Picking shares on the stock exchange

Once you have set the ground rules, you need investments to fit them. Warning: almost everyone who has ever had anything to do with the stock market has a theory of how to pick a share. They are similar to addicted gamblers and their sure-fire systems for winning at roulette or horse racing. The bookshops are bulging with pet schemes and private formulae. Those winning methods come in predictable categories. There are the strategic views, which range from in-and-out trading all the time, to the opposite extreme of buy and forget. There is the tactical advice category that shows the infallible way to pick the best bet. It does not take long to demonstrate the fallacy – if there were a certain and predictable scheme for making money everybody would have been using it long since.

That is not a recipe for despair. Although borrowed tactics will not produce infallible opulence, there are some common sense ways of looking at companies and their shares that will increase the chances of success. This is serious stuff however, and an investor who hopes to make money out of the stock market will have to make an effort. Everything has a price, and the cost of making money is usually hard graft. The famously successful Warren Buffett did not get rich by accident or by following a secret trick; he thinks, eats, breathes and sleeps the stock market. He may not be the world’s wittiest and most wide-ranging conversationalist, but then you have to ask yourself just how seriously you want to be rich, or even slightly better off.

It cannot be said too often: beware of all advice. Do not reject it out of hand, but just remember nobody gets it right all the time (see Chapter 7). And even the people who do get it right more often than not, seldom know how they do it – their explanations are usually post-hoc rational­ization as they struggle to explain just what instinct drove them to buy that or sell the other at just the right time. If by some mischance they really could formulate the trick, they would be very foolish to share the secret with the rest of us and so queer the pitch for themselves.

Judging by the proliferation of such books there is clearly more money to be made from publishing accounts of a wonderful new way of making a fortune on the stock market than from putting the principle to work and buying shares. Why otherwise would all those people be so diligently occupied writing and getting people to compete with them in searching for the routes to fortune, when they could be researching the market and dealing?

The point for an investor is to absorb all information available, but to weigh it carefully and always to test it against common sense. Following someone else’s method slavishly will probably not work, but some com­bination of the methods described in this section should help most people evolve their own way of approaching a challenging but personal task. Here are a few examples to show the diversity of methods and advice available.

One set of investment guidelines has six rules:

  1. In funds or sectors go for the ones near the bottom of the league tables. The top performers are usually overpriced or are last year’s fashion.
  2. Go for shares with high yields, but if they survive that long, sell in a year.
  3. Watch what directors do with their shares.
  4. Buy companies where at least 3 per cent of the shares are owned by the workforce.
  5. Companies spending over 4 per cent of turnover on research tend to do well.
  6. Buy after a profit warning if the company is fundamentally sound but going through an unlucky patch.

Even Warren Buffett claims to have a formula (if you can call it that, so wonderfully simple is it), but it is not very obviously helpful to the novice investor. When pressed, his advice was to buy good businesses and hang on to them. Which is about as helpful as the advice for success in business: buy cheap and sell dear. The businessman Richard Koch elaborated: buy companies with a good trading record, specialize, watch profit trends, stick to companies with good business reputations, pick companies that generate lots of cash and produce a high return on capital, risk part of the portfolio on emerging markets, and sell any share that has dropped by at least 8 per cent. T Rowe Price, who launched a fund in the 1950s, advised concentrating on companies with long-term earnings growth records and the chances of continuing that way, which he defined as reaching a new peak at the top of each business cycle. These are in an industry where unit sales and profits are rising, and have good patents, products and management. The US investor Michael O’Higgins reckons you should select the 10 highest-yielding shares in the index, and then pick the five with the lowest share price.

Malcolm Stacey, the author of an investment guide, advises spreading the money among sectors, buying slow but steady risers, and sticking to leaders (including ones in their sector). He also has a system of setting a price differential at which dealing is triggered – if the filter were set at 10 per cent then every time the share fell 10 per cent off a peak one should sell and start buying again when it came 10 per cent off the bottom.

Many of these people advocating systems have themselves been suc­cessful, but note how varied the advice is. So beware of formulae, but be especially wary of fashionable investment gurus.

In clear opposition to all those wonderful systems is the view that any attempt to outperform the average is doomed to failure – it is just not possible. The ‘random walk’ theory says movements of prices are inher­ently unpredictable in both size and direction, and as a result any wins or losses are purely a matter of chance. In the long run you will end up even, or at least will have moved with the market as whole.

Another hypothesis that also asserts that trying to outperform the market is a waste of time says the market is efficient in the economists’ sense – it incorporates in the share price all the available knowledge. That means everybody has access to all the information about the com­pany, economic prospects and the market, and there are no people with enough financial clout to move the market. As a result, the price of shares already reflects the concerted and probably relatively accurate view of the totality of investors, private and institutional. Since shares have no ‘correct’ price, runs this hypothesis, and are worth only what somebody is prepared to pay for them, the general consensus view is the right price.

Nice theory, but even the most cursory glance will show the stock market to be anything but random and a long way from being rational. There are anomalies, and not everyone has reacted yet to the information that can be gleaned. Information may be available but not everybody has taken it on board.

In addition, the market does not act in line with the economists’ depiction of optimizing behaviour. The swings seem to demonstrate frequent overreaction, amounting at times to hysteria or blind herd stampedes, and it is clear some people do have a shrewder appreciation of what is going on than others. If it were an efficient market, making it therefore impossible consistently to do better than the average, how do you explain people who have actually made themselves – and sometimes their clients – a major fortune? There are some notable names who have steadily made money and some famous investment managers who have over a long term performed about five to six times better than the market as a whole.

A plain indication that the perfect market is some way off can be gleaned from even the most cursory look at the views of stockbrokers’ analysts on company shares – there is little general agreement about the prospective performance of many companies. The price cannot have incorporated all these views because they contradict each other. And as the old saying goes, two views make a market.

The academics are therefore modifying their views and conceding there may be pockets of inefficiency continuing to exist that could provide the sharp analyst with an opportunity. Market practitioners have also pointed out that this sort of rigid academic picture depends on the timescale – in the very short term, movements in prices may seem random and irrational but the longer you extend the period the more logical it becomes.

1. Fundamental analysis

In deciding what share to buy and when, the first thing to remember is that there is no absolute or correct price. This is a market, so the value is what people are prepared to pay. But that is at any one time. A real­istic view is that the stock exchange is quite plainly a very long way from the economists’ perfect market with perfect information. But it is a reasonably efficient market so the shrewd analyst can spot companies or sectors that are out of favour or have a greater potential than the market seems to recognize, can anticipate price movements when the new information spreads, and so make an above-average profit. The tacit assumption contradicts the random walk theory as well as trust in the combined wisdom of all traders, and asserts it is possible to calculate the value of a business, and that the share price will eventually tend towards the true value.

This is the province of fundamental analysis. This is the process that:

  • evaluates a business and its products;
  • examines its published accounts, including return on capital;
  • takes a guess at earnings, earnings potential and dividend prospects;
  • looks at the economic ambience, such as the rate of inflation, the level of sterling, consumer demand and interest levels;
  • watches the market the company is selling in and what its competitors are up to;
  • judges the company’s management.

A diligent investor can try to keep an eye on advertisements for high- powered jobs in case they show a company about to move into or enlarging an important new area (such as the internet), which could be an insight not available to many. All of that research produces a way of deciding whether the business is fairly valued by the market.

But never forget the price is set by market reaction, so it is pointless to say a company’s shares are undervalued. If the market continues to undervalue the business, the shares will become no higher.

The assumption behind doing this work is that the market has developed only a temporary blindness or misjudgement and will in due course come to appreciate true value. So one is aiming to pick winners not yet spotted by others. Assuming the analyst is right and way ahead of the rest of the market, a correction could still take years, during which time the company could be so seriously hampered by its low share price that its business is overtaken by competitors.

There are two additional factors to take into account before acting on such analysis. One is the basis for the current share price and the other is market feel.

Share prices are based more on the future than on the past. That means a price may be lower than the available figures suggest would be just, because the market expects the next set of results to be poor – and of course vice versa. That is often based on a combination of what was in the last corporate announcement and what influential stockbrokers’ analysts have been projecting for the figures and have been saying about the state of the company. That is the reason, incidentally, why shares sometimes act paradoxically: falling on the publication of good trading figures or rising after a mediocre result. The market has already factored those numbers into the share price, and after publication is reassessing the shares in the light of the next set of results. If you think the market has got its expectations wrong it is possible to trade in the hope of a sharp reaction when the true figures come out, if they are in line with your projections. This requires that you are not only right, but that the rest of the market views the new information in the way you have expected.

For instance, a company may be producing pretty comfortable levels of profit and yet its shares fail to respond appropriately. There may be many reasons for that. The company may be too small for the major institutional investors, which dominate the market. Or it might be because the market reckons that further down the road there is trouble looming, or because the price had already reflected just that level of profit, or even because the company may be good but the sector is currently out of favour.

This is where market feel comes in – the result of all that reading of the financial press, listening to the radio, etc, and just good instincts. This is not about being more accurate than others in the market, but being able to anticipate the ways others will see and use new information. Some people just feel there will be an imminent shift in attitudes to a specific company, an industrial sector, or a type of company, but the more you know and the harder you work the luckier you will be.

One way to make such decisions easier is to set them down at the time of purchase. You work out how much the share is undervalued – what would be its right market capitalization, price/earnings ratio, yield, or whatever, considering its sector, performance and prospects? When it passes that level on the way up you watch like a hawk for signs the market realizes it has again overreacted, this time in the upwards direction, and then you must sell at least part of the holding. Never be afraid of missing the boat – it could just be the Titanic, as it was for the South Sea bubble in the 18th century, the railway mania in the 1830s, and the dotcom lunacy in 1999, among others.

In 1998-99 any business that had a new web-based idea or which produced software for internet trading, or invested in such enterprises suddenly became the philosopher’s stone. Share prices doubled every six weeks, with one going from 230p to £87 in less than a year; companies unknown a few months earlier were suddenly worth hundreds of millions. It was heady stuff and many people got carried away. The boom was clearly unsustainable and triggered an equally exaggerated reaction. It took over a year for more sensible approaches to prevail: the internet is evidently a big business opportunity but will not produce limitless profits overnight. The sensible investors spotted the opportunities early and the very sensible ones realized when the optimism had been over­done, and either sold or at least hugely reduced their holdings.

Bear in mind also that you are not alone in this quest. There are droves of analysts being paid ludicrous amounts of money to help institutions beat the market, plus millions of private investors on the hunt for the end of the same rainbow. As a result, the prices in the main reflect the sum of their expectations both about the company and the market in which it operates. In other words, they set the price not on what it is doing now but what it is likely to be doing over the next couple of years – the price has discounted the future.

Nearly all these calculations are done from published accounts (see Chapter 7). They are filed at Companies House, but most companies will send a copy to prospective investors if asked nicely. Extracting informa­tion from the mass of data is a painstaking business requiring applica­tion and experience. There is nothing difficult about it, but one has to learn the language of accounting, have an inkling about some of the dodges companies use, and understand the significance of the numbers.

The accounts reveal not just what the formulae calculate, but a wealth of other information. Elaborate financial engineering, suggestions of skilful burnishing of results, or careful reallocation of figures are all signs that the business is not all it seems or that the management is a touch flaky. Either way, these are characteristics to avoid.

All this research can yield data of such volumes it buries information. For the private investor the answer is to create a set of personal filters. This can be by sticking to companies with a P/E ratio of no more than five or six, or with a yield at least 10 per cent above the average. It can be by looking at neglected sectors; for example, is it fair that retailing should be under such a cloud; is manufacturing still going through those troubles that made professional investors shun them; are breweries really a better bet than catering companies? In a sense it is being the counter-cyclical investor.

Some people even consider shareholder perks. These are the benefits many companies provide as added inducements: restaurant chains and house builders, clothing retailers and insurance companies, palm-top computer makers to ferry operators, give discounts to shareholders. Those should be a bonus and not a reason for buying.

One then selects from that long list the companies that may appeal for other reasons. The best approach is to combine all of that with the other criteria available, such as a look at the country’s economy (some types of company do better on an upturn and some survive downturns better), the shopper’s view (see below) and technical analysis (see Chapter 6).

2. Tracking

All this discussion assumes an investor is trying to do better than the market as a whole. It is not the only strategy. Many individuals and hordes of investment funds reckon the task is too fraught and opt for the safer course of just trying to keep the investments as good as the market as a whole. Since on a longer term the market trend is generally upwards, this is a safe and lower-risk approach.

3. Shell and recovery stocks

Potentially spectacular changes of fortune could come from shell and recovery companies. They require a specialized form of forecasting.

‘Shell’ companies have little or no existing business but are clinging to a continued stock market listing. Their purpose is to act as a cheap way for another company to get a stock market quotation. Some sharp managers can move in, raise money to acquire other companies (possibly private), or another business can get onto the exchange by a ‘reverse takeover’ – the quoted company is legally buying the unquoted but is in reality taken over by the unquoted one’s managers and business. By definition it is almost impossible to get much information about such outfits or their prospects.

A ‘recovery’ stock is of a company that has suffered a poor period and is on the mend, or has acquired a doctor to heal its ills. It could bring rapid returns, but history shows the odds are against you. As Warren Buffett said, ‘When a company with a reputation for incompetence meets a new management with a reputation for competence, it is the reputation of the company that is likely to remain intact.’

That is a sobering thought from an acknowledged winner, but it is not always true. Stumbling companies have been rescued from the edge of the abyss by company doctors or revised policies. In addition, though the stock market may show its dislike, the profits could be down for some very good reason: the company has invested a massive amount into research and development for a series of new products that will create huge new markets; it has bought a new business that will extend its own range; it has restructured the company to be more efficient (including expensive redundancies); and so on. It is always worth look­ing behind facts for causes. There may be the seeds of hope, or Buffett could be right and the loser will sink into oblivion.

The converse does not hold true, as recent years have demonstrated all too clearly. Winners do not hold their top place for ever. J Sainsbury and Marks & Spencer were for a long time revered as the retailers with the magic touch, and it seemed they could do no wrong – until they seemed in the eyes of the market to do everything wrong and their shares tumbled. IBM was at one stage prophesized to eliminate all other com­puter makers.

By the same token the soar-away success of yesterday seldom lasts till tomorrow. Before getting too misty eyed at the success of a share that has doubled in price in the past three months, just stop and extrapolate – if it goes on like that will the company be able to buy the whole of France and Germany in five years’ time? Actually, even without being silly, it is worth considering whether it is reasonable for the business to be comparable with long-established companies such as Unilever or Shell. That creates a sense of perspective and may prompt one to cream off profits and distribute the proceeds to other likely successes.

Bearing all those factors in mind, one can then begin to set the criteria for an investment policy that relies less on hunch and hope and a little more on a realistic appraisal of personal needs and market circumstances.

4. The shopper’s view

Consumers know from personal experience that there are some goods, some shops, and some service companies that really seem good value and helpful, and they keep buying. Other customers may well feel the same way, in which case it could be a good business. And of course the opposite is equally a warning – if you have stopped buying some goods or going to a chain of shops because the goods are shoddy or the value is poor, sooner or later others are likely to spot that as well.

For instance, if shopping at Sainsbury has become expensive and a pain and you are going to Tesco instead, or vice versa, a similar view may strike other shoppers, and eventually the profits and share price will reflect that. Similarly, if you have come across a product or service that seems outstanding as well as providing good value, and the company behind it seems sound and ambitious, it may in due course become a darling of the stock market.

In a wider context, one can spot when a market has abandoned reality and is stoked up on hope and greed. Examples were the dotcom bubble, and the property boom in the 10 years to 2007 when many sane people could see that Gadarene swine were rushing headlong they knew not why, and could sense that things would end in disaster. The shrewd ones listened to instinct, watched sales and prices, listened to early reports of concern and exited with profits.

5. Losers

There is one outstanding characteristic shown by professionals that seems curiously absent in the amateur investor: the ability to drop losers. Small-time investors appear to have a sentimental attachment to shares they have bought no matter how bombed out the company, or perhaps they just hate to admit making a mistake, which taking a loss would entail. The share price falls from 850p to 55p and they sit and wait for it to creep up again, though any dispassionate view will show it to be heading to something between 20p and hell.

Some investors even go in for ‘averaging down’ – buying more shares at the lower price to bring down the average cost of the stake. This is on the assumption that the shares are about to recover. But to do this successfully you really do have to be absolutely copper-bottomed certain you are right and the market will soon share your view.

It would probably be more sensible to see if there are better opportu­nities elsewhere in the market, and shed the loser. One way the big boys keep their policy in check and make such decisions easier and more automatic is by establishing an action point – the stop-loss signal is triggered by a fall of 10 to 15 per cent.

6. Perks

In addition to the usual benefits of owning shares, such as capital appreciation and dividend income, many companies try to keep share­holders loyal and enthusiastic by providing perks – most of them are merely discounts and therefore entail additional spending by shareholders, which helps profits. For some there is a minimum holding before the perks kick in. Some stockbrokers provide lists.

Source: Becket Michael (2014), How the Stock Market Works: A Beginner’s Guide to Investment, Kogan Page; Fifth edition.

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