Last week, as part of our series on how to manage your money, we told you how you would go about investing in shares. This week, we look at what to consider when deciding which shares to buy.
When you invest in the stock market, the key is to glean as much information as possible about the share and its environment. American investment guru Warren Buffett says you should gather information and then evaluate a stock as though you were buying an entire company and not just shares.
First, you should understand exactly what it is that the company does and how it makes money. If you do, you will be able to identify market trends or economic cycle movements that could spell trouble for your investment. With this knowledge, by moving quickly, you could minimise your losses.
Find out as much as possible about the company. There are several ways to get the information you need:
- Financial media: Newspapers carry reports on different industries, market trends, companies and economic cycles. Keep up to date on what is happening in the financial world - you should keep an eye on the industry and competing com-panies as well as monitor what is happening at the company you want to invest in.
Newspapers (such as Personal Finance's sister publication, Business Report) publish the daily share price of listed com-panies, enabling you to follow share price movements. Share price pages give you valuable information such as how often a stock is traded. A frequently traded stock (known as a liquid stock) is one that you will probably be able to sell easily when you want to.
On the share page you will also find the share's dividend yield and its price-earnings (PE) ratio.
The dividend yield is the annual cash dividend paid to shareholders expressed as a percentage of the share price. This figure can give you an idea of the cash-generating ability of the company.
The PE ratio tells you how long, at the current level of earnings, it will take you to recover your investment in a share. It is calculated by dividing the share price by the annual earnings per share. Usually, the higher the ratio, the more investors are prepared to pay to get a slice of the company's future profits. Companies with low PE ratios may look like bargains but may, in fact, be heading for trouble, while companies with high PE ratios could simply be growing fast.
- Annual reports: Companies are obliged to send copies of their annual report to every shareholder. If you are not a shareholder in a company but are interested in that share, you can look up the annual report on the company website. Here you will find financial details, including the balance sheet, cash flow statement and income statement. The annual report includes information about the previous year and about the company's outlook and aims for the year ahead.
- Internet: Besides the company's website, which gives you access to the annual report, you can also use the internet to look up analysts' reports on the company you are interested in. Analysts watch specific sectors, such as health or agriculture, and their reports will give you an idea of how the sector and the share are expected to perform over the next six months to a year.
SENSIBLE INVESTING IS NOT ABOUT ACTING ON HOT TIPS
If you are new to stock market investing, choosing shares may be tricky. It may be a better idea to use a stockbroker's advice until you know enough to comfortably make your own choices. Or you could invest in either an equity unit trust fund - as discussed earlier in this series - or an exchange traded fund that tracks an index such as the JSE Top 40 index.
If you decide to choose your own shares, be wary of hot tips. What you really need is solid, reliable information.
Ideally, you should choose a range of shares across different sectors to diversify your investment and reduce your risk. If one share performs badly, your exposure is not so high and the performance of the other shares can offset your loss.
Large companies sometimes have share offers as part of black economic empowerment deals. These shares are usually offered at a discount, but make sure you read the fine print because there are often conditions attached. Conditions could include not being able to sell the shares within a certain number of years or not receiving any dividends for a certain period.
However, these public share offers can represent good value if you are looking at a medium- to long-term investment or if you want reasonable capital growth on your investment.
Outcome-based
There are two things you need to consider before looking at which shares to invest in.
- Your investment goal: If you see a financial adviser, he or she is obliged by law to deter-mine what your investment profile and goals are before giving you any advice. When you buy shares you should make sure you know why you are investing and that the shares you choose will help you achieve that goal.
You could be investing to grow your capital or to earn an income from dividends. You should be looking at a medium- to long-term investment period when you invest in the stock market and should stay invested for at least five years.
Your goal will set your investment horizon and define when you should sell your shares. It will also help you to avoid making emotional decisions about your investment, which could end up resulting in a loss. Remember that markets go through cycles and if you remain unemotional and stay invested, you are likely to benefit in the long term.
If you want your investment to provide you with a regular income, the types of shares you select will be different from those needed to grow your investment (see "Types of shares").
- The amount you are investing: You need to decide how much money you can afford to invest and possibly lose. Don't invest if you are borrowing to meet your monthly expenses. Ideally, you should pay off your short-term debt before beginning to invest money because, in most cases, you will pay more interest on your debt than you will earn on your investment.
TYPES OF LISTED SHARES
There are different types of shares in the stock market.
- Blue-chip shares:
Derive their name from poker in which blue chips have the highest value. Typical blue-chip shares, such as SAB Miller and Tiger Brands, are large, solid companies that are usually among the stock market's top 40. They tend to have a long history of returning solid profits.
- Empowerment shares:
Also called black-chip shares, these can be picked up cheaply when large companies, such as Sasol, do empowerment deals. But be sure you understand the terms and conditions that go with these offers.
- Growth shares:
These are shares in companies that have produced consistent above-average revenue and earnings growth, and are expected to continue to produce such results in the medium term.
- Value shares:
The share price is usually below the perceived value of the company. This may be because the industry in which the company operates is not performing well or the market has taken a dim view of the prospects for that industry. You would invest in a value share because you expect the price to eventually return to a level that reflects its fair value.
- Income shares:
These have a high dividend yield, meaning they pay good dividends. They are usually companies that have a high capacity to generate cash.
- Cyclical shares:
Shares in companies, such as Truworths, whose operating and earnings performance is closely linked to the economic cycle.
- Non-cyclical shares:
Shares in firms whose performance is largely unaffected by the economic cycle. An example is food producers. Even when the economy is going through a downturn, people will continue to buy food.
- Defensive shares:
These are shares in companies that are essentially non-cyclical and can therefore withstand difficult economic conditions.
- Rand hedge shares:
Companies (such as Richemont) that largely earn money in foreign currencies are considered rand hedges. They offer protection against rand weakness.
- Penny stocks:
The smallest of small-cap shares, they usually have a price of less than R1. These stocks are generally considered to be highly speculative and high risk because of their lack of liquidity and small capitalisation.
GLOSSARY
- Market capitalisation:
This is calculated by multiplying the number of shares in issue by the share price. Companies are ranked according to their size and can be referred to as small cap, medium cap or large cap. In South Africa, large caps tend to do better when the rand is weakening, as many of them depend on offshore earnings.
- Exposure:
Your exposure to a share or to a market is determined by the size of your investment in it. If you put all your money in the shares of a single company, you have a high exposure to that company. If the company collapses, you will lose your entire investment.
- Book value:
The value of a company's assets minus its liabilities. It tells you what the company would be worth if it went out of business today.
- Debt ratio or gearing:
This figure tells you how much the company relies on debt to finance its operations. Generally, companies with low debt ratios present a lower risk than those with high debt ratios.
- Bid price:
This is the highest price any buyer is willing to pay for a share.
Next week: How to read a company's financial statements.