There is no definitive answer to this but, having studied the investment techniques of three of the greatest investors of all-time – Benjamin Graham, the father of value investing and on whose works I have based my annual bargain shares portfolios; Philip Fisher, a highly respected American investor and the founder of investment management company Fisher & Co; and Warren Buffett, the greatest investor in the past four decades – I have developed an investment style that I feel has done me justice over the years.
By adhering to some hard and fast guidelines in my stock selection process, I have managed to side-step many, but clearly not all, of the pitfalls of generating less than favourable returns for the risk being taken. So, with this thought in mind, some of the key rules I try to adhere to are:
■ Focus on shares with potential to generate significant returns over the medium to long term. If these gains are made sooner, that’s a bonus, but never count on it. Remember, investing is a marathon and not a sprint. Moreover, it’s unrealistic to expect every investment holding to reap financial rewards. Clearly some will not as only the select few have the Midas touch. However, the most important thing is for the portfolio to produce positive returns overall, and market-beating ones at that, after accounting for the laggards.
■ Set a realistic time frame for gains to be achieved. If an investment is likely to produce a modest return then only invest if the time horizon is short and the risk is low. Otherwise the annualised return on your capital diminishes rapidly the longer you have to wait for an investment to come good.
■ Be patient. Even if a potential investment ticks all the right boxes, there is one thing worse than not being invested. That’s being invested at the wrong price. Timing is critical. That’s why I only recommend buying shares in a company when the future potential return embedded in the share price is high enough for the risk being taken. It’s not difficult to calculate the risk:reward ratio, either, as all you have to do is estimate what is a realistic fair value of the company’s equity and then estimate the worst-case scenario to gauge the downside risk.
I base my target prices on a host of factors including the earnings growth potential, cash generation and quality of the company’s asset base. In my opinion, you want the ratio of upside potential to downside risk to be as high as possible, and preferably no lower than a ratio of two.
■ Don’t ignore dividends. If an investor can make a return of 12 per cent a year on a portfolio, with the benefit of reinvesting dividends, this translates into a total return of 1,600 per cent over a period of 25 years. This is why it pays to target shares with a decent yield to start with. For example, if the starting yield on a portfolio is 4 per cent, this means a third of the targeted annual growth rate is in the bag from day one. Dividends grow over time, too, and can be reinvested to mitigate risk.
This helps explain why a large number of the companies I have recommended buying into over the years offer decent income streams for shareholders. It also explains why you are better off investing in higher-yielding shares for the long run than low yielders. Academic research backs this up. According to the Credit Suisse Global Investment Returns Handbook, in collaboration with the London Business School, the difference between the annual total returns on the highest-yielding shares (just shy of 11 per cent), and lowest-yielding shares (below 8 per cent), on the London stock market has been in excess of 3 per cent a year since 1900. To put this performance into some perspective, with the benefit of compounding, a portfolio of high-yielding shares would be worth more than double that of the low yielders after 25 years.
■ Quality wins in the end. Given the choice between selecting a good-quality company rated below its historic average earnings multiple, and one with an impressive long-term track record, or a lower-quality company priced on a sub-market PE ratio, it almost always pays to opt for the former. That’s because investors are more inclined to pay premium ratings for quality companies, so there is potential for the shares to re-rate to their long-term average earnings multiple, or even above. That means on a risk-adjusted basis the odds of a favourable outcome are far better.
■ Spread risk. There are a variety of different risks embedded in the valuations of companies, a number of which I discussed in my column last week (‘Secrets to successful stock picking’, 7 July 2014). It therefore pays to spread the risk of the holdings in your portfolio. To do this I consider the level of risk being taken on in five key areas: market risk; economic risk; liquidity risk; distress risk; and volatility risk. The idea is to minimise the total amount of risk embedded in each shareholding so that on average your portfolio is less volatile and less exposed to large amounts of risk in any one of these five areas.
■ Heed the bigger picture. In the digital age, newsflow is around the clock and global. It pays to be on the look-out for investment opportunities to exploit in other markets.
■ Momentum pays. Momentum strategies can work well in bull markets in enhancing portfolio returns, by focusing on companies whose shares have been performing well compared with the market. This is why my colleagues Algy Hall and Chris Dillow regularly offer momentum strategies in their weekly columns, and very successful ones too.
It’s hardly a surprise that such strategies work because, with investor sentiment positive, and equity market conditions benign, there is greater potential for the outperformance to continue as other investors buy into the momentum story. Of course, the fundamental case for investing must stack up too, but by screening out the best share price performers over the previous three months you can create a shortlist of potential investment opportunities to ride the momentum and enhance portfolio returns.
■ Don’t ignore the technical indicators. As part of my investment analysis I always analyse the technical set up. A company may tick all the right boxes by offering a decent potential return based on traditional valuation techniques, but if the chart is telling you something different then this should raise alarm bells. So, to avoid shares where the technical situation is unfavourable, I use a number of tried and tested systems to determine whether recommending an investment in a company is warranted.
In particular, I assess momentum indicators to identify key turning points for share prices. The most useful of these is the 14-day relative strength index (RSI), a momentum oscillator that measures the speed and change of price movements. Apart from assessing whether shares are overbought or oversold on this indicator I also look for divergences, where a share price continues to rise and reach fresh highs, but the RSI doesn’t. This is known as negative divergence and can prelude a share price sell-off as the momentum driving the share price higher starts to wane. At the other extreme, when a company’s share price has been stuck in a downward trend, what I am looking for is positive divergence. This is where the price makes new lows, but the RSI reading doesn’t.
In addition, I look out for key day reversals, hammer tops and hammer bottoms. I also scan end of trading market data for shares where there has been a spike in trading volumes. That’s because volume is the rocket fuel of the market. It also pays to scan the 12-month highs to identify shares showing positive momentum. One way is to target share prices hitting multi-week highs where the RSI is not overbought and trading volume is confirming the price move. This improves the odds of the share price continuing to run up further, assuming of course that the investment case still backs up the price move.
Share prices hitting 12-month lows are also of interest to me because these flag up companies to put on your watch list for when the RSI enters oversold territory and there is positive divergence on the chart.
■ Avoid ‘value traps’. Some companies are lowly valued for a variety of reasons and not just because they carry more risk than other companies. For example, they may not being run for the benefit of outside shareholders. As a result, investors are simply not prepared to value these companies on anything other than sub-market and sub-sector earnings multiples.
That’s not to say that all companies whose founders and main board hold majority shareholdings are worth ignoring when the shares are rated well below their sector averages. For example, the share registers of property companies Mountview Estates (MTVW), Daejan Holdings (DJAN) and Town Centre Securities (TCSC) are dominated by family holdings. I recommended buying into all three companies last year and all have worked out well mainly because the interests of the board and minority shareholders are aligned and importantly all of these companies are decent dividend payers too.
■ Avoid ‘bubbles’. When share prices are being buoyed by speculation, and the ability to undertake sound fundamental investment analysis is impossible due to the lack of relevant financial history, then walk away. The number one rule of investing is not to lose your capital. The obvious way of preventing this happening is to avoid investing in bubbles.
Clearly, there are other factors to consider in order to skew the investment risk towards a positive outcome, such as understanding how seasonal investment trends impact returns throughout the year. As the late David Schwartz, stock market historian and columnist of the Trader column in our sister publication, The Financial Times, wisely noted, there is no single magic approach to stock market investing. Different techniques or valuation methods have different odds of success at different points in the stock market cycle. That said, by adhering to some hard and fast rules, my own techniques have served me well over the years. I will endeavour to keep up the good work.
■ Simon Thompson's new book Stock Picking for Profit can be purchased online at www.ypdbooks.com, or by telephoning YPDBooks on 01904 431 213 and is being sold through no other source. It is priced at £14.99, plus £2.75 postage and packaging. Simon has published an article outlining the content: 'Secrets to successful stock-picking'
