Saturday, July 23, 2011

"All that glisters is not gold"

We all become investors for the same reason: to grow our capital. For the sake of growth we are always looking to buy low and sell high. When you go bargain hunting, you should always ask yourself why a particular company is trading low while its competitors are trading high. You may think you have found Gold but it might turn out to be Pyrite: it may glitter but it might not have any value. These companies are known as “value traps.” These companies are traps because when you think you have found value, the price depreciation does not cease.

In every business, the goal of management is to provide value for shareholders. A company's stock price is one indication of how much value management is creating for shareholders. When a stock's price appreciates shareholders benefit from the increase price; so how should you view a company whose stock price does not increase, but continuous decreases? From my perspective, stock price depreciation means that the company is not a great investment. Although it is not an investment, it might make a good trade – assuming you know how to take advantage of the price movement.
(NOTE: please don't become a trader until you have had enough practice).

You might wonder how a company can create value for shareholders. One way is to provide products and services that consumers want. If consumers want it then it would create demand > Increased demand would lead to higher revenues > High revenues minus expenses  = profits. These profits are where shareholder value comes from. Once investors/traders/speculators see that a company's financial statement has value, the demand for the company's stock will go higher (this is indicated by high volume); which leads to appreciation in the stock price.

As a result, when you see that a company's stock price is trading cheaply you should not come to the conclusion that you have found a bargain. It is possible that there is something fundamentally wrong with the company, and that the company stock price might continue going down. The fundamental problem can be management, demand for the company's products and services, etc. 

As a beginner don't become a contrarian and "rush where angels fear to tread."

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