Strategy for picking a share

1. Risk

There is no such thing as a risk-free investment. Come to that there is no risk-free life. In investment there is economic cycle risk, company risk, exchange rate risk, income risk, inflation risk, market risk, sector or industry risk, and so on. In this context that usually means capital risk, ie the danger that the share price falls or, worse still, that the company founders. No one share can match all one’s preferences, so the policy has to be to balance the spread of shares to match risk needs and then assess each new investment to maintain the balance.

There are risks connected with the quality of the company’s manage­ment, business area and size. In addition there are vulnerabilities such as great reliance on a managing director (causing major problems if such a key person dies or leaves), or a high portion of business with a few customers (which can be nationalized or go bust). It can also be because the business sector is doing badly through a change in fashion or com­peting products arriving, or health dangers associated with the product. It can also be because the whole market has fallen flat on its face. The results can be hit by turmoil in the currency markets or interest rates, or the state of the economy. In addition, some shares react more violently to market movements. The degree of this responsiveness is known to professionals by the Greek letter beta, b (see Chapter 6).

Companies with risk factors will probably have higher than average yields. This is called the ‘equity risk premium’ because it is generally recognized – not just in the stock market – that if you have to carry greater risk you should be rewarded with more money. Higher-risk companies with greater yields are fine for gamblers, or people with a sufficiently diversified portfolio to offset the risk by spreading across other, less dangerous companies and sectors.

Some trades have traditionally been volatile and precarious, and some we can tell from instinct are vulnerable. They may move sharply with fashions, seasons or the economic cycle.

Another good indicator is the way the rest of the world regards the business. There are three useful indications of this: the beta, the price/ earnings ratio and the yield, the last two of which are available on the newspaper share prices pages. Beta is a measure of the price volatility, measured against the market as a whole, and is strongly correlated with risk. The P/E is the price of the share divided by the attributable earnings, so a high P/E says the market expects a faster than average growth, and a low one means the general feeling is that the company will languish. In effect the price reflects, or discounts, the expected growth in the dividends the company will pay over the next few years. A very low P/E indicates a lack of market enthusiasm, probably because it considers the business risky.

The yield will show a similar pattern. There is a caveat here, though. Some shares have a low P/E and a high yield not because they are intrinsically dodgy but because they are unfashionable. And this is where the so- called perfect market breaks down and a shrewd investor can get an edge on the professionals. For instance, companies with a small market value were avoided for years for two main reasons: the major investment funds could not fit them into a policy of buying in big chunks of money yet ending up owning only a small percentage of a company; and few analysts bother to look at most of the shares. This neglect meant it was possible for the small investor to find relatively high yields on invest­ments by buying into these companies.

Similarly, if a couple of major companies in a sector – retailing, com­puters, insurance or whatever – report lower profits, leaner margins and tough times ahead, all the similar companies will be marked down. There is some sense in that, since the chances are that most of them will be affected in a similar way. If one discovers, however, that by good luck, good management, or good products, one company in the disdained sector actually has cash in the bank and is achieving a substantially higher profit margin than most of its competitors (and the figures are reliable and not just window dressing), then it will provide a relatively cheap way in, either for a good income or for capital growth when market sentiment reassesses the whole area of business. In other words, the signals of high risk were misleading or mistaken.

It is a foolhardy investor, however, who relies heavily on this sort of luck or imagines he or she knows better than the market. In general the market is more often right than wrong and the figures really provide a pretty good indication that there is something potentially dodgy. It is sometimes possible to find gold where others see only dross, but do not rely on it.

With investments, as with the rest of life, there are no free rides. Everything has a price. If something has a higher risk, it is likely to offset that with a higher return. What victims always forget when they get caught in something like the Bank of Credit & Commerce International’s or Lloyd’s of London problems, or a series of frauds like the Nigerian scam or the prime bank paper, is that the corollary of that rule also applies: if there is a higher than expected return there is probably also greater danger. Only very small children and people whose greed overcomes their common sense expect something for nothing in this world.

There is a market in risk. One can hedge against it – take financial measures to limit the extent of risk. Companies hedge their currency exchange exposure on foreign trading by buying currencies forward, and other such devices. An investor can limit losses on a share by buying options.

That in summary is the passive approach, accepting the market’s view and making the best of it to suit your personal criteria. Assuming that on a risk continuum of 1 to 10 you are prepared to be cautiously brave by opting for 6 does not mean every share has to be scored as a 6. It can mean a range of really safe 2 with the occasional reckless flutter on something like an 8 or 9.

Each time a buying opportunity comes along, it is worth at least thinking about how it fits into the overall portfolio picture and how far it will move the overall average risk profile. This will have to be done more carefully the longer you hold shares because, as the prices move, the various companies will change their percentage of the portfolio total and their effect on the total risk balance will also alter.

If the long and elaborate process of picking shares seems too hard, or the risk/reward system seems daunting and it all requires more effort than you have to spare, you are not alone. Some of the sharpest investment minds in the United Kingdom and the United States have admitted the chances of being able consistently to pick winners are pretty slim. And in any case, it may be unrewarded effort. The market as a whole, as represented by the FTSE100 Index, does pretty well thank you on any reasonable timescale. Tracker funds that follow the main stock market index can be an answer: the private investor can take a stake in one of those, or be a little more adventurous and go for an investment or unit trust with a broad but selective range of investments.

2. Defensive stocks

Some companies are reckoned a good bet for volatile or hazardous times. They operate in areas that are relatively immune to economic cycles and include companies dealing in tobacco, as that is a relatively steady market, and supermarkets because people go on buying food. Utility com­panies also tend to be in demand in bear markets, as people still need, regardless of a recession, water, electricity and gas.

3. Emerging markets

The label is generally applied to stock exchanges in countries which are becoming industrialized, becoming wealthy and with a growing number of local quoted companies. It is vague enough to encompass the BRIC countries (Brazil Russia India and China) which are pretty big and a next generation group which includes Mexico, Indonesia, South Korea and Turkey. Some include eastern Europe such as Poland, Hungary and the Czech Republic. These markets can be volatile, performing spectacularly well or plunging equally spectacularly. Other potential hazards include wayward supervision, lack of accountancy rigour, and less than full transparency.

4. Long or short term

As all the newspapers, magazines and books say, over the long term the stock market has produced a better return than almost any alternative. On the other hand, as Lord Keynes pointed out, in the long term we are all dead.

Over a period of 30, 50 or 100 years, returns from shares out­performed most other investments. They do better than property, antiques, deposit accounts, fine wines, building society savings, and so on. Since 1918 shares in Britain have on average provided a return of 12.2 per cent a year, compared with, for example, 6.1 per cent produced by the gilt-edged securities issued by governments. Those figures are despite the US market falling 87 per cent between September 1929 and July 1932, the UK index dropping 55 per cent in 1974, the steep drop following the hurricane in October 1987, or the plunge from 2007, and the Far East market battering in the 1990s.

Cash in a deposit account would have produced even less than gov­ernment bonds, probably something under 5.5 per cent. Taking a more recent period, from the end of the Second World War, equities have on the whole (taking into account both income from dividends and capital appreciation) beaten the inflation rate by about 7 per cent or more.

So on average – which is always the important word of warning to bear in mind – shares provide a good long-term home for spare cash. The return on shares is almost always higher than gilts, and certainly so over the long term. This is to compensate for the greater risk: index- linked gilts are guaranteed, while companies are subject to the vagaries of economic circumstances. The resulting difference – the greater return on equities – is therefore called the ‘equity-risk premium’. On the assumption you will not have to sell the shares to raise cash at any particular moment, you can afford to take the long view over which shares perform best. Because even normally sensible people forget the dangers, the government has insisted on the apparently obvious wealth warning on all the literature and advertising that the price of shares can go down as well as up.

Another aspect of the decision is whether you want income or capital growth. These are not complete alternatives since any company doing so well that it hands out great dollops of cash in dividends is almost certain to see its share price bound ahead. But not always: even a cursory glance down the prices page of a newspaper will show huge disparities in the yield figures. But if you are aiming for capital appreciation, the shares will be sold to crystallize the profit, while income shares will be retained until they stop producing an adequate flow of cash.

Experienced investors, experts and people prepared to devote time and serious effort deal. It entails bouncing in and out to take advantage of the short-term oscillations of the market. You spot a takeover trend, say among food companies, and get in as the other companies start rising; or you detect a growing fashion for a technology – computers, internet, biotech, etc – and pile in as the boom starts to sweep the shares to unrealistic heights. But this also means you have to watch the market like a hawk and see the sell signals in time to get out with a profit. Such tactics demand more spare money. The proportionately higher costs of spreads, broker’s fees and government tax mean you have to deal in larger amounts and achieve bigger share rises to make a profit (see Chapter 8).

One other point – every time one person manages to make a big profit, somebody else misses it. They may not always make a loss but just fail to get the real benefit. What makes you think you will be the winner every time, or spot the real successes and avoid the duffers? Some people do have a talent but not many.

At the more extreme end is the recent upsurge in ‘day-trading’ (buying and selling within 24 hours), which can be achieved fairly readily over the internet. The figures from the United States, where the fashion started, suggest that fewer than 5 per cent of the people doing it make money.

5. Ethical investing

The growing insistence on responsible and moral behaviour by companies both towards people and the Earth, means companies with sound ethical policies are more likely to prosper. So such a policy is good not just for the conscience but the wallet.

Personal choice dictates where to draw the line. Companies shunned by some investors have included tobacco, armaments, makers of baby milk for Africa, oil, paper and timber (deforestation), mining, pharma­ceuticals (animal testing), alcohol, and so on, to say nothing of specific companies being boycotted because of their policies on pollution, ozone depletion, waste management, personnel, etc. But it can produce con­fusion if pursued too far. Being opposed to gambling would presumably rule out the National Lottery, which could preclude all the shops and supermarkets that sell tickets. And how about buying gilts from a government that encourages arms manufacturers, trains soldiers and probably funds research centres that carry out animal experiments?

The ultimate point is that the investor should be able to sleep at night, not just because the money is safe, but because there is no need to worry one is supporting a company that oppresses workers or helps to kill people. On the other hand, it is then only logical that one not only avoids making a profit from the company’s success but also stops buying its products.

A useful source of information on this is the Ethical Investment Research Service. It was set up in 1983 by several Quaker and Methodist charities and researches over 1,000 companies plus most collective funds, and keeps a list of fund managers and stock-brokers concentrating on ethical investments. Another is Cantrade Investments.

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