October, wrote American humourist Mark Twain, is one of those peculiarly dangerous months in which to speculate on the stock market. The others, he added, are July, January, September, April, November, May, March, June, December, August, and February.
I’m often reminded of those words whenever I hear people talk about how ‘dangerous’ or ‘risky’ the stock market is. Usually, it turns out that they’ve never held any shares, and know very little about investing.
In which case, frankly, they might very well find stock markets to be risky places for their money. For if, as the saying goes, a little knowledge is a dangerous thing, then surely no knowledge at all must be even more hazardous for your wealth.
Buy low, sell high?
Even so, probe a little deeper into what lies behind such observations, and it usually turns out that people aren’t thinking about investing, at all.
Instead, they’re thinking of trading — buying shares speculatively, with a view to subsequently selling at a profit. You’ll often hear talk of charts, and such things as ‘breakout points’, trading ranges, and 200-day moving averages.
Sometimes, it’s taken to extremes: around the time of the dotcom crash — late 1999, early 2000 — so-called ‘day-trading’ was a popular pastime for some people. Shares were bought in the morning, and sold in the afternoon. Yes, really.
Investing vs. trading
Now, I’ve nothing against trading in principle. The idea of buying shares that you think are undervalued — and then selling when the price goes up — is perfectly sensible.
Is it ‘investing’, though? Not necessarily, in my book. Because a lot depends on the rationale for regarding a share as undervalued. And if the sole basis for regarding a share as undervalued is the shape of lines on a chart, or similar mumbo-jumbo, then it doesn’t tick any boxes for me.
And anyone buying shares on that basis might well find Mark Twain’s words to be an accurate predictor of the eventual outcome.
Instead, genuine value-based investing is a much more holistic approach to assessing the relative value of share — an approach that looks at the business, the business model, the company’s market, its finances, and likely prospects. Charts have a place, but generally in the context of long-term price movements, over three, five, or 10 years.
Taking a view
Usually, most of us have a reasonable view of companies’ markets and prospects: that part often isn’t difficult. The business model is a little more problematic, but Warren Buffett’s wise words about economic moats generally serve as a useful lodestar. And if nothing else, profitability provides a valuable clue.
A company’s size, too, is important: decent-sized businesses are generally more resilient than smaller ones. And resilience, I need hardly explain, is important. In terms of online data, ‘market capitalisation’ is the figure that you’re looking for. Personally, I like to see companies with market capitalisations higher than £500 million.
Generally, it’s the company finances that give novice investors the greatest pause for thought — even though a huge amount of information is freely available in the public domain. So too, helpfully, is a wealth of information on how to interpret the various numbers and ratios.
Digging deeper
What do I, personally, look for? A lowish price-earnings ratio, for one thing: that can indicate decent value. Too low a ratio, though, spells danger — or at the very least, a company that is very much out of favour with the market.
A highish dividend yield can also be a sign of value — although it’s important to make sure that the implied dividend is sustainable: sometimes a share price fall creates an artificially high yield, because the market is pricing in a dividend cut. For this reason, forecast dividends are useful.
Five-year trends for key financial metrics are invaluable too — and companies’ annual reports often have a selection of these in their first few pages. Revenues, dividends, cash flow, earnings per share, pre-tax profits: do these all exhibit steady growth? Or if not, are there reasonable explanations?
Debt (together with pension obligations) is another key thing to look at. Debt can cripple a business, and high levels of debt can bring a business down. ‘Interest cover’ is a handy figure to get at: how well are interest obligations covered by profits?
Lifetime learning
There’s more — much more, in fact. After almost 50 years of buying shares, I’m still learning. But these are a useful start, and are often good jumping-off points for further investigation.
And a lot more useful than peering into the innards of chart, trying to discern market movements that way.
The post Stock markets aren’t hazardous to your wealth appeared first on The Motley Fool UK.
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