Understanding the Stock Market

stock market

Many people have asked me in various ways how to invest in the stock market or how to know which company to invest in or indeed how to start. 

Well the first thing we must remember is that we do not literally invest in the stock market. We invest in specific companies or businesses that are listed on the stock market (now referred to as the Nairobi Securites Exchange). We get overwhelmed because we think we have to understand all the companies in the stock market (they are over 60 of them).

When you go to an actual fruits and vegetable market – you have a choice to buy tomatoes, apples, oranges, pineapples, potatoes, spinach etc.  So when you buy your potatoes, you did not buy the market did you?  The market was simply the avenue through which you could access a choice of different fruits and vegetables.  They were probably some items in that market that you did not recognise or even know what they were called.  However, you used the market to get to the potatoes that you wanted to buy.  The choice to buy potatoes was yours.

The stock market in principle works in the same way.  It is a vehicle through which you can buy shares (ownership) in specific companies that have decided to publicly offer their shares for sale. You do not need to know about all the companies to invest but just to keep a keen an eye on the ones you are interested in.

So how do we evaluate which company to invest in?

Mary has been running her salon for two years.  She is now looking for investors to buy into her salon so that she can take it to the next level.  Mary has invited you to invest in her salon.  In exchange for your investment you will get shares in the business.  You will be an owner.

What is the information you would need Mary to provide you with or what would you evaluate so that you can make a concrete decision?

Firstly you may need to buy into why a salon makes sense.  It could be that the beauty industry is growing and expected to keep growing as incomes grow.  It is also one of those services that people will always need so demand is always there.  Next you would need to evaluate what is the specific information about Mary’s salon.  You would probably look at the location (is it in a high traffic area), target market, other services that she is offering, quality of her hairdressers.  You would evaluate her financials – has she been making money or profit in her years of operation. What is her business plan? It is all well and good that she has been making money but you would need to be convinced that she is going to keep making money and grow the level of profitability.  Her business plan would probably need to include opening up new salons in new areas that are not already saturated with salons for this to happen.

As an investor there are two reasons you want to be convinced that she is still making money.  So that she can pay you a dividend (these are the profits that are distributed to the shareholders or business owners) or you can in the future sell your shares in the salon to someone else at a higher price.

This is no different from how you evaluate a company on the stock market.  You get in because you think that someone in the future will come and buy this share from you at a higher price.

Since Mary’s salon is not listed on the stock market, you would probably need to source this investor yourself. The companies listed on the stock market however are public. You do not need to look for the buyer of your share yourself.  You could say that everyday all the people who are interested in buying or selling any of the shares on the stock market are uploaded onto an electronic database through the stockbrokers.  So as long as someone wants to buy the share you are selling, the transaction will happen.

What you have to remember to ask yourself as you buy a share is – why would someone want to buy this share from me in the future? What am I seeing now that others are not seeing? In the future someone may want to buy your shares in Mary’s salon because she has now expanded, created a brand, has seen significant financial growth etc.

The first step is asking yourself which industry you are interested in.  The stock market report in the daily papers categorises the companies into sectors.  If you are interested in the Banking sector (and have understood why the banking sector makes sense as an investment) you would then do some research on why Bank A is preferable to Bank B.

There is a lot of information stock brokers can give you. Any decent stockbroker now has a research division that can give you a lot of information on the specific counters.  You do not necessarily have to do the number crunching yourself.  However it is your responsibility to know why and be convinced why you have invested in that share.  The same way we have evaluated Mary.  You have to know the general logic behind why that business or company makes sense and why you want to be an owner. The stockbroker did not loose your money.  When he advised on a share did you take time to understand the logic or ask the right questions?

The stock market is not as complicated as it is sometimes looks but there is no shortcut to it.  Just like going into business is never short term.  If you invested in Mary’s salon you would need to be happy leaving your money in for even 5 years.  The same way stock market investments are also long term.  They can be up and down market fluctuations so do not put next terms school fees in the stock market. It also takes practice.  The first time you read a stock market report or even the daily analysis on the papers it may look like Greek.  When you do it over and over again even if it is just following information about that one share you have bought, you learn a lot and it starts to make sense. There is obviously a lot more to be said that could not be covered in one introductory article.  The aim here is to introduce the logic behind stock market investments. To make the sequel to this a lot more practical please email me your questions on the stock market and I will try and answer as many of them as possible in a subsequent article.

Waceke runs a program on personal financial management. Find her at waceke@centonomy.com | twitter @centonomy

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