Discipline vital in the market
Published in the Courier Mail, October 2007
by Alia McMullen and Erica Thompson
THE days of throwing darts at the ASX200 are over, with investors who fail to carefully research their stock pickings warned to prepare to be burnt when market volatility returns.
Rodney Weston, general manager of independent investor services provider Bourse Data, says do-it-yourself (DIY) investors lose discipline when the sharemarket is performing strongly.
"During the last three years investors and traders have not needed information to make money," he says. "When all boats are rising it is easy to cast information aside and to think that you are doing something special, when in fact it is market-driven rather than skill driven."
He says recent market volatility is part of an inevitable cycle which always catches up with "dartboard"-type investors.
"History shows that after a huge jump in momentum the market reverts to about average growth levels," he says. "Likewise, an overpriced stock will always revert to its true value."
Wealth Within chief analyst Dale Gillham says the emotions of fear and greed can be amplified so it is wise for everyday investors to educate themselves.
"The process taken to invest $500,000 or $1000 should be exactly the same, as they both represent the same amount of risk," he says. "Education is extremely important for any type of investor though I would say it is even more important for the smaller investor as they cannot afford to lose."
While seeking professional advice can be helpful, Mr Gillham says not to be lulled into a false sense of security.
"Advisers do have a role to play but I always recommend investors question the advice and under no circumstances should they rely on only one person's opinion," he says.
If you are going to pick your own stocks, Mr Weston says there are a few ways to narrow down your list.
Return on equity
A company's profitability can be judged by its return on equity (ROE), which is calculated by dividing the net profit before abnormals by total equity. "If ROE is bad then investors need go no further because it means the company is not profitable," he says.
Mr Weston says investors should look for a ROE of at least 15 per cent as a benchmark to divide relatively profitable companies from unprofitable ones. A ROE of 8 per cent or less means the company is struggling to deliver a sufficient return to shareholders.
"It is possible for share prices to rise even with dismal ROE, but this is generally a sign of unhealthy speculation and will be corrected with some pain."
Price-to-earnings ratio
The price-to-earnings ratio (PE) is calculated by the number of years that current earnings will take to pay back the purchase price of the stock.
Mr Weston says good value is generally a PE of less than 15, though there are cases where a strong ROE could justify a higher PE.
Company history
Investors should aim to dig up at least five years' worth of company history, Mr Weston says.
"One or two years of company history is not enough to establish a pattern of performance, unless it is a newly listed company."
Mr Weston says inexperienced investors were better off aiming for established companies with a long track record.
"Find out how long the company has maintained a good ROE. If it is consistently strong and increasing every year, then net profits should also increase at a faster rate," he says. "Inconsistent, patchy performance is a warning sign."
Mr Weston says another warning sign could be directors' shareholdings reports.
"If the directors are selling, then there is probably a good reason to stay away."
