Buying shares: a guide in rocky markets – Smart Investor

Smart Investor, July 2009

It can be hard to see it this way at the time, but a share market crash is a gift. It presents a rare opportunity to buy shares in good companies at historically low prices. Given time – one of the most important assets you have in investment – you can expect most companies to increase dramatically in value, even if things get worse before they get better.

But how to do it? After all, we’re in a recession: buying a company at a cheap price is no good if it then goes under. The opportunity today is not to find the most outrageous bargains on the market, but to build a portfolio of strong, well-run businesses, even if they haven’t dropped as far in price as some others.

So really, there are two things you need to assess in deciding whether a stock is a good investment now. The first is forming a view on how good a company it is; the other, its valuation.

First of all, what’s a good company? In these uncertain times, some people are most comfortable getting in to blue chips – that way there’s much less chance of them going under (although of course in an environment in which General Motors has gone bankrupt, nothing is quite certain). In fact, there are many good opportunities outside of the blue chips – probably the biggest gainers will be among smaller companies – but if big companies give you comfort, there’s nothing wrong with sticking with them for the moment.

KEEP IT SIMPLE

There are lots of things that indicate good companies – a successful track record, stable management, sticking to what they know best without crazy acquisitions, consistent and steady profitability and dividends – but sometimes it’s the really simple things that help. Warren Buffett, perhaps the most celebrated investor in the world, has long argued that you should only invest in things you truly understand. The author met him once in London, and he explained his philosophy in terms of Gillette, the razor company he bought into through Berkshire Hathaway in 1989. “I sleep at night happy that all over the world, hair will be growing on men’s faces and women’s legs,” he said. He made billions on that simple investment by the time Gillette was bought by Procter & Gamble. If you understand what a company does, you can be more comfortable forming a view on whether it’s any good at it. (Buffett has notably applied this logic by buying consumer food companies – prominently Coca-Cola – and several American furniture groups.)

Buffett and other investors also talk of the idea of a ‘moat’ – something that stops somebody coming and doing exactly the same thing you do at a cheaper price right next door. If you’re the only company doing a particular thing in a particular place, that’s a great advantage. Patents and high barriers to entry are also parts of the same theme. Westfield is often cited as an example here: when it builds a shopping centre, there are generally agreements that a competing one won’t spring up nearby, and even if anyone wanted to, there’s not many groups around that can do it as well as them or have the money to try. Another example is a toll road.

Beyond the simple, though, probably the biggest fixation investors have had about companies over the last 18 months has been debt. This is what has brought down good companies. This is what saw off Babcock & Brown. If a company has a great big loan or bond about to fall due, and they can’t pay it, they run out of options very quickly no matter how good they are at what they do for a living. They can try to get the bank to roll it over; if that doesn’t work, sell assets, quickly; and if that doesn’t happen… well, off you go.

The most widely used measure of a company’s debt load is called its debt/equity ratio. An online broker like CommSec provides this information in its research section. This measures how aggressively a company has used debt to expand relative to its actual size. Too high – particularly at a time when banks are wary of lending – and you ought to think twice about investing. If you’re worried about this, try to find out if a company has any big loans due to mature soon.

WHAT’S CHEAP?

In working out how cheap a stock is, there are a couple of tools you can use; the one most widely revered by both individual and professional investors is the price/earnings, or PE, ratio. It doesn’t tell you everything, but it’s a great start.

A PE ratio is a number, showing you the price of a stock relative to how much money it’s making (its earnings). You can find lists of PE ratios in publications like the Australian Financial Review newspaper; if you have an online broking account, you may well find your broker provides this information too. It can be a bit perilous to compare PE ratios between different industry sectors – they tend to be higher for, say, resource companies than banks, for example – but it’s a very handy starting point for comparing companies within the same sector. The lower the number, the cheaper the price, relative to what the company is earning or expected to earn. If you look at the broader market of blue chips today, a stock that stands out as having a notably low PE is Telstra.

Now, it’s worth remembering that just because a company is cheap, doesn’t mean it’s a great buy: the market generally marks down the price of stocks for a reason. For example, at the time of writing Westpac was trading on a higher PE ratio than National Australia Bank, meaning it is valued more expensively; but nevertheless, Westpac still has more ‘buy’ recommendations from analysts than NAB does, because they think it has better medium term prospects, and that view is being reflected in the share price. Still, a PE is very helpful as a warning sign – if you see a very high one, it suggests that the market may have got ahead of itself and that this is not such a good time to buy in. (PE ratios got notoriously high ahead of the tech stock crash in the US; tech stock lovers at this time derided the warning sign, saying: “It’s different this time.” It wasn’t.)

Another useful measure is return on equity. Put simply, this measures how good a job a company’s management is doing with your money. Another Buffett/Berkshire Hathaway favourite, it tells you if the money you invested in a company’s shares is being used effectively to generate profit.

Still, measures like this have to be viewed in the proper context. Some companies complain that the markets have become far too short term in their outlook, expecting good returns every quarter and gleaming financial indicators all the time. The fact is, companies sometimes need to put a lot of money to work today for a benefit at some point quite a way into the future. That might be best for the company, but not for shareholders wanting immediate results. Consider Qantas: investing in fleets of new aircraft is clearly important for the future of an airline, but it makes a hell of a dent in your short term numbers when you commit that investment. This is why Richard Branson, having listed Virgin, then unlisted again because he found it impossible to run his company properly with shareholder expectations. So, while numbers help you take a view on a company, remember that you want to be in your investment for the long term, and that their vision for the long haul is very important.

DON’T FORGET THE DIVIDEND

Another thing to keep in mind when making an investment decision is the dividend. Australia is one of the world markets where this matters most: in good years, some of the sturdiest blue chips have routinely paid out about 6% dividends, far higher than in a market like the US.

Over the last year or two, everything has fallen out of kilter in terms of dividend payments: many companies have elected to stop paying them, or slashed them dramatically, on the grounds that they’re better off using that money to pay down debt, for example. This is actually sensible management, although it doesn’t feel much like it when you’ve got used to a nice dividend and it’s suddenly taken away. One lesson to take from it, though, is that when you buy a company on the basis of it having a high yield (meaning it pays a good dividend relative to the cost of buying the shares) you do need to be quite confident that it’s going to be able to maintain it. This has been particularly true of listed property trusts over the last year.

Assuming that markets do eventually find their shape again, historically the bigger dividend players in Australia have been the property trusts, the big banks, and Telstra. If you buy shares at a low share price which then appreciate in price and up their dividend, you’ve had a double success.

Finally, you’ll hear people talking about buying defensive or cyclical stocks at a time like this. A cyclical stock is one that tends to go up and down with economic cycles. Banks and resource companies fall into this category. Defensives are those that tend to do OK regardless – usually because they sell vital things that people still need even when they’ve pared their spending to the bone in hard times. Examples here are supermarkets, utilities, and manufacturers of basic foods.

There is some merit in the idea of switching to defensives in difficult markets, but the truth is this downturn was so bad that absolutely everything got bashed about. Defensives are good investments because you know people will always need them, but at the same time, good companies in sectors across the board look pretty good value now provided you’re prepared to hold them for long enough.

Which brings us to our closing thought: time. You need to give investments time to come right, and avoid the temptation to buy and sell in order to make the best of short-term dips and spikes in the market. Any investment advisor will tell you that time in the market is more important than timing the market; pick stocks you’re going to want to be associated with for the long haul.

NEED TO KNOW

• Cheap is good, but it isn’t everything. A PE ratio can help you tell if a company is cheap compared to its peers, but remember to ask why it’s cheap.
• Debt isn’t bad, but too much debt is. The companies that got into the greatest trouble in the financial crisis were those with loans or bonds falling due that they couldn’t repay or refinance. The debt/equity ratio tells you how heavily leveraged a company is.
• Keep it simple. If you understand what a business does, you’re halfway to understanding it it’s a good investment.
• Look for companies with good management who’ve been doing the same thing for a long time and doing it well. A history of whacky acquisitions is bad news.
• Dividends: marvellous things. But if a company has a high one, ask if it’s generating enough cash to maintain it.

NEED TO DO

• Find out what research tools you can get from your broker. If you use an online service make sure you’ve toured the site – you can find all sorts of balance sheet and financial analysis information on many of them.
• If you want to know more about a company, you can start with their annual report, always available on the web site. If you don’t have analyst research check the investment press for references to upgrades and downgrades – which is when analysts change their view on whether you should buy or sell a stock.
• A daily source of stock information is the Australian Financial Review, which carries P/E ratios and yield data on most of the country’s bigger stocks.