Sunday, March 22, 2009

Value Investing - Buying Shares For The Long Term

Investors buy shares in Australian companies for many reasons. Some buy stock in a company simply because they think the share price will go up, some may purchase based on the advice of their stock broker and some may even take the plunge based on a tip they received down at the pub on the weekend. However, today I'd like to discuss an alternative approach to the Australian stock market called value investing.

Value investing is an investment strategy or paradigm based on the teachings of Benjamin Graham and David Dodd going right back to the major sharemarket crash and subsequent great depression in 1929. In a nutshell, it involves buying shares at prices which are a significant discount to their intrinsic or underlying value based on fundamental analysis.

For those that are serious about buying shares and who have not heard of Benjamin Graham, I suggest you take the time to find out about the man. Security Analysis, originally published in 1934, became the foundation upon which an entire profession was built. While Security Analysis is worth reading, another of Graham's books titled The Intelligent Investor is much more accessible and I would say compulsory reading.

Perhaps the most famous of Graham's students is Warren Buffett - a renowned value investor and one who has consistently outperformed the S&P 500 index throughout his career. Other perhaps lesser known students, although each successful in their own right, include Irving Kahn, Bill Ruane and Charles Brandes. To find out more about the success of his students, read Buffett's article - The Superinvestors of Graham-and-Doddsville.

One of the most important concepts to come out of Benjamin Graham's writings is the margin of safety concept. The idea is that you're buying at a discount to intrinsic value, thereby giving yourself a buffer or margin of safety in case anything goes wrong.

One of Graham's classic methods of valuation was to use net current asset value. This approach calculated the value as being the company's current assets (I think from memory it may even have even been just cash and cash equivalents) less all liabilities. If you could buy shares in a company at less than two thirds of its net current asset value, Graham believed you had a low risk situation with significant upside potential.

So how do we apply these teachings? We need to understand the distinction between price and value. Price is what people are willing to pay for any given share while value is what it's actually worth. Trading and technical analysis involve looking at price and volume indicators, but does that really tell us what the company is worth and whether the current price over or under-values the company? Using fundamental analysis, we delve into the financial statements of the business to find out what it's really worth - it's value. I found a really good discussion of this topic in this article - Do prices Really Matter?.

Buying shares in the current market conditions requires patience and discretion. I suspect the days of making money by just taking advantage of the rising Australian sharemarket may be over for a while. I think the principles taught by value investing will provide you with useful tools during this period.

Thursday, March 19, 2009

Buying American Shares

Why should you consider buying US shares and how do you go about making your purchase?

The Australian stock market makes up only a couple of percent of world equity markets by market capitalization while the US stock market is a whopping 30% (based on some figures I found relating to values back in early 2007). This is a marked contrast and may give you an insight into why you might consider buying American shares.

Apart from being a much larger stock market by market capitalization and having an economy many times larger than Australia's, there are many more companies listed on US stock exchanges including some of the largest in the world.

Consider global companies with household brand names like Coca Cola, Johnson & Johnson, Kraft Foods, McDonalds and Microsoft among others. These are huge, truly international companies which dominate their industry the world over. It's hard to think of any Australian stocks which have the global reach and market dominance of these American giants.

So how do you go about buying US stocks? Broadly speaking, there are 2 main ways to go about it. You can either buy directly or you can invest in a managed fund which has at least some exposure to the sector.

A number of Australian stock brokers allow you to buy American shares. I'll let you do your own investigation as to the services offered fees (brokerage, etc) charged. I know that Commonwealth Securities charges $65 per trade. Remember that you'll need to do your own research into which stocks to buy. Also tracking your investment becomes even more important because you're less likely to hear about these companies through the Australian news media.

The other option is to invest via a managed fund. In this way, you don't need to worry about researching specific stocks. The fund manager does the leg work for you. Of course you should still put in the effort to choose one or more fund mangers to whom you happy to entrust your hard earned cash. Almost all international managed funds will have exposure to US shares but some fund managers offer products which target North America specifically. Of course, you will pay for the expertise of the fund manager through the ongoing management fees which are charged on your investment.

One of the risks inherent in being an Australian buying American shares (or buying international shares in general) is currency risk. Currency risk is the chance that the exchange rates chance between when you buy and when you sell. If the Australian dollar strengthens against the US dollar, you will lose money. This is because each US dollar you get for selling your American shares will no longer buy as many Australian dollars.

Of course this cuts both ways. If the Australian dollar drops in value against the US dollar (as it has done recently) you will end up with a greater profit. However, the important thing to remember is that it's notoriously difficult to forecast foreign currency movements. Therefore you need to be aware of this extra risk in on top of the general market and stock specific risks.

If you decide to go with a managed fund, you have the option of choosing a hedged or unhedged fund. Hedging means the manager will use currency derivatives to eliminate the currency risk. An unhedged fund will give you full exposure to currency movements - both up and down.

I'll leave you with one final thought. If you have your retirement savings invested in an Australian superannuation fund, there is a good chance the fund manager has been buying American shares on your behalf.