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A correct investment approach

by Andy George

A correct investment approach
By: Andy George

After a horrendous two-year period from the turn of the new century, world stock markets would appear to have come back from the dead with prices rising albeit in a not so spectacular fashion. The purpose of this article is to offer advice to investors as to the correct investment approach. I believe that by following the advice given investors will be successful on a long-term basis. This article is not intended for the day traders or speculators who use alternative investment approaches to the ones proposed by myself.

The objective of this article is to assist investors in making money from now on or in other cases to help investors in the task of reversing their losses caused by the decline in share prices in recent years.

I have noticed that a number of “experts” have been advising investors to be careful at the current levels of share price. I take a different approach to these people. In my opinion investors should be careful to identify those investment opportunities that will them significant gains on a long-term basis. There are probably not many in number and are investments that are undervalued when compared to their future prospects. The article aims to point investors in the right question by identifying the key questions that should be asked that would lead them to these investment opportunities. Before doing this I would first like to start with some general advice to investors.

ONLY INVEST SURPLUS MONIES:
A few years ago I wrote an article regarding the approach investors should adopt when investing on the Stock Exchange and I mentioned that investors “should not invest all their savings” on the Cyprus Stock Exchange. Unfortunately many investors in Cyprus did worse than this. They borrowed to buy shares when the CSE Index was at astronomical levels.

Hence let me stress again the advice that was given by me many years ago. ONLY EXCESS FUNDS SHOULD BE INVESTED IN SECURITIES. Some cash should be retained in a savings account to meet any possible emergencies.

DO NOT PUT YOUR EGGS IN ONE BASKET:
Another investment strategy that investors must follow is that they “should not put their eggs in one basket”. They should hold a diversified portfolio of shares. In other words they should have a number of holdings in various sectors. If they believe that a particular sector will outperform the market then they will have a greater proportion of their portfolio in that sector. I do admit that this strategy did not work on many of the international stock markets during 2000 and 2001 since nearly all sectors registered sharp falls. However the events over these years were extraordinary and may not occur in our lifetime.

If investors invest all their money in one sector and if a disaster should strike that sector then the effect on the value of their investments will be significant. An example of this is if an investor had a large holding in Technology stocks on the London Stock Exchange (LSE) during 2000/2001 then he/she would have suffered heavy losses. If the investor held a diversified portfolio then their losses would have been a lot less since other sectors on LSE did a lot better than Technology stocks. For example companies such as Tescos (Food Retail) and Centrica (Oil) have actually seen their share prices increase during the corresponding period.

KEY QUESTIONS:
Before investors make an investment decision then there are a number of key questions that need to be answered. The answers to these questions will give an indication as to the possible future share price direction of the company. The key questions that need to be answered are as follows:

1) Does the management team have a good track record?
2) What are the growth prospects of the Company in relation to its Price Earnings rating (PEG factor)?
3) How does the Price Earnings Ratio compare to other companies both domestically and on other international stock exchanges?
4) Does the company rely on debt finance?
5) Is the net asset value per share higher than the company’s share price? (One way this can be known is by looking at whether the Price to Book Value (PBV) of a share is less than 1 times.
6) How is the liquidity of the Company? Is it satisfactory?

If the management has a good track record (i.e. earnings per share increase steadily year by year) then investors should have extra confidence in the management and should increase the possibility on investing in that company. If the opposite is true then this should make investors reconsider whether or not to invest in the company.

Research has shown on other more developed stock exchanges that significant capital returns are generally made on companies whose Earnings per share figure increases on a year-by-year basis at a satisfactory rate. A satisfactory rate is something around 15% per annum. Hence investors should try to identify investment opportunities that do this. In the table below two hypothetical companies have provided their EPS for the past few years:
EARNINGS PER SHARE INFORMATION:
YearCompany AEPS (cents)Company BEPS (cents)
19961.51.4
199721.5
19982.41.7
19992.91.5
20003.51.8

Company A produces a consistent increase in EPS of more than 20% per annum. This a what’s known as a growth stock and investors should invest in such company since it is very likely that if the present trend continues it will produce excess capital gains for its investors. However for Company B the EPS past trade record is disappointing since there is virtually no growth. Hence it would be extremely difficult for investors to make significant gains from holding this share since the growth in this share is minimal.

Another point investors should be on guard is some of the new companies listed on the CSE have seen massive jumps in their EPS in the past few years. Previous to this the EPS for these companies was at lower levels. I would tend to advice investors to avoid such shares unless there is a good explanation behind the increase in EPS and that this is not a temporary phenomenon.

GROWTH PROSPECTS:
Further to this investors should invest in those companies that have good growth prospects in relation to their Price Earnings Ratio. One way to do this is to compare the Prospective Price Earnings Ratio of the Company (i.e. for the current year) against the expected annual growth in Earnings per share. If the figure is below 0.75 times then a purchase of the shares should be considered.

A practical example that illustrates this point in Cyprus in the past is the shares of Multichoice (a paid for subscription TV Channel). The Prospective P/E Ratio of the business is estimated at around 13 times with the expected growth of earnings estimated at 20% per year. I believe the growth rate is high due to the management skills of the Group and the expansion plan of the Group. Since the PEG factor is 0.65 times then this is a good candidate for investment. Had investors used PEG factors when the index was high then nearly all shares would have registered a sell signal.

PRICE EARNINGS RATIO:
Additionally investors should use the Price Earnings Ratio to help them decide if shares are cheap or not. I believe that the way to do this is to compare similar companies in both domestically and abroad. However investors must be careful in that they should use future earnings not past earnings as a guide to making this calculation. This is because historical earnings do not always provide a good guide of what the future performance will be. Another important point that I always highlight in my articles is that the P/E Ratio must be based on operating activities. It should eliminate the effects of exceptional items (i.e. non recurring events).

An example to illustrate this is as follows. A Company last year made CYP 5.5 million of which CYP 5 million were investment gains. The P/E Ratio should be based on the earnings from operating activities (i.e. Maintainable Earnings) and not Earnings including exceptional items. Hence the figure to use for calculating the P/E Ratio in this example is CYP 0.5 million plus/minus an adjustment for the current year’s earnings.

Another point that needs to be considered is if Company is heavily geared or not (i.e. if its Debt is high in relation to its Shareholder Funds). A highly geared company has a high financial risk. Such companies will be badly hit if there is a recession in the economy and/or if the industry as a whole has been badly hit. This is because if there is a fall in their Operating Profit then they may not be able to cover their interest obligations since the latter is fixed cost. In times of recession lowly geared companies will not have the same problems since they will have low interest charges. Since there is the possibility that the Cyprus economy may move into a recession (i.e. due to the CSE slump) investors should tread carefully when considering investments in highly geared companies.

NET ASSET VALUE (NAV):
Another vital question that must be answered is whether the net asset value per share is higher than the share price. Another way one can put this is whether the Price to Book Value (PBV) is under 1 times. If a Company has a PBV of less than 1 then it means that the share price is supported by strong asset backing and it may indicate that the downside to the share price is restricted. The opposite may be true for companies with high PBV values.

There are a number of old industry stocks (especially in the retail sector) where the NAV is equal if not greater than the share price. That means an investor can buy the shares at a price below the net asset values of a business. If one carries out research on other stock exchanges this is a phenomenon that occurs in a bear market. In a bull market this is likely to reverse with few shares below their NAV.

An example in the London Stock Exchange of a share where exceptional gains were made when a company had a low PBV was Aston Villa (the football club) who had a PBV of around 0.2 times in 2003 and whose share price from the middle of 2003 to the middle of 2004 has increased by around 200%!

Investors should also pay attention to the investment sector where there are companies whose share price is at a 30% discount to their NAV. In bull markets this discount tends to narrow hence providing markets stabilise at these levels such investments could represent good buying opportunities.

Finally, the liquidity of the company is also important since many profitable businesses have failed due to a lack of cash. There are a number of ways of doing this. One away is by looking at the Cash Flow Statement that indicates whether the company has increased its cash balance and this analyses its sources and applications of funds. A more easy method is to examine the Current Ratio of the Company. This is the Current Assets divided by the Current Liabilities of a company. If the figure is above 1.5 times this suggests that short-term liquidity is satisfactory. If the figure is under 1 times then this indicates the business may have problems. Care needs to be taken in interpreting this figure since new sources of finance (e.g. share issues) or new applications of funds (e.g. purchase of fixed assets) may affect the figure since the Balance Sheet date.

CONCLUSION:
After the bad experiences of the past it is important that investors do carry out their own research before making investment decisions. I do not believe that investing on the basis of “rumours” will work as an investment strategy but do believe that investing on the basis of value will pay dividends in the long-term.

About the Author

Andy George is an accountant with years’ experience as a lecturer. Andy was financial correspondent for eight years at the Cyprus Financial Mirror where he wrote articles on business & accounting related issues to a non-technical audience.

He is the author of eBooks: How to write and Publish Your Own With a Shoestring Budget http://www.budgetebook.com
New! Easy Way to Make Auto-Pilot Income http://www.budgetebook.com/cbmall

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