Even the most seasoned investors succumb to emotion when making decisions. However, understanding some of the common investment pitfalls will keep your emotions in check and provide a far more profitable experience for you and your clients.
1. Treating the share market like a lucky dip
Part of being a good investor is recognising that you’re buying into a business that employs staff, borrows money and generates earnings from one or more core business activities. Buy companies based on quality fundamentals not share price momentum, and avoid low quality businesses.
2. Buying tomorrow’s dog stocks
Buffet proved convincingly that share prices eventually converge with a company’s intrinsic value. Ideally you want to buy good companies when there is a large discount between the share price and its underlying value. Paying too much for a top-quality company can destroy wealth as fast as investing in those with excessive debt.
3. Riding the bear market down instead of selling
The closer a company’s share price gets to its intrinsic value, the greater the risk of holding the stock. And the more the share price exceeds a company’s intrinsic value, the greater the argument for locking in your gain. Moreover, stocks with low P/E ratios or high dividend yields have typically become that way for good reason. Take these smouldering time-bombs out of your client’s portfolio and use the funds to buy superior investment opportunities.
4. Fascination with price over intrinsic value
P/E ratios only reveal what the market is prepared to pay for the current earnings per share. More meaningful measures when it comes to stock selection are the following performance ratios: Intrinsic Value; return on equity (ROE), which should be greater than 15 per cent; management’s track-record; net-debt to equity, which should be under 40 per cent; and earnings per share (EPS) growth, which offers a snapshot into future prospects and profitability.
5. Lured by unsustainable yield
A key determinant of affordable dividends is the quality of the underlying business, and its ability to consistently grow earnings. So avoid companies offering dividends that cannot be supported through cash generated by the business. Also beware of those that only have a high dividend yield based on a falling share price due to declining fundamentals like high debt, falling profits or negative cash flow.
6. Overlooking the big picture
By keeping abreast of economic conditions, you’ll be better positioned to actively review an investment portfolio in light of those sectors that will either benefit or suffer going forward. Keep an eye on: interest rates, currency, job vacancies, unemployment rate, building approvals, trade balance, GDP, housing credit, commodity prices, and inflation as measured through CPI.
7. Setting and forgetting
Within an environment where the market can move as much as 1 per cent in a week, a ‘set and forget’ approach must give way to a strategy for actively managing shares.
8. Backing value destroying capital raisings
Capital raising may reduce company debt but will it increase value on a per share basis over the long term? Typically capital raising will dilute earnings per share (EPS) in the short term, in the hope that the future earnings impact will be positive, but this outcome is never guaranteed. So if capital raising results in a material decline in intrinsic value, then sustainable price increases are unlikely.
Chris Batchelor is Skaffold’s general manager.
Chris is a specialist in equity markets and securities. He is a Chartered Financial Analyst and has 20 years’ experience in financial markets.
