Famous investor Peter Lynch tells a story where he invested in a company called Hanes in the 1970's because his wife loved their L'Eggs stockings. He did research into the product and found that these stockings were sold in supermarkets. He found out that a woman usually goes to a department store once every six weeks but a supermarket once a week. Lynch knew he had a winner and the rest is history.
The point is that investment opportunities are all around us.
What phone do you have? Nokia, Samsung or an iPhone? They are all made by companies listed on the market.
What car do you drive? Toyota, BMW or a Honda? They are all made by companies listed on the market.
The truth is that you meet a lot of doctors invested in healthcare stocks, architects invested in building and property stocks and engineers invested in infrastructure and mining stocks. That's because they understand the industry that they work in.
In fact, if you look around at the people you know, the chances are that you can connect with quite a bit of knowledge. Use your connections. If your friend is in architecture, ask them about building companies. Even your local corner store can come in handy. Ask them how business is. Chances are that a downturn in the economy and sharemarket will be felt by small business owners first.
Keep your eyes and ears wide open. Notice that the iPhone is growing in popularity, then investigate further. We all have the ability to spot trends. Talk to people in shops and in shopping centres.
It's like kicking the tires of the company on a smaller scale. If you can do it in different regions to get a larger sampling, even better.
Remember that while the opportunities are all around us, finding them is only the first step. All opportunities should be investigated further and thoroughly.
In the market, we can't control the return we get from shares. One thing that investors have some sort of control over is risk.
Now risk is not about maximising returns but about minimising the losses. In fact, if you wanted to maximise returns, you would also need to maximise the risk involved and probably invest in just one stock.
Diversify
Most investors aren't willing to put all their eggs in one basket. We've learnt through stocks like HIH or ONE that the risk is too great.
Diversification is about spreading risk across different markets, sectors and stocks. The key here is to choose stocks that don't move in the same way.
For example, if you held the big four banks, you would be diversified but not well diversified as the banks all tend to move in the same way.
If you choose stocks that don't move in the same way, you maximise the benefits of diversification.
Conditional orders
If you are a trader, than a golden rule of trading is to have trading limits. A price limit protects against unlimited losses. A conditional order, or stop loss order, is one where you sell your shares if the price falls to a certain level. It's a good idea for when you are on holidays or cannot watch the market.
A conditional order takes the emotion out of getting out of a position when it is falling.
For example, if you put a stop at 10% below your purchase price then you only risk 10% of the purchase price.
The trick is to have a plan. Without a plan, investors often rely on gut instinct or emotions. You know the saying: "To fail to plan is to plan to fail". The sharemarket can be a crazy place at the best of times. A plan helps you to get to your goals even if the market does seem illogical. A plan should ask questions such as:
So the three ways you can limit your risk:
The underlying drivers of the business are important. If you are involved in property trusts then you should be concerned about commercial property prices. If you are involved in gold mining companies, you should be interested in gold prices.
I've written before about the underlying drivers of a business, economic events and sentiment in my previous article ‘What moves share prices?'
Looking at value – price to earnings ratio
As I’ve said before, I like to take the advice of one of the greatest investors of all time. Warren Buffett says:
"It’s better to buy to buy a wonderful company at a fair price than a fair company at a wonderful price."
At the heart of each stock is a business and in the long-term, it’s that business that drives the stock price.
But how can you tell if a stock is cheap or expensive?
When I am shopping, I use price to tell me how expensive or cheap an item is. The sharemarket is a different story. You can’t say that a $2 share is cheaper than a $10 share — it would not make sense to compare shares only on price.
That’s why the Price to Earnings ratio, or P/E ratio, is the most popular fundamental ratio.
The P/E ratio is important because it doesn’t make sense to only use the share price to try and figure out whether it is cheap or expensive. We can get an idea of value, or whether a share is cheap or expensive, by looking at the P/E ratio. It’s a measure to help us figure out whether a share is more expensive or cheaper than another share. It gives us a measure to compare like with like.
Equation: P/E = Share price/ Earnings per Share
The higher the P/E ratio, the more expensive it is. The lower the P/E ratio, the cheaper the stock is.
Example 1: If I compare a P/E ratio of 10 and 20, which one is cheaper? The P/E ratio of 10 would be cheaper.
Example 2: If company A has a P/E of 11 and company B has a P/E of 16, which one is more expensive? Based on current earnings, company B is more expensive with a P/E of 16.
Example 3: If company C has a P/E of 14 and the Aussie Sharemarket has a P/E of 17, which one is more expensive? That’s right, the Aussie sharemarket is more expensive based on current earnings.
It’s relative
A Price to Earnings ratio (P/E) tells us whether a share is cheap or expensive in relation to another share, the market or the industry it is involved in.
Keep in mind that the equation only takes into account share price and earnings so it is a limited measure of value.
Nevertheless, it remains the most popular fundamental ratio out there today.
The P/E ratio as a popularity gauge
The famous economist John Maynard Keyes likened the sharemarket to a silly newspaper competition in which the readers have to decide who has the prettiest face out of 100 different faces. The competition gets to the stage that people are trying to guess what the popular opinion would be. If the sharemarket is the competition, then the measure of popularity would surely be the P/E ratio.
P/E ratio is a measure of value. A low P/E ratio share is often viewed as unpopular or cheap whereas a high P/E share is often viewed as expensive and popular. David Dreman did a study which showed that low P/E ratio shares outperformed high P/E ratio shares while exposing the investor to less risk.
Generally as a rule of thumb, income shares will have a P/E less than 15 and growth shares will have a P/E greater than 20. Income shares tend to be more established companies with less emphasis on future growth and hence, the lower P/E ratio. Growth shares tend to focus on growing the business and hence earnings in the future, so growth companies usually have a higher P/E ratio to reflect the expectation for higher future growth.
The theoretical explanation is that this number is the number of years that it would take the company to make back the share price with the current level of earnings. Since share price and earnings constantly change, this is not a very practical application of the P/E ratio.
Instead, it makes more sense to use the P/E ratio to compare like companies on the basis of their earnings.
A company with a higher P/E ratio would look more expensive in relation to what it’s earning and a company with a lower P/E would look cheaper. Investors are often willing to pay a premium for companies when they believe that future earnings growth might be higher than the market.
You don’t really have to physically calculate the P/E ratio as it is published for free on numerous financial websites as well as in the financial press. Here at Bell Direct you can see the P/E ratio on our ‘Quotes’ page.
Tip!
A low P/E ratio is one that is under 12.
A high P/E ratio is one above 40.
The average P/E ratio on the Australian market is historically around 16.
The average P/E ratio on the US market is around 20.
Sometimes you may notice a different P/E ratio for the same company. This may occur because different analysts use different ways to calculate the P/E ratio. Some analysts may use purely historical numbers. Others may include forecast information in the EPS calculation. If they do include forecasts, some may use a one year forecast while others may use two or three year forecasts. This is the most common reason why you may find different P/E ratios for the same company.
Looking at performance – return on equity (ROE)
The return on equity ratio is a performance ratio and is based on past performance.
You may have heard the adage that ‘past performance is not an accurate predictor of future performance’, yet how do you judge the future if not by the past? In the sharemarket, past performance, although not an accurate predictor, is an important predictor of future performance.
After all, best performers rarely become the worst performers overnight and the worst rarely becomes the best overnight.
The return on equity is an important measure of past performance The heartbeat of a company can be measured through the return on equity ratio. It measures the return on shareholders funds or equity. I often compare this number with the cash or risk free rate.
Equation: ROE = (Net profit/shareholder equity) x 100
Shareholders’ equity is the capital in a company which originates from shareholders in the company as well as from retained profits (retained profits are the profits not distributed as a dividend but reinvested back into the business).
For example, the CEO of Woodside Petroleum could have decided that he didn’t feel like working this year and put all of the shareholders’ funds into a cash deposit account. How much would he have returned? Perhaps he might have returned 5%. But instead of just putting the shareholders funds into a cash deposit account, he put his strategies in place and instead returned 15%.
So, the higher the return on equity, the better. And the more easily the company will be able to raise money for growth.
Remember, ROE is a measure of performance so the higher the performance the better.
As a potential shareholder, I would be more comfortable seeing a ROE above 20% then one below 10%.
But try and look at more than one year’s worth of numbers. You would want to see consistently great returns, and therefore high ROE, year after year. You do not want to see a terrific result one year and then a fall the following year.
Looking at debt – the debt-to-equity ratio
We’ve seen many companies being punished for being too aggressive in their borrowings. So when is debt good and when is it bad for a business?
We know through the experience of the past year that financial markets punish companies that have too much debt at the start of a downturn in the economy.
One of the ways to measure debt is through the debt-to-equity ratio.
Equation: D/E = Total liabilities/total shareholders equity
The higher the number, the more highly geared the company is.
Keep in mind that this ratio can be used for all sectors of the market except for the finance sector. The finance sector has other debt ratios that are used.
The average debt to equity ratio in the market is around 40%. If a company has a debt to equity ratio less than 40%, then it is less geared than the market, and over that amount, it is more aggressively geared in comparison to the market.
Generally as a rule of thumb, a debt to equity ratio of less than 40% is conservatively geared.
Debt can be beneficial for a company if it finances growth and bigger profits. For debt to be worthwhile, you want to make sure that the company uses the debt to increase profit. So in addition to looking at debt ratios, have a look at what the company is planning to do with the extra funds.
Summing up the right tools
So to make your job easier you’ve got the following ratios to consider:
Fundamental analysis
Finally, the numbers don’t tell the whole story. They are a starting point. If you were looking at hotels then you would be interested in their vacancy rates. If you were looking at gold prices then you would look at gold prices.
Fundamental analysis allows the investor to get their investment universe down to a smaller number. There are over 2000 companies listed on the Australian market alone. To research all these companies would be an almost impossible task for one person.
Fundamental analysis allows us to sort through the duds so that instead of researching 2000 companies, hopefully we only need to look in-depth at 10 companies that spark our interest because they look like good business propositions.
Markets trend up and markets trend down. They can also trend sideways. So markets move up, down or sideways.
The first step of outwitting the market is to determine whether the market is going up, down or sideways.
In the daily epic struggle between buyers and sellers, technical analysis shows who is winning. If buyers are in control then prices go up, if sellers are in control then prices go down. Everyday a battle is played out between buyers and sellers. Buyers drive up the prices and sellers drive down the price. A perfect example I’ve used before to describe this is at the seafood markets. Normally prawns sell for around $25 per kilo. At Christmas time, prawns sell for around $50 per kilo. Why? Because at Christmas time there is a large number of buyers, they drive up the price. It’s the same with the sharemarket. Buyers drive up share prices and sellers drive them down.
Candlesticks
There are many ways to look at indicators of prices when using technical analysis.
Candlesticks are one way of looking at the battle between buyers and sellers to see whether share prices are being driven up or down. Candlesticks are a short-term trading tool which is usually used to try and figure out whether buyers or sellers have the power in the short-term.
A candlestick needs four pieces of information: the opening price and closing price and then the highest and the lowest price reached for the period.
The rectangle part of the candlestick is called the body and represents the difference between the opening and closing price. If the opening price is lower than the closing price then the body is white or green. If the opening prices is higher than the closing price than the body is black or red.
The long lines above and below the body represents the trading range. The top of the line is the highest price traded for the period. The bottom of the line is the lowest price traded.
If buyers are in control then the share prices usually goes up. If sellers are in control then the share price usually goes down.
This first bar shows a body that is white or green which means that the price opened near the low and then ended near the high so the buyers were in control. It’s quite a bullish signal going into the next day of trading with trading likely to start with the buyers in control and prices moving up.
They say a rising tide lifts all ships and so can a bull market. Technical Analysis or charting can help determine if we are in a rising market or a falling one. After all, around 3 out of 4 stocks follow the general market direction.
Conversely, this next bar shows the body of the candlestick as black or red. So the day’s trading starts near the top and ends near the bottom showing the sellers are in control, driving the share price downwards. It’s a bearish signal indicating that sellers are in control and the next day of trading is likely to start with sellers in control with prices moving down.
The middle ground is a balance, where no one wins the battle. Usually this signals consolidation and then potentially a change in direction.
So you can see with candlesticks it’s all about the body.
The body can let us about the strength of the move. The longer the body then the stronger and more intense the move was.
A long white or green body signals strong buying power which will most likely see the price continue to move upwards.
A long black or red body signals strong selling power with price most likely moving downwards.
Short bodies on the other hand signal balance in the buyers and sellers. This signals low volatility which means that the price may be looking to break out.
Buy signals
Long Lower Shadow: the lower line must be the same or bigger than the body. The longer the lower line then the more reliable the signal.
Marubozu White: usually a signal that shows a continuation of an uptrend
Sell signals
Long upper shadow: the upper line must be the same or bigger than the body size. In fact the longer the upper line then the more reliable the signal.
Marubozu Black: usually a signal that shows a continuation of a downtrend.
There are many, many indicators when using technical analysis. Candlesticks are just one way of looking at the price action to find out whether buyers have the power or sellers. But as always, if buyers have the power, prices head upwards. If sellers have the power, prices head down.
Happy investing!
Julia Lee Equities Analyst Bell Direct
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