls you should avoid. Learning the basics of trading will help you invest smart.
For instance, blindly following the herd is not advisable. You might make money but you might also be jumping on a bandwagon that has run out of steam or is heading full-steam over a cliff edge.
Following the herd, like sheep, is not advised Credit: Shutterstock.com
If you stick to the basics of trading you shouldn’t go far wrong but all too often investors pile in at or close to a market’s peak (for instance high-flying tech stocks) when there is little more upside to gain.
Then, when stock prices start to fall, they sell as panic sets in – crystallising a loss rather than taking a longer-term view and weighing up the realistic prospects of a recovery.
Basics of trading
Following the money is seldom a good idea – unless you have done your homework and worked out that the fundamentals of a stock are supportive of further gains.
The company’s balance sheet, its annual profits, its order book, its likelihood for future merger/acquisition, competitive advantage are all factors that could sway whether you invest in in a stock or not.
Financial statements from companies can only tell you so much – but they are important. For instance, it would be crazy to ignore a profit warning but should it, in itself, trigger a sell? Conversely, if you don’t hold the stock already could it signal a buying opportunity?
Much will depend on whether you deem the profit warning catastrophic or only a temporary blip to the company’s long-term prospects.
There is a shock factor attached to profit warnings since they indicate that the company thinks its earnings are going to disappoint and be below expectations.
The price may initially crash but quickly recover when it appears investors have over-reacted to what is essentially a trimmed forecast by a company in pretty good shape. For instance, a contract may have fallen through – a one-off that does not indicate any long-term damage. This could signal the buying opportunity.
However, if a profit warning relates to a combination of cancelled contracts, a general drop off in consumer demand and/or the impact of regulation change, the alarm bells will be ringing since these headwinds might represent a longer-term problem.
Profits warning will make headline news in respected financial newspapers. Credit: Shutterstock.com
It is important to look at the company itself and look at all these factors rather than just sell as a knee-jerk reaction. It may be that the company’s sector is under extreme pressure rather than the firm itself doing anything badly wrong. How does the company compare to its peers – is it best of breed?
What should you look for in financial statements?
- Cash is king. Has the company enough liquidity to maintain operations? If a company is illiquid, it cannot pay its bills which could spell disaster. If a firm cannot generate positive cash flow from its operations, they may be forced to take on unwanted debt
- Total debt. A company encumbered with large amounts of debt (with interest applied) will need sizable cash commitments to make repayments
- Total debt to total assets defines the total amount of debt relative to assets. This enables comparisons of borrowings between companies. The higher the ratio, the greater the extent of leverage, and therefore, financial risk
- Gross sales margins. Are products sold at a gross profit that will allow the company to pay its operating expenses? If not, the company is staring at a loss
- Are operating costs in line with sales or is the company spending too much money relative to its revenues?
- What are the comparisons year on year with regards to revenues and costs? For an established company that may have decades of profitability, trends may be easier to pick up. For start-ups, the picture may be improving despite little in the way of profit
- Net earnings – essentially the 'bottom line' – was the company in the red or black?
Reading between the lines
While it is important to factor in every number in a company’s financial statement – it is essential to see the bigger picture when deciding to invest or not. For instance, just because a company has seen profits fall and costs increase, it does not necessarily mean it is a no hoper.
Take for instance a company that hires six sales reps in January on salaries of £100,000 each. They have taken on an extra £50,000 a month in costs yet these sales people might not close their new deals for another six months.
The company’s Q1 results will be £150,000 less profitable than if they hadn’t hired them. The company is looking to fund growth that may not be evident on the balance sheet until later.
Exceptional items in accounts
There may be ‘exceptional items’, outlined in the company’s annual or interim results. These are either costs or profits that need to be separately disclosed in order to provide a more accurate view of accounts.
Examples of one-off special items would be profits on any disposals and restructuring costs.
There are usually a few questions you want answering in an annual report. That is why the executive summary by the CEO is essential reading.
They may be able to provide reassurance on any flagged issues (increased costs, exceptional items etc) or alternatively make excuses and talk in toe-curling jargon - either way, it can be highly instructive.
Watching the directors
Nobody has a better understanding of a company (usually) than its directors. So, if they are buying shares in their own business that is a good sign of their confidence in the company and a signal to buy at a good price? Possibly but not always.
There are some pretty crazy directors out there, particularly in the less-researched small cap market. Watch the buying patterns, if these directors have been purchasing as the share price has continued to drop and their company reports don’t ring true, then give a wide berth.
Also, be aware that sometimes companies raise money from their directors because they can’t raise finance from anywhere else. Once again look at the bigger picture – trading statements, earnings figures, debt levels, operating costs, management changes.
You don’t just want the company’s take on things. The basics of trading also include researching how independent investment analysts have reacted to the company’s latest report and what they think?
You may find a broad consensus of opinion from brokers on whether to buy, hold or sell the stock.
Alternatively, broker forecasts may differ markedly. What is their reasoning and how does their take on the company’s prospects compare with your own, rational. non-biased research?
There is no crystal ball for investors and even the most savvy fund managers make mistakes now and again.
But by sticking to the basics of trading – understanding a stock and its sector as much as you can and gaining perspective from the views of others – you should be in a better position to maximise gains and minimise losses.