Many investors will be feeling bruised and battered after a year or two of punishing stock market conditions. Even those who don't purchase shares directly will be feeling the pain. Superannuation returns have plummeted and most managed funds have gone backwards as well. So how do we as investors go about finding the best shares to buy now that stock prices seem to have stabilized?
In this post I'd like to describe some of the criteria I look at when investing. With share prices cheaper than they've been in years (although not as cheap as they were in March) I think now is a good time to buy shares provided they are as a long term investment in a quality business.
Perhaps at this point I should provide a caveat. I think there is a good chance that the Australian stock market will fall again in the short term. It has probably risen too far, too fast and any unexpected nasty surprises could trigger a sell-off. Or it might just be a round of profit taking as traders seek to lock in their short term gains. But if you're buying with a 5 year plus time-frame in mind, then short term setbacks shouldn't be too much of a concern and today's share prices will look good value.
Finding Good Shares To Buy Is About Reducing Risk
If events over the past 18 months have taught us anything about investing, it is that we need to understand the risk we take when we invest. Not just when buying stocks. It applies equally to other financial products as well. If you look back over the past year or two, you'll notice the financial landscape is littered with collapsed investment schemes. Opes Prime and Storm Financial are two high profile Australian examples but there are plenty more.
Permanent loss of capital is something which I believe should be avoided at all costs. Consider a portfolio of 10 stocks, each with with equal weighting. If you were to sustain a 100% (permanent) loss in one of those holdings (think of ABC Learning or Babcock & Brown) then you would need to generate a return of over 11% on the rest of the portfolio just to break even! Avoiding such disasters puts you ahead of thousands of other investors already (even some of the professionals).
For this reason, debt is one of the most important things for me to look at. I'm interested in the debt to equity ratio, the interest coverage and any debt that falls due in the short term.
Debt to equity is the amount of debt a business takes on when compared to the shareholders' equity. It's difficult to prescribe an exact ratio to look for as companies in different industries can sustain different levels. Cyclical industries like retailing have cash flows which can vary greatly through the economic cycle so high levels of debt are a problem during a downturn. Conversely, utilities with relatively stable cash flow through the economic cycle can probably sustain higher levels of borrowing. But in general, lower is better. Less than 1 is good and less than 0.5 is better.
Interest coverage is another thing to check. A company's ability to service it's debt is critical. The interest coverage ratio is the number of times the interest bill is covered by EBIT (Earnings Before Interest and Tax). I like 3 times as a rule of thumb but obviously more is better. Also, I like to go back over the past 5 to 10 years and pick what looks like the lowest EBIT figure over that period and use that in my calculation. That way I know that there's adequate coverage even at the bottom of the economic cycle.
What Are The Best Performing Shares?
Making sure that a company will still exist in 10 years time is one thing, but I also want to know that I will earn a decent return on my hard-earned cash over that tome. For that reason, I want to know that a company is going to take my investment and do something with it.
There are a couple of measures I look at to find out. Return on equity is one. It provides a measure of the rate of return the company is able to generate on its shareholders' funds. So a company which can generate a return of 15% on equity over an extended period of time is a pretty good investment. If this return is maintained as the equity levels grow (ie. the company is reinvesting profits into the business and continuing to generate good return on this additional investment). For companies with high levels of debt, the return on equity figure can be inflated by the level of leverage used. However, as I've already noted, I'm trying to avoid those companies with significant levels of debt.
Alternatively, we could use return on invested capital as our performance measure. Some argue that it gives a more realistic measure of financial performance as it takes into account all of the funds employed in generating profits, not just those contributed by investors. After all, a company which only takes 100 million dollars to return a profit of 20 million dollars probably has a better business than one which has to invest 200 million dollars to earn that same 20 million dollars even if in each case shareholders have only contributed 100 million dollars (the additional $100 million for the second company was funded by debt).
Value is important as well. Low debt and a high return on invested capital don't justify an excessive share price. I want to invest in a high quality company but if I pay too much then the return I can expect on my investment over the long term will be correspondingly lower.
What I like to do is build up a list of stocks which meet these strict quality criteria, then rank the list according to their relative value, from cheapest at the top to most expensive at the bottom. I can then apply some more subjective criteria to a handful of the stocks at the top of the list. Online brokers like ComSec have all of the data I need to compile my list. If your online broker doesn't have the information, you could use NineMSN or even the Australian Financial Review website (but I think you have to be a subscriber).
What I mean by subjective is to look at some of the factors which can't be boiled down into simple ratios and percentages. I need to use my judgment as to the future of the industry in which the business operates. I need to make an assessment of the quality of the management running that business. After this process, one or two companies will stand out and these are typically the ones where my money gets invested.
By following the above process, I hope to find not only the best shares to buy now, but also those that are worth holding in my portfolio for the long term.