Why invest in the stock market?
The stock market provides greater flexibility and liquidity than property. And dividends are a great bonus!
Investing in the stock market provides an investor’s portfolio with a balanced exposure to multiple asset classes.
Regardless of whether they’re more interested in capital growth or income, it’s critical that investors wanting to manage their portfolios with balanced exposure to asset classes, while maximising returns, aren’t scared off shares listed on the stock market due to fear of short-term volatility.
Even the most conservative investors, including retirees with little or no appetite for risk, could benefit from some exposure to listed shares, (otherwise known as equities) to offset the times when bank rates struggle to outperform inflation and they end up actually losing money.
In addition, listed shares – which provide an investor with a financial stake in a company – can offer investors greater flexibility and liquidity than other assets, especially property or bonds.
Equally important, the cost of buying shares is low and the capital requirement is minimal. You can buy a small parcel of shares with as little as $500, and then turn those shares back into cash by selling them on the Australian Securities Exchange (ASX) or other exchanges worldwide.
The single biggest reason for investing in the stock market is the potential for capital growth, combined with the power of compounding returns. Here’s a quick example:
An investment earning 10 per cent annually doubles every 7.2 years.
Let’s assume you put aside $50 a week and invest it into the share market every time you save $1,000.
If those shares earn 9 per cent a year, in 30 years you would have amassed $442,000 in wealth by investing only $78,000 of your own money.
It’s fair to assume that long-term returns in the 21st century are unlikely to be what they were in the 20th century. Nevertheless, assuming US investing guru Warren Buffett is right – and long-term annualised returns are a more modest 7 per cent – you could still double your money every 10 years.
Investing in shares is a long-term commitment. If you approach the stock market like it’s a casino, placing your bets on red or black, then your chance of a successful investing career is greatly diminished
If however you view the stock market as a place to pick top stocks, acquiring shares in businesses that are run by honest and high performing managers and implementing a sensible portfolio risk management strategy, the opportunity to build your wealth over the longer term is vastly improved.
This explains why 55 per cent of adult Australians – eight million people – own listed shares, either directly or through managed funds and superannuation.
Despite the innately volatile nature of stock markets, research suggests that shares repeatedly outperform other key asset classes over the long term.
Smart investing is rewarded with outperformance
Average returns for the last 18 years – 1995 to 2012 – saw listed Australian shares deliver in excess of 10 per cent, while cash and fixed interest delivered just over 5 per cent and 7 per cent respectively.
Different asset classes perform better at different times, depending on market conditions and economic cycles. However, the ‘average return’ reveals that listed Australian shares returned nearly twice the return of cash over the last 18 years.
While cash has never been the top performing asset class over the same time frame, there have been shorter periods when cash and bonds have outperformed shares. But over the longer haul, history shows that shares have delivered better returns, especially when tax benefits are factored in.
Adding to an investor’s after-tax position are dividend imputations, another tax benefit exclusive to shares. Assuming a listed company has already paid tax on its profits, as a shareholder you will receive a tax credit up to the corporate rate when these profits are distributed to you as dividends. However, there may be a shortfall if an investor’s personal tax rate is higher than the 30 per cent corporate tax rate.
Buy and hold or technical analysis? Why you need an investment plan
Devising an investment plan will help you achieve your investing goals.
Whether you follow a Buffett-style buy and hold approach, or adopt technical analysis, learning how to invest and devising an investment plan will not only help to crystallise your short and longer-term financial goals and objectives, but also dramatically improve your ability to achieve them.
It can be incredibly empowering to comprehensively review your current financial position, and if you do, you’re more likely to develop an investment plan that’s custom made for your specific requirements.
Understand your current financial situation
Before devising an investment plan, it’s important to have an accurate picture of your cash flow, including income, regular outgoings – especially any discretionary spending – and your capacity to save/invest surplus money. “Do not save what is left after spending, but spend what is left after saving”, is a handy piece of advice from Warren Buffett.
Remember, all good investment plans will have one aim in common, wealth accumulation over time. Based on the ‘principle of compounding returns’, an investment earning 10 per cent annually doubles every 7.2 years.
The right investment plan for you will depend on a myriad of factors – most importantly your age, earnings and existing assets – which have a direct bearing on both your investment time-horizon, and risk/reward profile. While cautious investors would also like above average returns, their need for wealth preservation is greater than that of more aggressive investors who can afford to take bigger risks in pursuit of higher gains.
As a prudent investor looking for both capital growth and income, you’ll want to diversify your exposure to key asset classes like shares, cash, property and fixed interest. And if like most investors, you have a moderate tolerance for investment risk, and are investing for long-term wealth creation, it’s important to balance your investments to avoid over-exposure to any single asset class.
That’s because investment markets, whether in shares, property or cash, typically run in cycles (like the broader economy). So by offsetting better performance from one asset class against worse performing assets, you can smooth out your returns.
While many macroeconomic and industry-specific factors influence a company’s earnings performance, a lower cash rate environment – which is bad for fixed interest investors – is typically good for those invested in listed stocks as the cost of (corporate) borrowing becomes more affordable.
Economic indicators drive market sentiment
As an informed investor, it’s equally important to understand primary economic indicators and how they will impact different sectors of the economy. You’ll get a good insight into any trends developing within the economy by monitoring key pieces of data like gross domestic product (GDP), interest rates, unemployment, inflation, the Australian dollar, the balance of payments and the current account deficit.
These overall trends will fashion the market sentiment dished out to the asset classes you’re most likely to invest in. So by keeping abreast of the global and local economy, you’ll be better positioned to actively review and tweak your investment portfolio in light of those sectors that will either benefit or suffer going forward.
Instead of putting all their (investment) eggs in one basket, balanced investors typically divide their portfolio between cash, fixed interest, shares and property. Exactly how much of your portfolio is allocated to each asset class should directly reflect economic conditions and investment prospects, plus your requirement for investment-generated (or passive) income. Also take into consideration how quickly you may need to convert investments back into cash (liquidity requirements).
For example, with cash rates barely keeping pace with inflation, there’s been a corresponding return to equities. But during the Global Financial Crisis (GFC) the portfolios of most investors were seriously overweighted towards cash, with many spooked into sidelining the share market altogether.
Ironically, this decision resulted in mixed blessings, and a look at past performance explains why. While different asset classes perform better at different times, shares, despite their innate volatility, historically outperform other asset classes.
Admittedly, there have been shorter periods when cash and bonds have outperformed shares. But over the longer haul, history shows that shares have delivered better returns, especially once tax benefits (like dividend imputations) are factored in.
Shares add risk
According to research by Goldman Sachs, average returns between 1995 and 2012 saw listed Australian shares deliver 10.93 per cent, while cash and fixed interest delivered 5.63 per cent and 7.88 per cent respectively.
But remember, to get the (potentially) higher returns that shares typically offer, means accepting higher risks than holding cash does. So do your homework and never buy shares on tip-offs or unsubstantiated rumours. And while it’s important to stay ‘in the market’, that doesn’t mean buying stocks and parking them in the bottom drawer indefinitely.
Similarly, while a gearing strategy – borrowing from a broker or bank to buy more shares – can accelerate your wealth creation, it means taking on even greater risk. Don’t forget the value of shares can go down as well as up, and if it falls below a set loan to value ratio, you may have to put up the additional cash. So don’t borrow more than you can afford to service.
For the shares component of your financial portfolio, one approach is value investing – focusing on the very best companies and buying those shares at prices less than the business is worth.
Value investing and short selling in volatile markets
Short selling can add significant value to your share portfolio during periods of stock market volatility.
As a value investor in shares you ideally want the market to keep climbing, and prior to the GFC this is pretty much what it did. Within this buy and hold environment, value investors who bought (good) stocks could safely park them in the bottom drawer, knowing that the share price would ride the momentum in an upward trajectory.
However, the post-GFC environment brought with it hitherto unseen bouts of volatility in which the stock market can and does move 1 per cent, even within one week. The wakeup call for value investors is that in an environment where volatility is the ‘new norm’, a buy and hold approach may need to give way to a strategy for actively managing shares.
Balance value investing with short selling
One of the ways you can balance a value investing strategy – based on the worth of the business appreciating – with share market volatility is through what’s called long/short investing. If done successfully, a long/short strategy can add significant value to your share portfolio.
To the uninitiated, the machinations of short selling (aka shorting) involve profiting from share prices going down rather than up. As counterintuitive as it sounds, what you’re doing as a short seller is borrowing a company’s shares from an investment bank or broker and then selling them, with the express purpose of buying them back at a cheaper price, to return to their owner.
While increased volatility and tougher economic headwinds make it harder to achieve adequate returns from long only investment, there is no shortage of opportunities to capitalise on a long/short strategy in some shape or form.
Finding stocks that complement a long/short strategy
Let’s paint a picture of a typical shorting strategy being implemented…
You are sceptical of the outlook for retail due to the negative impact of currency headwinds and rising interest rates on consumers’ appetite for discretionary purchases.
As a result, you identify Myer (MYR) as a stock that will be materially impacted, and on further investigation find that the retailer looks to be fully priced, and as a result may drift lower over time.
Based on the strength of this conclusion, you decide to borrow a parcel of shares from your broker and sell them at $2.59. Over the next six months your hunch starts to play out as suspected, and following weaker employment numbers, plus lower consumer confidence, Myer’s share price drops to $1.78.
At this point you decide to ‘lock in’, buy the parcel of shares back at $1.78 and then return the borrowed shares to the broker. In this instance you have made 81 cents per share (less the agreed borrowing costs).
So what you’ve done is take a bearish outlook for Myer, and marry it with good timing to benefit from the fall in the share price.
Things you need to know before shorting stocks
You’re required to pay interest when shorting a stock, plus dividends if they’re also due. If the price goes up instead of down then you’re seriously out of the money.
So to avoid short-term hype, it’s important to take shorting positions on companies you think will fall in value, rather than rely solely on market sentiment.
Profile of a typical shorting stock
Interestingly, the profile of a stock worth shorting is one that you typically wouldn’t contemplate buying, and many fall into the value trap category. While these stocks appear cheap based on their price to earnings ratio, they have questionable debt levels, fading competitiveness and declining cash flows.
Had they asked the right questions, shareholders in the ill-fated ABC Learning Centres would have seen hefty capital expenditures, minuscule cash flow and growing leverage as compelling reasons to exit the stock up to three years before the company went into administration.
Typical value traps also include stocks overexposed to a single core business that’s becoming a victim of technological change or a shifting regulatory environment.
So while the bulk of your portfolio should be focused on buying companies that appreciate in value, a shorting strategy can add value, especially in today’s highly volatile market. The market is constantly throwing up opportunities to put this strategy to good use.
Using technical analysis to support value investing
With one simple technique you can avoid value traps and invest in stocks once they have upward momentum.
Have you ever had the feeling – the one where you are absolutely sure about a stock?
You have done your research – dotted the i’s and crossed the t’s – and then guns blazing bought into a low priced stock because it represents “great value” only, to find that once you enter into the investment it falls, or fails to rise, drifting sideways and weighing down your portfolio.
But you can’t sell it! God forbid! The fundamentals make so much sense!
What happens if you close out of the stock only to see the price rise? Your psyche could not bear that – not after you have invested so much time in research, and found such a wonderful company to buy.
So instead you decide the prudent thing to do is wait. I mean that’s what value investors do isn’t it? They patiently wait for the stock to rise, as surely it will.
Little do you realise you have been caught in a classic value trap.
You have been plonked with a laggard. You know you should cut your losses and move your capital into a more productive stock. But you can’t bear to.
You are stuck. A victim of fear of missing out, and a victim of the sunken cost effect of spending so much time on research that you don’t want to go to waste.
Sound familiar at all?
It doesn’t have to be this way.
A simple technique to avoid value traps
By using this one simple technique you can learn to avoid value traps and invest in stocks once they have upward momentum, catapulting your stock into profit right after you buy it – or at least getting out with a small loss and free capital to invest in the next good idea.
Yet most value investors will frown on this approach. Why? Because it involves technical analysis, and value investors know it’s not technicals that move the market but fundamentals. And the proof is in the pudding right?
Mum and dad investors don’t have the resources (except Share Analysis – Yay!), or the skill of professional fund managers so we can always do with something else, to help pick winners and supercharge our returns.
So for the rest of us technical analysis can be the secret sauce we can add to our value investing to turn it up a notch.
Value investing and technical analysis = a power combo
A typical value investor might wait for a high quality stock to be a certain percentage below its intrinsic value, say 20 per cent, before they buy.
Combining technical analysis, investors wait for a stock to be not only 20 per cent below value, but also wait for signs of upward pressure on the price – and then buy.
On a chart the contrast is something like this:
Once you have found a top stock you wish to purchase, you will need to bring up a monthly chart of the stock. You can do this in most share brokerage accounts, or in specialist charting software packages (hint: often Contract for Difference (CFD) providers have excellent free charting packages at no cost for account holders).
On the monthly chart plot a 3 period moving average and a 7 period moving average.
The next step is simple. Just wait until the 3 period moving average crosses over and closes above the 7 period moving average. Finally, make sure you check that the stock is still a good distance below its intrinsic value when you buy.
Patience is required
This strategy does require patience to wait for the right time.
Remember that you are not bottom picking. You need to be comfortable with the stock rising a bit first before you get in – and on occasion missing out on one that rises too quickly.
Other advantages of a value investing/technical analysis combo
There are a few other advantages of this method too.
Wondering what A1 Share Analysis-rated stock to buy? Pick the one that is showing momentum on the price chart. Easy as pie! As you are not bottom picking, you now have a great place to put a stop-loss. Stick your stop loss below the low.
That way if you are wrong you can get out quickly, and can either get back in at a lower price – or you get to invest in a better opportunity, rather than holding onto a sideways moving stock in the hope that it will one day rise.
Avoid “catching a falling knife”
Market crashes present great buying opportunities for value investors, but how do you avoid “catching a falling knife”? Easy, wait for the market to bottom out first and then enter. When the market bottoms out you will have plenty of A1 stocks with rising share prices to pick and choose from using this technical analysis method.
Is value investing and technical analysis a forbidden partnership?
Using simple technical analysis techniques in conjunction with value investing can help provide you with an edge over the market.
Whilst it’s not a foolproof method, the ‘forbidden partnership’ can help you remain disciplined and objective about your purchasing decisions, and stops you from getting caught in the dreaded value trap.
It’s not a foolproof method, so you will want to practice proper money management as always.
By Sam Eder, founder spoonfedinvestor.com.au
Sam Eder is the founder of SpoonFed Investor – www.spoonfedinvestor.com – and a Share Analysis Global member. Sam is fiercely independent–minded and has seen too much to accept the way customers get treated (and charged!) by the big firms. SpoonFed Investor is Sam’s way of helping people achieve their goals and be financially abundant while keeping more of their hard-earned savings in their own pockets.
Investing in the unexpected
How do professional investors make money in the stock market?
It’s the question every self-directed and SMSF investor wants the answer to!
Financial commentator and stockbroker Marcus Padley shared some wisdom from his 32 years of experience in the stock market at a Share Analysis webinar.
“I think it boils down to picking top stocks, and of course, Share Analysis is a stock research tool designed to help you do that, which is why I love the product”, Marcus said.
“Prior to 1974 nobody bought balanced funds and nobody invested in the stock market just because it was there, like the way we do now. Instead what you had to do was pick stocks. And this is why books like The Intelligent Investor became famous, because to be successful you had to do better than the average punter”, Marcus added.
Marcus joked, “I have a favourite saying, ‘The money is in the unexpected’. If you look back over the last 10 years you’ll find some incredible gains and some incredible losses, and what you’ll find is that the stocks moved because things happened to them that weren’t expected.”
“For example, if BHP is going to make exactly what it’s expected to make every year you will not make money out of the stock because if it hits the numbers the market expects, the share price won’t move”, Marcus explained.
Marcus recommends taking a top-down approach when hunting for top stocks.
He encourages investors to ask the question: What is going to happen this year that isn’t expected?
“That’s where the money is. The money is not in pouring over P/E ratios and dividend yields and forecasts that everybody has already reviewed. The unexpected is where money can be made, and where it is lost. So you have to think about the good and bad things that may happen”, Marcus said.
Create a watch list of great businesses
Marcus suggests creating a watch list or spreadsheet and populating it with great businesses (Share Analysis members can find top stocks easily with a powerful stock rating system and easy-to-use filter).
“Making money in the stock market really just boils down to the stocks on your spreadsheet”, Marcus said. Is your watch list full of top stocks?
“What you want to do is to use tools to find or pick a list of what I call preferred stocks. The other half of the process is to find the right time to purchase the stocks”, Marcus advised.
How does Marcus Padley find a list of top stocks using Share Analysis share investment software?
Step #1: Think about what criteria is important to you as an investor: low price to earnings ratio, rising earnings per share, strong return on equity, high yield, undervalued stocks? Are there particular sectors you want to focus on, or avoid?
Step #2: Use Share Analysis’s filters to reduce the market down to a handful of the best stocks to invest in. Check out how Share Analysis’s powerful filtercan give you a shortlist of the best stocks to invest in.
Step #3: Make a watch list or spreadsheet of these top quality stocks. Share Analysis members can create unlimited watch lists.
Step #4: Time your entry into those stocks as best you can. At Share Analysis, we believe the best time to buy shares is when the share price is trading at a discount to the business’s intrinsic value. Read more about the best time to buy shares here.
Create alerts to let you know about opportunities
Share Analysis’s custom alerts feature makes it even easier to track changes to your watch list and be the first to know when new opportunities emerge. Set up a custom alert and you’ll receive an email every time one of the stocks in your watch list moves above or below a certain safety margin, has a significant price change or has an update to its intrinsic value or Share Analysis Score. See how you can easily set up a custom alert.
If you have just discovered Share Analysis stock market research software and would like to take a look at what Share Analysis can do for you, try our free demo or book a no obligation demo and experience Share Analysis first hand.
Franking credits, explained
Profitable companies may accumulate franking credit balances that make their dividends extra special.
Given that they’re an off-balance sheet item in Australia, there is no readily available data on the size of franking credits per listed company. Nevertheless, companies that have been making large profits and hence paying high levels of corporate tax, while not distributing a large proportion of these profits to shareholders, are likely to have large franking credit balances available for special dividends or off market buybacks.
It’s worth hunting for companies with the capacity to increase their dividends or issue special dividends due to war chests of cash or hefty franking credits.
To ensure that a dividend cheque arriving in the post is an even more joyous event, it’s important that you understand the difference between a dividend that’s been franked and one that hasn’t. Sadly, shareholders who don’t understand the significance of fully franked dividends often fail to maximise their benefits.
It’s easy to see a company’s history of dividends and franking in Share Analysis. The Dividends Per Share chart available in Share Analysisillustrates a company’s dividend history. The level of franking for each year is indicated by a blue ring on the column.
Spotting companies that pay fully franked dividends is easy with Share Analysis’s Earnings and Dividends Evaluate screen.
Franking credits are prepaid tax
But before we enlighten you on these benefits, let’s take a look at what a franking credit is, and why some companies have them while others don’t.
Put simply, franking credits are the tax a company pays on the earnings before it pays dividends to you, the shareholder, typically twice a year. Ideally you should be looking for what are called ‘grossed-up’ dividends which have the franking credits built in.
Remember, not all dividends automatically have full franking credits embedded within them. So when companies pay less than 30 per cent tax on their earnings – due either to a tax break, or a previous year’s losses carried forward – their dividends or other distributions will have both franked and unfranked components.
As they are a form of income, you are typically required to pay tax on dividends. However, under Australia’s imputation system – whereby companies distribute dividends with franking credits equal to the tax already paid – you are entitled to get that tax back in the form of a rebate when you declare your tax return.
But this doesn’t mean your dividends are tax-free. What tax you get back depends on your personal tax rate, and if it’s lower than the 30 per cent a company pays on tax, you’re entitled to pocket the difference. Similarly, if your tax rate is above the 30 per cent company tax rate, you’ll only pay the difference.
How franking credits affect your tax bill
Tax payable before franking credit
Tax owed (rebated) after $0.30 franking credit
Post tax dividend income
While tax should never be the primary determinant of investment decisions, couples on different tax rates may wish to buy shares in the name of the one who stands to receive a full refund of franking credits. Likewise a retiree with a tax-exempt pension income can use the refund of the franking credits to supplement their pension income. Franking credits also represent money in the bank to self managed super funds (SMSF) that pay a tax rate of 15 per cent.
But if you’re buying a stock with the express desire to receive a fully franked dividend, remember that for any franking credits over $5,000 you’re required to hold shares for a minimum 45 days.
Take care when seeking dividends
Remember, focusing solely on yield can be dangerous. A yield of 5 per cent today will be eroded if the company releases a surprise announcement, or the business’s economics change.
If your focus is income from dividends, make sure you seek out companies with strong balance sheets and sustainable cash flows whose future growth prospects are heading in the right direction. Only once you’ve identified top quality companies should you begin narrowing your search to those that pay a dividend.
Download Share Analysis’s free checklist that you can use to find stocks that can afford to pay dividends. It includes five tips to help you sort the good companies from the bad.
What is dividend stripping? Is it a sensible strategy?
If timed successfully, dividend stripping gives investors their dividend and sometimes a nice capital gain too.
With most stocks choosing to time dividend payouts with their financial results, investors chasing dividend stocks have little excuse for not getting onto the share register in sufficient time to benefit from the surplus cash that a company rewards shareholders with (typically) twice a year.
However, there’s another group of investors who time their share purchases just before a dividend is paid, with the express purpose of selling those shares after that payment (when they go ex-dividend).
This strategy is known as dividend stripping, and the end game – if played successfully – means investors can have their dividend, plus a transactional gain on their shares when they exit the stock. Interestingly, a perusal of historical dividend and share price data by Dividends.com.au concludes that dividend stripping of S&P/ASX200 index shares can provide a significant edge of more than 6 per cent over the S&P/ASX200 index for a holding period of 46 days – assuming simple guidelines are followed.
While dividend stripping can deliver a nice little earner for investors, it’s not for the faint hearted, and within today’s more volatile market, you need to tread carefully to prevent this investment strategy blowing up in your face. To put a dividend stripping strategy in the right context, let us walk you through exactly how it works.
Typically the domain of active share investors, dividend stripping is the art of buying the shares several weeks before the ex-dividend date in the hope that the share price will rally closer to this date as new investors (just like you) buy the stock – to capitalise on its dividend cash-flow – and then sell it after it goes ex-dividend.
By doing this investors hope to pick up the dividend, the imputation credit and a capital gain in one fell swoop, or at the very least a capital loss – smaller than the dividend gain – that can be used to offset gains elsewhere. Let’s take a look at a classic dividend stripping example.
How does it work?
To satisfy the 45-day rule, you buy a bank share 46 days before the ex-dividend date. What you’re hoping for is that the price will rise before the ex-dividend date, and generally speaking the bigger the dividend pay-out, the more likely this outcome is.
Share prices of Aussie banks typically run a month ahead of their results, and given where cash rates are at, income-investors are watching banks and other big income-plays (like Telstra) closely. As a case in point, ANZ’s entry price 46 days prior to ex-date in 2013 (9 May 2013) was $28.55, and ex-dividend closing price was $30.59, hence delivering a 10.8 per cent dividend strip return (46 days) and a 5.9 per cent edge over the S&P/ASX200 Accumulation Index.
In the normal course of events, the bank’s share price will rally ahead of the results, and assuming the result is good, will continue doing so when the stock goes ex-dividend. You then proceed to sell the bank shares with your capital gain intact, having received the dividend, (and franking), and an entitlement to the imputation credit. You’re entitled to claim a tax credit equal to the amount of corporate tax paid by the company by holding the shares of a company for more than 45 days (not including the day of purchase or sale).
The trouble is that the less reliable the stock is as a dividend payer, the less bankable this strategy tends to be. So if the only people who bought the stock were dividend strippers, then there’s no underlying market support, and you risk the price dropping far more than the dividend.
What can go wrong?
Let’s look at a worst case scenario of how a dividend stripping strategy may play out.
In the lead up to reporting season (46 days out) you buy shares in a mining services provider with a consensus yield forecast of 14 per cent (fully franked). Prior to the result, the share price falls, and the dividend is subsequently cut because of disappointing results.
Given the small size of the dividend yield, you decide to hold on for the ‘ex date’ only to find that the price continues sliding and when it goes ex 9 cents, the share price opens down 13 cents (the dividend plus the franking). At this point sellers outnumber buyers, the price falls 20 cents and surprise, surprise, after you finally sell – the share price starts to rebound.
Had you done your homework properly, you would have recognised:
A. that the company’s share price was already on a downward trajectory following an earlier profit warning a month before you bought in,
B. the stock only had a 14 per cent yield due to a falling share price, and
C. the pre-profit warning consensus dividend forecast was now out of date.
For tips on how to find high dividend stocks that can actually afford to pay a dividend click here. The lessons here are obvious: The value investing principles you apply to unearth quality stocks are just as relevant when choosing stocks for a potential dividend strip. Remember, you’re much better off buying quality stocks on an upward trajectory due to a rising market – that are incidentally going ex-dividend – than being swayed by a hefty yield or consensus forecasts that may only disappoint.
On an equally cautionary note, it’s important to remember that after going ex-dividend, a stock could typically be expected to fall by the amount of the dividend payment, with banks being among a few notable exceptions to this rule.
Admittedly, the share price recovery should be quicker for higher quality stocks, but the art of successful dividend stripping ultimately comes down to knowing when to enter and planning when to exit.
Investing in quality IPOs
Size alone doesn’t guarantee instant IPO success.
Not all IPOs are good for investors. The number of wealth-destroying floats in recent times serves as a healthy reminder that not all floats will necessarily make you money, either short-term or even over the long haul.
The share market has no shortage of IPOs that bombed. Collins Foods (CKF) and Myer (MYR) have both struggled to trade above their float price. And if Boart Longyear (BLY) is any indication, there’s no guarantee these stocks will rally any time soon. Since floating in 2007 BLY’s share price has fallen more than 97 per cent.
Size alone doesn’t guarantee instant success either.
IPO KPIs for value investors
So don’t get sucked into buying overpriced and overspruiked companies wired to uninspiring sectors with questionable growth projections destined to lose you money. To avoid future disasters you need to pressure-test your argument for IPOs against key performance criteria. The following list of IPO tips should help you unearth the next Flight Centre (FLT) and avoid the buying the next Myer (MYR).
1. Stick to your value investing principals
The principals of value investing apply as much to IPOs as they do to any other listed company. So you should be attracted to the floats of companies with consistently above-average return on equity (ROE), with little debt and not too much goodwill on the balance sheet. On the flipside, steer clear of buying into floats where the net tangible assets (NTA), or net worth (pre-IPO), as happened on the Myer float, is negative.
2. Floats are designed to make money for the sellers
Remember that companies don’t engage in philanthropy when they decide to float a stock. They have their own interests at heart, not yours. The decision by Myer’s private equity owners to sell down their entire 100 per cent stake highlights the importance of timing an IPO when investor appetite is very forgiving.
It’s understandable why sellers want to get out at a time when they can get the best prices, but remember that also means you risk buying into an IPO at the top. Other floats involving a sell down by private equity owners include Penrice Soda Holdings (PSH) and Kathmandu. Both had equally bad results for investors. So if you’re contemplating buying into a float where the people responsible for turning the company around plan to immediately exit the business – DON’T.
3. Invest in the business, don’t focus on short-term gain
As a value investor, you should be more interested in investing in an IPO for the long term than “stagging” or selling immediately after the IPO for a quick profit, which could potentially see you “blacklisted” by a broker from future IPOs. Given that a company’s (IPO) glossy prospectus is also an advertising document, you need to see through the hype to the underlying quality of the business and its core earnings. What the prospectus is unlikely to reveal is the reason why owners are selling out, so make a point of finding out yourself.
4. Do thorough research
It’s equally important to investigate previous financial statements of companies planning to float. Also find out whether the money raised is being earmarked to fund expansion or repay debt, and the amount to be paid to existing owners.
5. Words of wisdom from Warren Buffett
Warren Buffett, the world’s most successful investor, expressed his cynicism towards IPOs in the following quip. “It’s almost a mathematical impossibility to imagine that, out of the thousands of things for sale on a given day, the most attractively priced is the one being sold by a knowledgeable seller to a less-knowledgeable buyer.”
How to invest in stocks that benefit from a moving Australian dollar
A moving Australian dollar heralds mixed blessings for stocks on either side of the currency divide.
Investors should understand some useful guiding principles, when it comes to identifying the most likely winners and losers from a falling Australian dollar.
While currency should never be the only determinant of stock selection, you can’t incubate yourself against currency risk with around 30 per cent of Australia’s listed companies sourcing earnings from offshore.
That’s why you need to know the currency impact on the stocks you own. The more direct the currency exposure your businesses have, the greater the earnings hit (good or bad) is likely to be.
Everything else being equal, a 10 per cent drop in the Australian dollar could typically be expected to increase company earnings by a notional 3 per cent.
A falling dollar is typically good for exporters, especially companies in agricultural and manufacturing sectors, as it boosts their price competitiveness in overseas markets. Property trusts with unhedged overseas exposure should also benefit.
Key beneficiaries of a falling Aussie dollar
ASX-listed stocks with both local and offshore earnings include CSL Limited (CSL), Coca Cola Amatil (CCL), Cochlear (COH), Ansell (ANN), Ramsay Health Care (RHC), Amcor (AMC), Brambles (BXB) and Westfield Group (WDC).
Stocks positioned to benefit from a falling dollar
From an earnings perspective, a weaker Australian dollar is also expected to have a positive earnings effect – especially for miners and other companies with large amount of their revenues in $US – through either conversion – when exporters compete with imports in Australia – or translation – when foreign currency is converted to Australian dollars on balance sheet.
But you need to understand that the effect of falling commodity prices and reduced demand for goods and services far outweighs the translation effect of having offshore earnings.
Included among industrial stocks positively impacted by a falling Australian dollar are Paperlinx (PPX), Incitec Pivot (IPL), Caltex (CTX), Sims Metal Management (SGM), Arrium (ARI), Aristocrat Leisure (ALL), James Hardie (JHX), Treasury Wine Estates (TWE), QBE Insurance (QBE), Amcor (AMC), Boart Longyear (BLY), Domino’s Pizza (DMP), Navitas (NVT) and Sonic Healthcare (SHL).
Losers when the dollar falls
Given that currency is a by-product of global economic conditions and investor risk tolerances, cyclical stocks tend to underperform their defensive counterparts in a falling Australian dollar environment. Similarly, the declining value of the dollar should disadvantage importers and industrial stocks with little overseas exposure, and consequently little negative translation effect.
Stocks in this category are Qantas (QAN), Virgin Australia (VAH), The Reject Shop (TRS), Goodman Fielder (GFF), Wesfarmers (WES), Pacific Brands (PBG), JB Hi-Fi (JBH), Harvey Norman (HVN), Toll Holdings (TOL), Computershare (CPU), Flight Centre (FLT), plus selected media stocks, including Ten Network Holdings (TEN) and Seven West Media Ltd (SWM).
However, given that they often hedge their orders up to a year ahead of their sale period – using forward exchange contracts – the impact of a falling Australian dollar on retailers can take some time to be fully realised.
Given that the Australian dollar still hasn’t dropped that far from its record highs, there’s still plenty to be gained from capitalising on further falls, and if it is destined to fall to around US85¢ – which, incidentally, would remain above historical averages – a review of opportunities outside Australia could be timely.
Reasons to avoid bonds when interest rates are low
If interest rates are falling, bond yields are too.
When interest rates reach record lows, investors are better off avoiding so-called ‘safe havens’ like government bonds and investing in top stocks with dividends.
If interest rates are falling, bond yields are too, and exposure to bonds can be more trouble than it is worth. Newcomers to this asset class may not know this.
Before adding bonds to your investment portfolio, you must:
• Recognise where we are in the cycle, and;
• Decide what role you want bonds to play in your overall portfolio.
As shares and bonds are uncorrelated assets, shares tend to do well when bonds are out of the money and vice versa.
It’s normal for investors to move out of bonds when share markets rally and invest more in bonds when the share market isn’t looking so bullish.
A danger of investing during a bull market is that you’ll lock in low yields via fixed-rate instruments (like bonds) – with a view to holding to maturity – effectively forfeiting the opportunity to receive higher returns elsewhere. That lost opportunity may not look like a big deal when interest rates are low. The negative impact will, however, rapidly accelerate once interest rates start going up.
Lost investment opportunity aside, you also need to ask yourself how exposed the capital values of bonds (as fixed rate instruments) are to interest rate movements (compare with floating rate instruments), and how this could also negatively impact the value of your portfolio.
AAA-rated government bonds provide an enviable level of credit quality. However, during bull markets the problem for would-be investors is the degree to which these bonds trade at premiums to their $100 face value.
How bonds work
An attractive annual coupon might be expected to offer anything from 5.25 per cent to 6.25 per cent, but remember that it’s not uncommon for capital values to exceed $110 and the further out that instrument is dated the higher the capital value is likely to be.
Once you see what can happen if bonds are held to maturity, you’ll start to understand why portfolios that hold bonds need to be actively managed. The combined impact of solid annual returns, plus capital losses on maturity (once you realise the bond’s $100 face value), is a yield of between 2.5 per cent and 3.5 per cent.
Here’s a classic example:
A Treasury bond is due to mature in five years, offering an attractive annual coupon of 5.5 per cent based upon a purchase price of $100.
The market has rallied and the bond is now trading at $114. Purchasing the bond at $114 results in a yield to maturity of 2.8 per cent.
If you’re considering adding bonds to your portfolio, use this calculation to figure out how much you will earn (the bond’s yield if held until maturity):
Current Yield = (Annual Dollar Interest Paid / Market Price) x 100 per cent
A bond with a $100 par value, trading at the discounted price of $95.92 and paying a coupon rate of 5 per cent, would have a current yield of 5.21 per cent.
((0.05 x $100) / $95.92) x 100 per cent = 5.21 per cent
Another argument for actively managing bond portfolios is the risk that in the lead-up to maturity yields will move higher as the 20-year bull market in government bonds comes to an end.
Should this happen, and portfolios aren’t actively managed, a move higher in yields will result in lower capital values and potentially negative returns as the value of coupons are offset by higher capital losses.
In an interest rate environment that favours shares over bonds, investors chasing yield would be better rewarded investing in high quality stocks with dividends.
How value investors use Share Analysis
Value investors, including SMSF trustees, AFSL licensees and private investors, use Share Analysis share investment software to guide their investment strategy.
There are many different ways value investors can use Share Analysis. Whether you’re looking for the best stocks to buy for your SMSF, seeking short-term high growth to finance another venture, or using Share Analysis as a professional investor, Share Analysis’s flexible features ensure all value investors can take advantage of investment opportunities suited to their risk profiles and investment strategies.
Lloyd Evans, SMSF trustee
Lloyd Evans uses Share Analysis to manage his personal and family’s SMSF investments.
“Prior to Share Analysis my investment results tended to roll with each new fad. Now I wait patiently and take my cues from business value appreciation rather than share price gyrations.
“Share Analysis allows me to review a large amount of key information about a company quickly, weed out the businesses with poor economics and focus on what is important – top quality businesses trading at discounts to their future intrinsic valuations.
“I tend to use Share Analysis initially for my stock selection and back test my expectations on intrinsic value growth and return on equity. I use it as a check method. As I tend to be a glass half full person in my day-to-day job, I also err on the side of caution with analyst consensus forecasts available in Share Analysis. Analysts tend to extrapolate growth projections”, Lloyd said.
Click here to read about Lloyd’s winning investment in Codan (CDA).
Andrew Rowan, AFSL licensee
Andrew Rowan is the founder of boutique financial planning practice Andrew Rowan Wealth Management. Andrew is based in Ballarat, Victoria, and has been advising clients for more than 20 years.
Prior to using Share Analysis, Andrew relied on research from external brokers and research platforms, which generally resulted in a lack of uniformity across his clients’ portfolios.
“I was drawn to the value investment approach through a lot of reading and research. Before Share Analysis I ran spreadsheets and charts to arrive at preferred stock positions.
“Then I discovered Share Analysis.
“I’m a visual person so I was attracted to Share Analysis’s visual presentation of a company’s fundamental information.
“After comparing a number of research options, I felt Share Analysis provided myself and my business with the most useful range of stock information which we could use in building client portfolios.
“It’s built on the same principles that are consistent with my own personal views on what constitutes a good business”, Andrew said.
As a professional financial advisor, Andrew’s primary aim in managing client investments is to avoid disasters.
When asked how he uses Share Analysis to find new stock opportunities, Andrew said, “We use Share Analysis’s Filter and Table Aerial View to trim the universe to stocks that Share Analysis rates A1, A2, B1 and B2, because they tend to be the type of companies that have good balance sheets and strong cash flows.
“I then only consider stocks that have increasing intrinsic values and earnings outlooks, and make an assessment on future year safety margins so we can hopefully take longer term positions.
“Share Analysis has provided us with more structure in the way we go about building client portfolios”, Andrew said.
Christophe Capel, private investor
“When I evaluate a company in Share Analysis I generally start at the final Evaluate screen, Share Analysis Line.
“Next I look at the Cash Flow screen. I like it because it helps me assess the cash flow ratio of a company (without having to calculate it) and whether it is above 0.8 or not. The cash flow ratio is important for me because it indicates how well a company can cover its current liabilities using cash flow generated from operations. It is a great indicator of liquidity.
“I also check whether both the Funding Surplus (green line) and Cash Flow Generated from Operations (blue line) are rising (the steeper the better), and are above $0.
“I avoid companies in a Funding Gap because this means that the company will need to increase debt, raise capital (which dilutes equity) or dip into its bank account, (or a mix of these). My preference is for a company to fund itself with cash flow generated from operations (eg company puts money in its pockets versus spending more than it earns). I also check whether Reported Net Profit After Taxes (NPAT) is rising”, Christophe said.
“The other Evaluate screen I always check is Capital History. I like it because it helps me check the company’s forecast return on equity, which is the best economic measure of business performance according to Warren Buffett, and its average ROE over the last 4 years.
“On the Capital History screen I can also see the total debt of the company and how it has been moving in the last few years at a glance. I also check the company’s net debt / equity ratio is under 30 per cent.
“Other questions the Capital History screen helps me answer at a glance are: have profits been rising and are they forecast to continue rising?; has NPAT been increasing or not and is it forecast to continue heading in the right direction?; how has equity been changing?” Christophe said.
Steve Macdonald and Dane Pymble, professional investment managers
Infinitas is a boutique firm with particular expertise in investing for income following the value investing methodology.
“Infinitas Asset Management uses Share Analysis as an important tool for investment idea generation.
“We were keen to shift our Women’s/Income portfolio from a pure yield focus to incorporate some growth elements – “growthy yield”.
“Share Analysis was throwing up Flight Centre (FLT) as a high quality business that was substantially undervalued. We similarly viewed it as high quality, with potential growth in its yield and having net cash.
“Given the discount to intrinsic value that Share Analysis was highlighting, we added Flight Centre to some of our model portfolios with our maximum 10 per cent weighting.
“The stock has performed strongly, buoyed by positive earnings guidance and subsequently a strong profit result. As its discount to valuation narrowed we have reduced our position size but retain a reasonably large position in the stock in portfolios due to its high quality (rated A1 by Share Analysis) and continuing positive outlook particularly as the US business moves back into profitability.
“In many ways this epitomises the Investing Like A Woman approach: a common sense, considered and well-researched assessment of the opportunity; a focus on moderately low risk investments providing sustainable and growing income; prudent capital allocation; and in this instance a welcome opportunity to invest in a well-managed company with a female COO was the icing on the cake.”
Steve shared his insights on global investing at a Share Analysis webinar.
Lindsay Byrnes, SMSF investor
Lindsay Byrnes joined Share Analysis in November 2011 as Founding Member to help him manage the investment portfolio of his self managed superannuation fund (SMSF).
Share Analysis complements the excellent support Lindsay receives from his full service broker, allowing him to identify opportunities that may be outside his broker’s research scope, likely to be in the smaller company sectors.
Share Analysis is an excellent tool to evaluate his broker’s research recommendations in the larger cap sector, as a further check that the companies measure up, is Lindsay’s review of Share Analysis.
As a means of earning income and providing modest hedging, Lindsay also uses options. He only writes options, through the services of his broker, for covered calls and puts. “Share Analysis is a handy tool in helping confirm strike prices and to bring the net cost of acquisitions, given the option premium received, closer to the stocks’ intrinsic value”, he said.
Using this strategy Lindsay can invest in the riskier resource area, mitigating risk by writing options over the stock or to reduce the entry point should a put option be exercised.
As a self-funded retiree, Lindsay says Share Analysis also helps him identify the best dividend stocks. “Share Analysis is also helpful in maximising dividends between different stocks, particularly banks whose relative intrinsic values fluctuate to provide opportunities to sell one in favour of another, given different dividend cycles, to maximise yearly fully franked dividend income.”
“Share Analysis’s integrity in the calculation of intrinsic value is very helpful in acting as tool to support my investing decisions with the benefit of consensus forecasts. If a stock is overvalued and the forecasts are not bullish, it’s a good indication that the stock is overvalued”, Lindsay said.
Quality, growth and value = a winning strategy
High-quality growth stocks, acquired at a bargain price, can provide impressive returns for your portfolio.
In a working paper titled “Quality Minus Junk”, Asness, Frazzini and Pederson “found that stocks categorised as high quality at time t tend to remain high quality up to 10 years later.”
They also discovered that high quality is positively related to stock prices. Why?
“There is little rational justification for why high-quality stocks should command a high return… the high returns earned by quality stocks are still a puzzle”, Frazzini said.
The human race is pretty good at spotting quality (and we’ll often pay a bit more for the privilege) – clothing, cars, property, people – so a gravitation towards quality stocks seems logical.
Quality and value = a winning formula
In a paper titled “Quality and Value: The essence of long-term equity returns”, MFS portfolio managers Katrina Mead, Jonathan Sage and Mark Citro found that value was a higher driver of performance than quality. “Companies that were both high quality and inexpensively valued with respect to fundamentals delivered the most consistent outperformance.”
In short, over time quality is a way to add value, “especially when you marry it with valuation”, MFS managers wrote.
The managers define quality by return on equity (ROE), stability of return on equity and balance sheet strength.
Why is a strong balance sheet an important predictor of future success?
It puts a company in a better financial position to control its own destiny.
“Highly leveraged businesses don’t have a great deal of flexibility. When something unexpected happens, it can put a lot of stress on the company to do uneconomic things to satisfy creditors”, Mead said.
“Having a good balance sheet helps to increase your confidence level that the company has the ability to sustain itself over time. It’s an important source of downside protection”.
And don’t forget about compounding. “I think investors underappreciate how sustainable and persistent the returns of higher-quality companies tend to be”, Mead said.
Why competitive moats sustain long-term performance
Over the long term, top stocks generate impressive profitability because they have a competitive moat: strong brand recognition, valuable intellectual capital and entrenched networks. Sustainable high return on equity is also generally supported by minimal debt.
Take a look at Seek (SEK), CSL and Nick Scali (NCK). Over the last 10 years these stocks have generated average returns on their equity of 36, 24 and 54 per cent.
4 qualities of growth stocks
If you’re on the hunt for growth stocks, look for:
• Profitability (return on equity)
• Consistent earnings growth
• Stable levels of inventories
• Investment in intangibles related to future profitability, such as branding and research and development, which are likely to contribute to future growth
Move forward with your investment plan
Knowing your investment type can boost your portfolio performance
Knowing the strengths and weakness of the seven popular investor types, and finding a style that suits you, can help you make better investment decisions.
Some investors are incredibly conservative, while others love the thrill of a big trade. Fundamental investors insist on knowing every little detail of a stock, while technical traders rely on signals from charts.
The beauty of investing in the stock market is that you can be a successful investor, no matter what your style. You just need to know what type of investor you are.
While your personality and investment goals are unique, you’ll most likely feel a connection with one of the popular types of investors. Knowing the strengths and weakness of that investor type can help you to make better investment decisions.
Which investor type are you?
1. Big Punter, George Soros
Big punters love the thrill of the trade. Slow and steady is not in their vocabulary. They’re on the lookout for that one big trade that will either make or break their bank balance. Sometimes their bets come good, but the investing landscape is littered with big punters whose “sure trade” didn’t go as anticipated.
Tip: It’s important for the big punter to know when they are wrong so they can cut short their losses.
George Soros attained fame as “ the man who broke the Bank of England”. In 1992 Soros bet against the bank’s unwillingness to float its currency or raise interest rates. Soros bet 10 billion pounds that the bank’s policies would fail. When the Bank of England was finally forced to devalue the pound, Soros was left US$1.1 billion richer.
2. Market Technician, Martin S. Schwartz
Technical analysis traders are glued to their computer screens, watching share price charts for hints into the future direction of share prices. Technical traders are fluent in stochastic oscillators, Bollinger bands and candlesticks.
Tip: Technical indicators, aka charts, are just that – indicators. Whilst charting and technical analysis gives investors an idea of what could happen, market forces can easily make a mockery of any trade that relies solely on a historical price pattern.
At one time responsible for 10 per cent of the total daily volume on the S&P 500 futures contract, Martin Schwartz is one of the greatest technical traders who ever lived. When skeptics challenged the validity of his methods, Schwartz remarked, “I always laugh at people who say ‘I’ve never met a rich technician.’ I love that! It’s such an arrogant, nonsensical response. I used fundamentals for nine years and got rich as a technician”.
3. Quant analysis, Myron Scholes
Quants use mathematical formulas to make investment decisions. Mean reversion, capital pricing theory and volatility clustering are part of the quant’s vocabulary. They spend hours developing complex financial models and algorithms, often with the help of powerful computers.
Tip: Things that are statistically “impossible” occur frequently. Quants need to make sure they cater for the “black swan” that brings down their system.
Myron Scholes co-developed the Nobel Prize-winning formula used in the calculation of stock options, the Black-Scholes model. He is infamous for his involvement in the Long-Term Capital Management (LTCM) hedge fund debacle of the late 1990s. LTCM achieved an annualised 40% return on their capital before coming unstuck during the 1998 Russian financial crisis, losing $4.6 billion dollars and bringing the global capital market to its knees. LTCM is a lesson that statistically “impossible” events occur in the stock market.
4. Systematic Trader, Richard Dennis
Systematic traders follow trends. They’re happy to take small losses in anticipation of a big win.
System traders can be contrarians, trading failed breakouts with tight stop-losses to avoid getting stuck the wrong way against the trend. System traders take every signal their trading system presents them, because they know that the one they fail to take could be the trade that produces all their profits for the month (or year).
Tip: Be wary of system death. The Turtle system that made millions for Richard Dennis has been flat or lost money since the 1990s.
Dennis, the “prince of the pit”, reportedly made $200 million on $1,600 dollars he borrowed in only ten years. Dennis is the progenitor of the Turtles, an experiment into whether trading could be taught or if it required innate ability. After a discussion with fellow trader William Eckhart, the pair recruited 21 investors and trained them in a simple commodity trading system. While some traders failed (though they were all taught exactly the same thing) a number were successful in making millions of dollars. A study of the Turtles reveals the importance of your psychology on your investing performance.
5. Fundamental Investor, Benjamin Graham
Fundamental investors are simply interested in buying top stocks. They treat the stock market as a place to go bargain hunting for under-valued stocks. Fundamental investors spend their days pouring over financial statements and meet with a company’s management. They’ll even hang out in supermarket isles observing buyers’ reactions to their potential investments products.
Tip: Before you buy a stock, check that you are not a victim of “sunk cost effect”. If you spend hours researching a stock it can be hard to walk away from it. Investors tend to find reasons to justify their purchase, because they don’t want the time they have spent to seem like a waste.
Benjamin Graham is the granddaddy of fundamental investing. Graham’s investing method involves buying high quality stocks at a “margin of safety” to their intrinsic value – that is, when the share price was less than his calculation of the intrinsic value of the company.
6. Contrarian, Paul Tudor Jones
Contrarians believe that opportunity is to be had away from the herd. When you’re buying stocks, the contrarian is selling. They like to invest at extremes of fear – when everyone else is fed up and can’t take the pain any longer, in steps the contrarian to gobble up the best stocks at bargain prices. Similarly when greed is in abundance and everyone is piling into the stock market when it’s making new highs, the contrarian knows that it’s time to sell – or if they are brave, they might even go short.
Tip: A trend can continue on far longer than may seem logical. Many a contrarian has been burnt by shorting an irrational bubble.
A consummate contrarian, Paul Tudor Jones is America’s 100th (or there about) richest man.
While most investors get “killed” trying to pick tops and bottoms, Jones believes “the very best money is made when the market turns. Everyone says you get killed trying to pick tops and bottoms and you make all your money by playing the trend in the middle. Well, for twelve years I have been missing the meat in the middle, but I have made a lot of money at tops and bottoms.”
7. Macro Investor, Louis Bacon
Individual companies don’t matter to macro investors; it’s whole countries they’re interested in. Macro investors are sponges for world news and invest based on global fundamentals. This could be the collapse of the housing market in the US, or on the success or failure of “Abenomics” in Japan.
Tip: Not all macro trends are what they seem on the surface. Dig deep into an idea before you invest in it.
If Benjamin Graham is the granddaddy of fundamental investing, then Bacon is the modern father of macro investing. In the 1990s when the concept of macro investing was rarely heard of, Bacon bet that Iraq would easily capitulate against the US in the First Gulf War, and that the oil market would recover as a result. This view led to a big payday for Bacon’s hedge fund. Bacon’s accurate macro predictions returned 35 per cent a year over thirteen years.
This article was written by Sam Eder, Founder of SpoonFed Investor.
Technical + fundamental analysis = better buy and sell decisions
Combining fundamental with technical you can potentially enhance the timing of your buy and sell decisions, especially within a share market where volatility is the new-norm.
Technical analysis and fundamental analysis are often considered polar opposites when it comes to stock market investing.
Together, technical and fundamental analysis can provide a more complete picture of a company and what’s happening on the share market.
Start with fundamental analysis
You can’t apply an ‘investor’ mentality to stock selection if you don’t know what a company is worth. That’s where fundamental analysis comes in. By analysing historical financial data, along with forecast earnings and profit projections, you’re in a better position to predict future company performance and growth.
Remember, as a share market investor, you’re buying a piece of a company, so it’s critical that you understand the underlying business you’ve bought into. If you make no attempt to do so, then you’re treating the share market like a casino. Gambling is not investing.
By drawing on financial ratios – like return on equity and net debt to equity, plus qualitative indicators like management capability, earnings sustainability and a company’s competitive advantage – you can determine the all important intrinsic value of a company. Once you calculate a company’s value, you’re better positioned to form an opinion on its future share price.
Don’t overpay for shares
What you actually pay for a company’s shares is the most important determinant in your future returns. You can’t just buy a quality company at any old price and hope for the best. This is where technical analysis (aka charting) can help.
As a smart investor your ultimate goal is to buy quality stocks trading at a discount to their intrinsic value (IV) – the sum total of the businesses worth based on earnings, dividends, equity and debt. That’s because over the long term, share prices typically reflect the value of the underlying business.
Value investors who are patient enough will sooner or later be able to capitalise on negative announcements or unflattering macroeconomic data, which occasionally triggers a share market correction. Its called ‘buying on the dips’, and it’s not unusual for the share market to move over 200 basis points in any trading month.
Use technical analysis to time trading decisions
Negative market sentiment can drag down even the highest quality top stocks. These occurrences can represent mouth-watering buying opportunities.
Technical indicators, which focus on volume and price, try to gauge the direction in which share prices might be heading. This technique can help you time your entry into top quality stocks when they’re most likely to be cheaper.
Technical analysis won’t help you identify the best stocks to buy. It will however let you draw conclusions from trading patterns, company charts, graphs and trend lines to help you pick the best time to act on a stock.
Technical’s advantage over fundamental analysis
So what exactly can technical analysis add to your stock research that fundamental analysis can’t?
Fundamental analysis can’t tell you what the market thinks of a stock you want to buy. That’s where the ‘technical stuff’ like volume indicators can help.
Notable spikes traded volumes typically suggest that a stock has attracted abnormally high attention from the trading community and that its shares are under either an ‘accumulation or distribution’ phase. Volume indicators can help confirm whether other investors agree with your fundamental outlook on a stock. They can also help gauge whether a stock is gaining or losing momentum – if it’s the latter then a reversal could be around the corner.
This serves to remind you that a stock’s inclusion in or out of an index will have a material impact on the market’s interest in it, and can directly impact share price momentum. The same can be said for a share buy-back program.
Useful technical charts
If you like the look of a stock based on its fundamentals, and are seeking to time a trade or solidify a favourable entry (or exit) point, then these technical charts can be extremely useful:
Lets traders watch for spikes in volume, which often correspond with block trades. Intraday charts can be extremely helpful in deciphering exactly when large institutions are trading.
While most fundamental investors still tend to focus on the long haul, they still want to obtain a favourable buy-in price and/or a favourable selling price upon liquidating a position.
Pay particular attention to when a stock pushes through what called its 15- and/or 21-day moving average, as this typically indicates what’s expected to follow in the coming term.
Similarly, you can also use 50- and 200- day moving averages to determine longer-term breakout patterns.
Reactions over time
By looking at a chart of a specific stock, industry, index or market, you can determine how that entity has performed over time when certain types of news have been released. Remember these patterns tend to repeat over time.
Here you can see the market’s reactions to Cedar Woods Properties (CWP) interm and half-year results announcements.
How fundamental and technical analysis adds value
Select stocks to include in your investing universe or ‘watch list’
Time the entry into an already filtered fundamentally sound stock.
Determine whether a stock is overvalued or undervalued relative to its intrinsic value.
Manage the investment execution.
Avoid overvalued stocks or high debt companies to lessen risk.
Time an exit for the investment.
Share Analysis members that use technical analysis
Spoonfed Investor founder, Sam Eder, combines technical analysis with Share Analysis’s fundamental approach. Sam shared a few trading examples at Share Analysis’s blog.