More: How to buy stocks
Okay, you have a handle on a few investing basics–discipline, setting goals, and buying quality stocks at bargain prices. Next, you’ll want to add some more tools to your investment kit.
Here are some key points to research before you invest in any company.
4. Buy stocks that pay dividends
There are two ways to make money from your stocks: dividends and capital gains.
Capital gains are usually the number one priority for stock investors.
But a steady dividend flow will ensure a continuing return on your investment. And if your stocks are Canadian and held outside a retirement plan, they will entitle you to claim the dividend tax credit.
You’ll hear a lot of conflicting arguments on this point. Many investment counsellors will advise you to forget about dividends, especially if you’re younger, and concentrate on stocks with the greatest growth potential.
High dividends and strong growth potential usually don’t come together in the same package, they’ll point out.
Dividends with capital gains
They’re wrong. It’s true that stocks with high dividend yields will usually be those of large, ll-established companies, such as banks and utilities.
Normally, their share prices will tend appreciate in value as the market rises, but not as much as some of the more volatile high-flyers. But there are many, many exceptions.
For example: Bank stocks were badly beaten up when interest rates were pushed up in 1999-2000. The dividend yields rose (the banks were still making great profits and cutting dividends was never an issue).
But the potential for future capital gains grew as the share prices sank. Sure enough, when interest rates levelled off, the bank stocks bounced back.
At the end of 2000, the Financial Services sub-index of the Toronto Stock Exchange showed a 47 per cent gain for the year. So much for the theory that dividends and capital gains are always mutually exclusive.
Next page: Buy into low debt companies
5. Buy stocks of companies with low debt
I’m an old-school conservative when it comes to buying stocks. I don’t like companies with a lot of debt.
Many experts would dispute this particular bias, pointing out that some companies have used debt successfully to increase the asset base many times over. That’s true. But many of those same companies subsequently crashed in flames.
Laidlaw became penny stock
Laidlaw Corporation is one example. Tthe company skilfully deployed borrowed money to help build a transportation network across North America. At one point. it was a powerful force in school bus services, ambulances, trucking, and municipal public transit.
The firm even used its seemingly limitless credit lines to purchase the venerable Greyhound Bus Company.
But the huge debt load and some bad management decisions eventually caught up with Laidlaw. The shares, which had risen as high as $23.50 in 1998, were trading in the 12 cent range at the end of 2000. And the company experienced the ignominy of being delisted by the New York Stock Exchange because of its penny stock status.
Exceptions to debt rule
There are some blue-chip companies which, by their nature, will carry a high debt load, such as utilities.
You can make an exception in these cases, because the companies are conservatively managed and government-regulated. The chances of them going under because of an overextended debt load are remote.
But, as a general rule, avoid high debt enterprises.
How to tell
How do you know when a company’s debt is out of line? A standard measure is a company’s debt/equity ratio. This is arrived at when you:
- Divide the total long-term debt by the current market value of the company’s common stock.
To get the market value of the common stock:
- Multiply the number of outstanding shares by the market price.
A good research report will contain this information. Otherwise, ask your broker for it. A debt/equity ratio of less than one is good; under 0.5 is excellent.
6. Buy companies with positive cash flow
This is a lesson from the dot-com collapse. Many of the Internet firms that went down in 2000 had great concepts but not enough money coming in the door.
As a result, they went through their cash reserves faster than the money could be replaced. In the process, they created a new test of financial strength known as “cash burn rate”.
In the early days of the Internet bubble, that wasn’t a problem. Dot-com companies just sold more stock to eager investors to raise money whenever it was needed.
But when the bubble burst and investors fled to the sidelines, cash burn became a serious issue. When the money ran out, the doors were closed – it was as simple as that.
So find out about a company’s cash flow (which is not the same thing as profitability) before you put any money into it. If the cash is flowing out the door faster than it is coming in, be very wary.
(To be continued as: “Still more: How to buy stocks”)