Friday, January 15, 2010

Best Shares To Buy In 2010

Buying shares over the past couple of years has certainly been a hair-raising experience for most of us. It's been an extraordinary roller coaster ride. The All Ordinaries index started 2008 at 4,882 before reaching a low of 3201 in November of that year. Then in March of 2009 we got lower still - down to 3,090 in March before finishing the year at 4,882. Overall in 2009 the index gained more than 33% or around 58% since the low point in March but that was a shocker of a year in 2008.

2008/2009 Share Price Graph

So what can we expect from the Australian stock market in 2010? Well quite frankly, your guess is as good as mine. But I think it's worth putting what we learned in 2008 and 2009 into practice in 2010.

What Did We Learn From 2009?

Well the first and perhaps most important thing is that investing in shares is a long term game.

While I like to consider myself a rational long-term investor, I must still admit that when the stock market went into free fall early last year, I was very worried. I found myself checking the prices of the shares that I own much more frequently than I should have been. And even when I was able to restrain myself, a colleague of mine updated me at least daily on the turmoil in Australian and world share markets.

Even though I kept telling myself that my investment strategy is to buy shares in good companies and hold them for the long term, there was still a part of me that wanted to sell my shares immediately and wait for the stock market to recover it's equilibrium before investing again. I knew that doing so would have resulted in missing at least part of the rebound when it did eventually come, but I was still worried. I kept telling myself that I should be focused on what share prices would be in 5 or 10 years time, not what they would be in the next 5 or 10 days.

So in 2010, good shares to buy will be those I'm willing to hold for the long term.

Buying Shares In Quality Companies.

The second lesson learned was to invest the bulk of my portfolio in businesses with strong balance sheets and a history of strong financial performance. If you managed to stick with this investment strategy, you would have managed to pick your way through the minefield of corporate collapses of the past couple of years. Don't get me wrong - your investments will almost certainly be worth less than there were a couple of years ago, but you have every chance of recouping your paper losses as the companies in which you're invested continue to grow and prosper. If a company in which you're invested becomes insolvent (as has happened in a number of highly leveraged situations) then your loss will be permanent. When the liquidator is finished there is not normally much left over for ordinary shareholders.

Fortunately (due to a couple of expensive lessons in the past) my portfolio has managed to survive the latest downturn unscathed. The vast majority of my holdings have little or no debt. And the companies I own which do have any level of debt, have sufficient cash flow to service the debt (plus some to spare).

As I have just alluded to, I lost money in in a couple of corporate insolvencies in a previous downturn. It was an expensive lesson but one which I suspect paid for itself many times over this time around. You see, I am a bargain hunter at heart. I love finding companies with cheap share prices relative to their assets or earnings. However, there is quite often a good reason why they are cheap - high levels of debt being one of those reasons. So these days I avoid investments where debt is a major factor.

Debt can be a company-killer. Bankers don't like to lose money and get very nervous when a business gets up a wobble. A banker is not usually the type of person who will say "...that's fine - just pay me back when you have the money...". They will generally want to see their interest paid on a regular basis and the principle repaid in full at the agreed time.

I should say that I looked closely at both ABC learning and Babcock and Brown when their respective share prices plummeted. I concluded that if they survived, they would turn out to be screaming bargains. However, while their survival was at all in doubt I resolved to stay away. Though I should admit that a previous me would have jumped on board both of those trains.

So in 2010 the best shares to buy will be those with sound balance sheets and strong financial performance. I need to maintain my commitment to avoid any investment opportunities where there is a real risk of permanent loss of capital.

Selling Shares To Raise Capital

A common theme in 2009 was capital raising. A staggering number of companies, many of them blue chip, went out to investors with their hands out, asking "Please sir, may I have some more?"

While it was necessary for many companies to repair their balance sheets through the issue of new shares, unfortunately the capital raisings were at discounts to already depressed share prices. This of course has a dilutive effect. A company which has the same profits this year as it did last year but which issued new shares during the year will have correspondingly lower earnings per share. Put simply, you get a smaller share of the profits.

As an example, imagine a company which last year had 10 million shares on issue and made a profit of 10 million dollars. This would equate to earnings per share of $1.00. Now imagine that the company had sold an additional 10 million shares in order to raise capital to strengthen its balance sheet. If it earns the same 10 million dollars as last year but now has 20 million shares outstanding, the earnings per share will only be 50 cents. This might be an extreme example, but hopefully it illustrates my point.

Will Gold's Bull Run Continue?

The following graph shows the performance of gold in US dollars over the past 5 years.

Gold Price Over 5 Years

As you can see, there is a very strong upward trend. The question is whether it will continue. I have to admit that I don't know a lot about what drives the price of gold. However, I do know that it does well in times of uncertainty and that it is considered by many to be a hedge against inflation.

With the recent stimulus packages delivered both in Australia and overseas, inflation is the word being uttered furtively in economic circles. Warren Buffett warned of the risk of inflation on the New York Times in August last year. So perhaps some exposure to gold might not be a bad thing. I have written on how to go about investing in gold before.

What About Buying Bank Shares?

The big four Australian banks seem to have increased their stranglehold on the residential mortgage market since the global financial crisis - but are they good shares to buy? I've already mentioned the effect that capital raisings will have on earnings per share. And I'm pretty sure that all of Australia's major banks have raised capital over the past 18 months.

Another risk is that regulation will be introduced tightening capital requirements for banks (if you're ever having trouble sleeping, just try reading about capital adequacy requirements). This will lead to lower returns on equity and ultimately lower returns for shareholders.

The last thing to consider before investing in bank shares is the likely impact of higher interest rates. It seems we are past the low point in the interest rate cycle, at least in Australia. As rates continue to rise we will probably see slower credit growth in Australia as people borrow less. This in turn will lower the rate of profit growth of our banks.

What About The Strong Aussie Dollar?

The last thought I'll leave you with is related to the strong Australian dollar. It may be worth considering what further strength in the Australian dollar would mean to your investment portfolio or alternatively what a drop in the exchange rate would mean as well. Certainly, companies with significant US dollar earnings feel the pinch when the dollar is high.

If you've ever considered buying international shares, now might be a good time as well. You'll get more bang for your buck and if the dollar does start to lose value later in the year, you will end up with foreign currency gains as well. But as I've written in the past, your gains will turn into losses if the exchange rate moves the other way.

Good luck buying shares in 2010!