Download Topic 7 – How do I know what to buy?

Topic 7 – How do I know what to buy?
What to buy is very much driven by your investment goals,
what you are looking to achieve and what level of risk you are
prepared to take. The below section provides a few key points
to consider but the list is by no means conclusive. This list will
offer a brief overview of the different areas to consider when
investing.
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Strong position in the market
A company’s position in the market and competitive
advantage can be a key driver of growth and profits over
time. If the company is positioned in a profitable sector and
maybe even a market leader this is a clear advantage.
In some ways, assessing companies is similar to selecting an
investment property. If you are looking to buy a rental property
you are looking for a property that is sound, in a good location,
is reasonably priced, can generate a good and reliable income
stream and has the potential for capital gain over time. Shares
are the same in a way. You are looking for a company with the
following attributes;
A company’s management and board of directors is
important to consider as their decisions and company focus
will influence operations and future earnings.
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There is little point in investing in companies that have no
growth potential. Investors should look for companies with
a solid existing business and with opportunity for growth.
Income (dividend and dividend growth)
In order to receive an income from our shares we need to
invest in companies that provide a good dividend.
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Leadership
Growth potential
But what is a good dividend? The best dividends are not
necessarily the highest at that point in time. It is important
to consider the company’s track record for paying consistent
dividends.
A company offering reasonable dividend with the potential
to grow this dividend over time is generally the most sought
after. This ability to produce growth in income over time is
what sets shares apart from other investments.
A couple of things that can signal a good dividend growth
investment may be; track record showing a growing
dividends and a focus on consistent but sustainable dividend
payouts. For example, a company reinvesting some of their
earnings can help drive future earnings and dividend growth.
In a world of uncertainty and risk, focusing on dividends can
offer investors a degree of stability and certainty. Overall,
dividends are far less volatile than share prices, and earnings
for that matter. This is because they are driven by a company’s
operations and performance in the ‘real world’, and not by
financial markets. Investors who focus on dividends will
receive an annual cash return which is more reliable than
share price movements. Focusing on stocks that not only
pay a dividend, but also have the potential to increase their
dividend over time, can result in higher returns in future.
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Financially sound
By financially sound we mean a company producing good
profits with a strong balance sheet without much debt.
Excessive debt leaves a company vulnerable to a downturn
in the economy, falling earnings or a tightening of financial
conditions. Of course not all debt is bad, and as long as debt
levels are maintained at a reasonable level compared to
assets and earnings, debt shouldn’t be a problem.
When assessing a company, a range of financial ratios are
often used such as debt to equity, debt to total assets, EBIT
(earnings before interest and tax) and EBITDA (earnings
before interest and taxation, depreciation and amortisation).
See the glossary for explanations of these terms.
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Cashflow
Cashflow is the movement of money in or out of a
business. Incoming cash flow is a company’s lifeblood.
Therefore analysts may value companies by estimating
the future expected cash flow. Companies which generate
operating cash flow which is close to or exceeds net
earnings are often preferred when choosing where to
invest.
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Quality
All the previous points go into establishing if a company
offers quality. A quality stock offers income, has a strong
balance sheet, is profitable, has a competitive advantage,
strong management, positive cash flow and opportunity
for growth.
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Value
Value is hugely important. In fact many of the other
characteristics won’t matter if the company isn’t offering
the right value. When it comes to price, the key measure
used is dividend yield and price to earnings ratio (P/E).
Dividend yield gives an investor an indication of how much
dividends they are receiving and the ability to compare
different companies with different share prices and
dividends.
By assessing the P/E ratio (both the current and forecast
ratios) of the company, investors can evaluate whether the
company appear over or underpriced, and offer the right
value.
© Craigs Investment Partners 2012
Different types of shares
There are many different types of shares, each with different characteristics. The below table explores the risk and return
elements within each share type.
Type of
Investment
Blue chip
shares
Income
shares
Growth
shares
Defensive
shares
Cyclical
shares
Speculative
shares
Description
Blue chip shares are generally regarded as the largest and most established
companies in the market. They have a long track record of operation and
profits, and being big, they tend to have relatively mature businesses. Blue
chips don’t usually deliver spectacular growth but are liked by many investors
because they often provide good dividends and steady growth. Some
examples of blue chip shares include Auckland International Airport, Westpac
Banking Corporation and Port of Tauranga.
Income shares provide income in the form of dividends. Companies that
choose to pay out a higher proportion of earnings as dividends are termed
income shares. In New Zealand, the proportion of profit companies opt
to payout as dividends is higher than overseas, perhaps reflecting the
fewer growth opportunities available here. Without growth opportunities,
companies have no need for the extra funds and hence decide to distribute it
to shareholders. On average, listed companies distribute between 60% and
80% of profits to investors. A share with a payout ratio of 70% or higher is
generally referred to as an income share. Examples of income shares include
Hallenstein Glasson, Kiwi Income Property Trust, and Westfield Group.
In many ways, a growth share is the opposite of an income share. They pay
low dividends and reinvest their profits into growing their business. Investors
give up income today (in the form of dividends) in the hope of better returns in
the future, in the form of growing sales and profits, and therefore a rising share
price. Successful growth stocks tend to have a track record of growth in sales
and earnings and also pay at least a modest dividend. Some examples of growth
shares include Apple, Ryman Healthcare and Mainfreight.
The opposite of a cyclical share is a defensive share. These companies have
businesses that are largely immune to changes in the economy and continue
to sell their products whether the economy is booming or in recession.
Defensive shares tend to be relatively unexciting investments as performance
is usually steady rather than spectacular. Examples of defensive shares
include Woolworths, Johnson & Johnson and Coca Cola.
Companies whose performance is closely tied to the health of the economy
are termed cyclical stocks because they follow the business cycle. When the
economy is doing well, so do they, and vice versa. Their share prices tend to
be quite volatile and move up and down in line with the market’s expectation
of the future health of the economy. Some examples of cyclical shares are
Fletcher Building, Cavalier and Schlumberger.
Speculative shares are usually small companies, often newly formed.
These companies are almost always focused on delivering growth – fast.
As investments, speculative shares are high risk due to a lack of financial
strength or track record in earnings and dividends
Share Price
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Value
shares
Quality
shares
A value share is one that looks ‘cheap’. Value shares tend to have low PE ratios.
As a rule of thumb, the higher the PE ratio, the more expensive the company,
hence the reason why value investors focus on buying companies with low PE
ratios. Value shares also have high dividend yields (investment return received
by dividends). As such, value shares are often either defensive shares (which
typically have low PE ratios) or income shares (which have high dividend yields).
However, growth shares can also be value shares if they have a low PE ratio in
relation to its future growth prospects.
Probably the most important class of shares are quality shares. Quality shares
can be found in any of the above categories. Look for great management, a
rock-solid business and finances, and a track record of growth in profits and
dividends.
Recession
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© Craigs Investment Partners 201213