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Women & Investing – Part 4: What Shares Will I Buy? written by Bill Dodd
This is the fourth in the series of articles on investing, where we look at investing in the share or stock market. The terms ‘shares’ and ‘stocks’ are often used interchangeably so in this article the term shares is used. Let us assume that you have decided to invest in the share market. An investment in shares should always be planned for the longer term, preferably a minimum of 5 years. The share market can be quite volatile and in the short term may show considerable fluctuation. There are risks with any investment but in the long term the share market has provided the best returns for investors. Having decided to invest in the share market what shares should you buy?
When purchasing shares, the starting point should always be your investment plan which is the guide to what type of shares that you will buy and how much you will invest. Let us assume that your investment plan states that you will not invest in speculative shares but the portfolio will comprise only blue chip shares which pay a dividend. How will you determine which companies to invest in and how many shares to buy? This will in part be determined by how much capital you have to invest.
Consider the situation of two investors, one with $5,000 and another with $50,000 to invest.
Risks in investing can be minimised by diversifying the investment capital over a number of companies. There is also the consideration of transaction costs involved in investing in shares. With a very small amount of capital the transaction costs would take a large part of any profits.
If you are an investor who has a small amount of money, say $5,000, then you could invest in perhaps two companies but your transaction costs would be high and this reduces your returns. Also by buying shares in only two companies you are not diversified and so have higher risks. It would be more practical with a small amount of capital to invest in a managed fund or a listed investment company (LIC) where your transaction costs are lower and you would benefit from being diversified over many companies so that your risk is spread.
If you have more funds to invest, say $50,000, you could invest this sum equally in 10 different companies. This means that you are adequately diversified to spread your risk and your transaction costs are proportionately much lower.
So which shares should I buy?
When we invest in shares we are looking for companies that are sound, have good businesses and low debt. So we are trying to estimate the future profitability of a company based on its past and present performance and we do this by using Fundamental Analysis.
Fundamental Analysis uses economic data and company statistics to value a company. This includes studying the company records as well as understanding its management and what the company does. Fundamental Analysis makes use of ratios as analytical tools because they can be used to make comparisons between the values of two or more different companies. There are many different ratios that can be used. ‘Return on equity’ and ‘debt to equity’ are two of the most important ratios to use as well as ‘cash flow and earnings growth’ to analyse the performance of a company.
1. Return on equity (ROE)
‘The return on equity’ ratio measures the profitability of a company and is a measure of how many dollars of profit a company generates with each dollar of shareholders’ equity. A company with a high ROE of 20%, is potentially a much more profitable and attractive investment than a company with a ROE of 5%.
2. Debt to equity
‘The debt to equity’ ratio compares a company’s total debt to its total equity, (where equity is the total value of the assets of a company minus its liabilities). Companies that carry large amounts of debt are very vulnerable particularly if there is a rapid rise in interest rates so companies with little or no debt are much more attractive.
3. Cash flow and earnings growth
As well as the above ratios, cash flow and earnings growth are very important because they indicate the ability of the company to generate cash and to continue to increase its profits. A strong history of earnings growth should reflect in a regular increase in dividends over the longer term.
With this information we should be able to select companies which have a high ROE with little or no debt, a good cash flow and it would be desirable that they pay a good dividend.
Consider some examples
As I write this article in late September 2015 the prices of shares are falling and the share market is very volatile. Consider the example of three companies that meet our fundamental criteria with a high ROE, acceptable debt and a good record of dividend payment. These are the blue chip companies Broken Hill Proprietary, Commonwealth Bank and Woolworths.
Broken Hill Proprietary (BHP) is the world’s largest miner with products including iron, copper, coal, petroleum and aluminium. It has very low production costs and its market price at September 2015 is 10% below its real value based on fundamental data.
Commonwealth Bank (CBA) is Australia’s biggest bank. Based on fundamental analysis its current market price is estimated to be 28% below its calculated real value.
Woolworths (WOW) is Australia’s largest grocery with businesses covering, food, liquor, gambling and fuel and its market price is 9% below its current valuation based on fundamental analysis.
The fact that such high calibre companies are all returning about 10% dividend to investors at a time when the interest rate is 2.5% makes them very attractive. But are these companies suitable for you as an investor? In this volatile market the share price of these companies may continue to fall, perhaps significantly and there is also a possibility that they may reduce their dividends if the economic conditions in Australia deteriorate.
If one takes a long term view, all of these companies have very strong businesses and should continue to perform well and would be good investments but the investor always needs to consider the risks. Having selected the shares you want to buy, in the next issue of GHGTM we discuss when to buy because timing your share purchases is very important.
Disclaimer: This brief article covers some aspects of selection of shares. It cannot take into account the needs of individual investors and as such it is not investment advice. I am not a licenced financial advisor. No one should rely upon this information without seeking professional advice.
Author of this article:
Bill Dodd is a retired academic and experienced investor. His concern at the lack of financial literacy in Australia prompted Bill to become active in investment education. Since 2009 he has provided courses on investing for the Australian Shareholders Association and the Australian Investors Association in all states. Bill’s website provides investor information and his ten session video course on investing is available on the Australian Shareholders Association website. This course is available at no cost to members.