Shares: Picking Winners

Choosing the right shares to invest in can be a daunting task, especially for beginners. There are thousands of stocks to choose from, and numerous investing philosophies, schemes, strategies, and mindsets that investors use to approach the market. Here are some key considerations to help you make informed decisions:

- Determine your financial goals: Different investors have different objectives. Younger investors may aim to grow their portfolio over the long term, while older investors may focus on capital preservation as they approach retirement. Understanding your goals will guide your choice of companies to invest in.

- Identify your risk appetite: Before investing, analyse your risk tolerance. Different investment options have varying risk and return profiles. Understanding your risk appetite will help you pick investments that align with your needs and requirements.

- Understand the business: It is crucial to invest only in companies you understand. Conduct thorough research and due diligence to assess the business's prospects, management, revenues, and profit margins. Avoid investing based on hype or fear of missing out, as this is a common pitfall for investors.

- Consider financial ratios: Analyse a company's financial disclosures, including profit-and-loss statements, balance sheets, and cash flow statements. Key financial ratios to consider include the working capital ratio, quick ratio, earnings per share (EPS), price-to-earnings (P/E) ratio, debt-to-equity ratio, and return on equity (ROE). Comparing these ratios with peers in the same industry or sector can help make informed investment decisions.

- Avoid value traps: Be cautious of 'value stocks', which may appear undervalued due to poor performance or a lack of future growth prospects. Consider qualitative factors such as management effectiveness, competitive advantage, and potential catalysts to make more informed decisions.

- Focus on competitive advantage: Choose stocks based on sustainable competitive advantages, often referred to as a 'moat'. Organisations with a strong economic moat can maintain industry dominance for decades, translating into higher margins and consistent cash flow.

- Diversify your portfolio: Diversification is essential to managing risk. Owning stocks from various sectors can add stability to your portfolio, as different sectors may perform differently during market fluctuations. A well-diversified portfolio typically includes 5-10 different positions, ensuring no single position dominates the portfolio.

- Research and stay informed: Conduct thorough research before investing and stay updated on market news, trends, and events. This includes analysing financial statements, industry blogs, corporate presentations, and expert opinions.

- Keep emotions in check: Investing success requires discipline and a long-term perspective. Avoid making impulsive decisions based on short-term market fluctuations. Instead, focus on your investment strategy and the fundamentals driving your choices.

Understand your risk appetite and financial goals

Understanding your risk appetite and financial goals is crucial when deciding how to invest. Risk appetite refers to the amount of risk an investor is willing to take to achieve their objectives. It is influenced by factors such as age, income, investment goals, and personality. For example, younger investors with a longer time horizon are generally more willing to take on greater risk, while older investors tend to be more cautious as they need their investments to be more readily available. Those with higher incomes and more disposable income can typically afford to take greater risks.

There are typically three types of risk appetite: aggressive, moderate, and conservative. An aggressive investor has a high-risk appetite and is willing to lose large amounts of money for the potential of huge returns. They are often looking for get-rich-quick opportunities or are highly knowledgeable about the market. A moderate risk appetite investor is comfortable with risk but is not willing to lose too much money. They carefully weigh their options and only invest what they are prepared to lose. A conservative investor has a low-risk appetite and is more concerned with preserving their capital, often accepting lower returns for greater liquidity or stability. They tend to invest in low-volatility instruments that bring gradual returns.

To determine your risk appetite, ask yourself the following questions:

• How much money do I have to invest?
• How much money am I willing to lose?
• How worried would I be if the share markets fell dramatically?
• Will I be tracking my investments daily?
• Am I willing to invest in different types of investments?

It's important to note that your risk appetite is not static and may change over time as your age, income, and family situation evolve. Therefore, regularly reviewing and adjusting your investment strategies is crucial to ensuring they remain aligned with your risk appetite and financial goals.

Risk tolerance is closely related to risk appetite and refers to the practical application of risk appetite. It considers the degree of variability in returns that an investor is willing to accept. While risk appetite is a broader statement of an investor's attitude towards risk, risk tolerance is the actual implementation of that attitude in their investment choices.

Research the company and its industry

Researching the company and its industry is a crucial step in deciding whether to invest. Here are some detailed instructions on how to do that:

Understand the Company's Business

Before investing in a company, it is essential to understand its business model and operations. Ask yourself if you understand the company's products or services, revenue model, target market, and competitive advantage. If you cannot explain the company's business model, it may be too early to invest.

Analyse the Company's Financials

Start by reviewing the company's financial statements, such as its balance sheet, income statement, and cash flow statements. Look at key financial metrics such as revenue, net income, earnings per share, and price-to-earnings ratio. Compare these metrics with those of competitors and industry averages to assess the company's financial health and performance.

Assess the Company's Management

The quality of a company's management team is critical to its long-term success. Evaluate the experience and track record of the CEO and other key executives. Are they making decisions that are in the best interests of shareholders? Do they have a history of successful strategic decisions and effective execution?

Understand the Industry

Learn about the industry in which the company operates. What are the industry trends? Is it growing or declining? Are there any regulatory or technological changes on the horizon that could impact the industry? Understanding the industry will help you assess the company's competitive position and future prospects.

Look for Competitive Advantages

Look for companies with a sustainable competitive advantage, also known as a "moat." This could be in the form of brand recognition, patents, a strong distribution network, or any other factor that makes it difficult for competitors to challenge their market position.

Consider Industry-Specific Factors

Different industries will have different key performance indicators. For example, in the retail industry, metrics such as same-store sales and customer traffic are important, while in the software industry, metrics like user growth and retention may be more relevant.

Keep Up with News and Trends

Stay informed about news and trends affecting the company and its industry. Follow industry publications, blogs, and thought leaders. Keep an eye out for significant developments, such as new product launches, strategic partnerships, or changes in management.

Compare with Competitors

Research the company's competitors to gain a broader understanding of the industry. How does the company stack up against its peers in terms of financial performance, market share, and innovation? Are there any emerging competitors that could disrupt the industry?

Look Beyond the Numbers

While financial analysis is crucial, it is also essential to consider qualitative factors. Assess the company's culture, its reputation, and its social impact. These factors can influence consumer behaviour and regulatory environments, ultimately impacting the company's performance.

Remember, investing in the stock market involves risk, and there is no guarantee of positive returns. Always do your own research and consult a financial professional before making any investment decisions.

Understand financial ratios

Financial ratios are an essential tool for investors to gain insight into a company's financial health and potential for success. They are calculated using data from a company's financial statements, such as the balance sheet and income statement. While ratios provide valuable information, they should be used in combination with other metrics and not in isolation to make a comprehensive assessment of a company's viability.

Liquidity Ratios:

• Current Ratio: Measures a company's ability to pay off short-term liabilities with current assets. A higher current ratio indicates better short-term liquidity.
• Quick Ratio (Acid-Test Ratio): Similar to the current ratio but excludes inventory from current assets. It provides a more conservative assessment of a company's ability to meet short-term obligations.
• Cash Ratio: Assesses a company's ability to pay off short-term liabilities with cash and cash equivalents.
• Operating Cash Flow Ratio: Indicates how many times a company can pay off current liabilities with the cash generated in a given period.

Solvency or Leverage Ratios:

• Debt-to-Equity Ratio: Evaluates a company's debt levels relative to shareholder equity. A higher ratio indicates higher debt levels.
• Debt-to-Assets Ratio: Compares a company's total debt to its total assets. A lower ratio is preferable as it indicates less debt compared to assets.
• Interest Coverage Ratio: Shows how easily a company can pay its interest expenses.
• Debt Service Coverage Ratio: Indicates a company's ability to meet its debt obligations.

Profitability Ratios:

• Gross Margin Ratio: Compares gross profit to net sales, showing a company's profit after deducting the cost of goods sold.
• Operating Margin Ratio: Compares operating income to net sales to determine operating efficiency.
• Return on Assets (ROA): Measures how efficiently a company uses its assets to generate profit.
• Return on Equity (ROE): Assesses how effectively a company uses shareholder equity to generate profit. A key ratio for investors to understand.
• Earnings Per Share (EPS): Indicates a company's profitability and is calculated by dividing net income by the total number of shares outstanding.

Valuation Ratios:

• Price-to-Earnings (P/E) Ratio: A widely used ratio that compares a company's stock price to its earnings per share. It indicates a stock's potential for growth and whether it is undervalued or overvalued relative to its earnings.
• Price-to-Book (P/B) Ratio: Compares a company's market value (market capitalization) to its book value, which is the value if the company ceased operations, paid off loans, and sold its assets.
• Dividend Yield: Indicates the dividends paid to shareholders relative to the stock price, providing insight into potential returns.

These financial ratios provide a snapshot of a company's financial health and performance. However, it is important to consider industry benchmarks and compare ratios with competitors to make informed investment decisions.

Avoid high-yield dividend stocks

When choosing the right share to invest in, it's important to consider your goals and risk appetite. If you are looking for income, dividend stocks can be a good option. However, it's important to be cautious of high-yield dividend stocks as they may not always be a good investment. Here are some reasons why you should avoid high-yield dividend stocks:

• Reinvestment of profits: A high dividend yield may indicate that the company is returning a large portion of its profits to investors rather than reinvesting in the business. This could be a sign that management prefers not to reinvest in the company's growth.
• Financial health: A high dividend yield may be unsustainable if the company is facing financial challenges. For example, high litigation costs or declining revenues could impact a company's ability to maintain its dividend payouts.
• Stock price: A high dividend yield may be the result of a declining stock price. In times of financial crisis, dividend yields can be pushed artificially high, but this may not be sustainable if the company's profits plunge.
• Business model: Some business models may not be well-suited for sustained sales growth, such as a lack of retail store presence or a multi-level marketing strategy that results in high costs.
• Litigation risks: Companies that sell products or services with potential regulatory issues, such as nutritional supplements that are not evaluated by the FDA, may face significant litigation risks.
• Industry trends: It's important to consider industry trends and how they may impact a company's ability to maintain dividend payouts. For example, a company in a slow-growth industry may struggle to maintain high dividend payouts over time.

When considering high-yield dividend stocks, it's crucial to look beyond the dividend yield and evaluate the company's financial health, business model, and industry trends. Remember that a high dividend yield is not always a good indicator of a safe or profitable investment.

Determine the company's competitive advantage

When determining a company's competitive advantage, it's important to remember that this is the unique edge a company has over its rivals in the market. It is the factor that allows a company to produce goods or deliver services better or more cheaply than its competitors. This enables a firm to outperform its competitors and achieve superior profits.

A competitive advantage can be achieved through factors like innovation, cost leadership, quality, or customer service. Companies with strong competitive advantages are best positioned to succeed within their industries and fend off rivals more easily.

Some examples of competitive advantages include:

• Access to natural resources not available to competitors
• Highly skilled labour
• Strong brand awareness
• Access to new or proprietary technology
• Superior personnel
• Strong brand identity

A competitive advantage can be broken down into two types: comparative advantage and differential advantage. A comparative advantage is a company's ability to produce something more efficiently than a rival, leading to greater profit margins. A differential advantage is when a company's products are seen as both unique and of higher quality relative to those of a competitor.

To build a competitive advantage, a company must know what sets it apart from its competitors and focus its message, service, and products accordingly. This can be achieved through several strategies:

• Researching the market to identify and define its target market
• Identifying strengths by reviewing products, services, features, positioning, and branding
• Evaluating finances to spot profit centres and areas of stability
• Reviewing operations to assess efficiency and areas for improvement
• Research and development (R&D) to secure intellectual property and prohibit competitors from using certain processes or knowledge
• Considering human resources and the talent a company can attract as employees and leadership

Overall, a competitive advantage is crucial for a company's success, enabling it to outperform its rivals, achieve superior margins, attract more customers, and generate greater profits.

Frequently asked questions