27 September 2013

Essential ingredients for smart share investing

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essential ingredientsCautious investors often complain that the sharemarket looks more like a casino than a source of wealth creation, but looks can be deceiving. Viewed over the long term the potential benefits of share ownership are clear.

 

In the 20 years to December 2011 shares returned approximately 9 per cent1 a year. By comparison, the safety of cash in the bank earned average annual interest of just 4.1 per cent with no opportunity for capital gains.

 

When you buy shares in a company you become a partial owner of that company. This gives you a direct stake in the company’s profits and growth, via regular dividend income and a capital gain if the share price rises and you sell your shares.

 

Price vs. value

One of the most important issues for share investors is to recognise the difference between price and value. Share prices fluctuate on a daily basis and sometimes overshoot or lag behind the true value of a stock for lengthy periods.

 

Investment guru Warren Buffett aims to identify undervalued stocks and hold them for the long term. Growth investors look for companies with strong growth prospects and a rising share price. Income investors seek a reliable income stream from dividends that will grow over time.

 

In practice, all investors are searching for great companies at a fair price with the potential to grow profits and dividends. The challenge is to work out what a company’s shares are worth. Your adviser can suggest quality stocks that fit the bill, but there are also signs you can learn to identify yourself.

 

Stock selection

With the assistance of your adviser, the first step is to think about sectors of the local and global economy that are growing strongly then develop a watch list of companies that are exposed to those sectors. For example, as the mining boom gathered pace, resources stocks, engineering and labour hire firms all benefitted.

 

Once potential investments have been identified you need to check their viability, beginning with some key investment ratios commonly found in a company’s annual report, newspaper sharemarket tables and online investment sites.

 

Earnings per share (EPS). This is the company’s after-tax profit divided by the number of shares on issue and provides a snapshot of the amount of profit available to shareholders. Look for a track record of growth in earnings per share.

 

Dividend yield – this is the most recent annual dividend divided by the current share price and expressed as a percentage. A high dividend yield is attractive but make sure the company has strong earnings growth to maintain dividend payments.

 

Dividend cover – this tells you how much of a company’s profits are being used to pay dividends. Anything below one tells you the dividend may not be sustainable at the current level.

 

In recent years debt has also been in the spotlight. Companies with high levels of debt are the first to falter when the market suffers a downturn or the economy is weak.

 

A competitive edge

Numbers tell part of the story but not the whole story. Great companies are led by management with a history of delivering strong profit growth. Steer clear of companies where directors give a vague earnings outlook or there is a revolving door of top executives.

 

Great companies also have a competitive edge. This is something that gives a company an advantage over its competition, such as a strong brand name, superior products and services or a market monopoly.

 

When you are satisfied that a company ticks all the right boxes for its quality of earnings it is time to check the share price to see if it represents value for money. A simple rule-of-thumb is a low price-to-earnings (PE) ratio.

 

A low PE generally indicates that the market expects lower growth so the share price is low for good reason. But if the company has a bright earnings outlook, a low PE could signal a buying opportunity. If a company is undervalued and its earnings continue to grow the share price should eventually rise too.

 

A high PE suggests the market expects strong earnings growth, but it could also be a sign that the shares have surged ahead of fair value.

 

As the father of modern share investing, Benjamin Graham wrote2: “In the short term the stock market is a voting machine but in the long run it is a weighing machine.” The best way to share in a nation’s wealth is to learn how to weigh up the true value of shares and be prepared to get rich slowly.

 

Your adviser will be able to explain the details of the share market, how each company differs and an appropriate approach for your personal strategy.

 

1 Russell Investments Long-term Investing Report 2012, viewed 26 May 2013http://www.russell.com/AU/_pdfs/market-reports/asx/ASX_Report_2012.pdf, page 6

2 ‘The Intelligent Investor’, Benjamin Graham, 2003 revised edition, HarperCollins.

The author is an employee of Verante Financial Planning in Castle Hill, Corporate Authorised Representative of Magnitude Group Limited, Licence No 221557, Magnitude Group Limited ABN 54 086 266 202.

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