Everyone wants to make an overnight fortune on the stockmarket. The trouble is, unless you get colossally lucky and put a potentially life-ruining amount of capital at risk, you can't. So what you need to do over the long run that you are investing, says experienced value investor David Merkel on Alephblog.com, is to "tilt the odds of success" in your favour. But how can you do that?
Make industry trends your friend
Professional analysts spend most of their time looking either at the market as a whole or at single companies, says Merkel. That leaves a gap "industries are underanalysed". So his first tip is to look for two types of stock. In industries with "lousy pricing power", you are looking for good companies with strong balance sheets the ones who are most likely to survive a fight to the death.
But in industries that already have pricing power, go for the cheaper companies the ones whose share prices will benefit most from any re-rating. In short, you are looking for stocks where "the trend is not fully discounted" (baked into the price).
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As for what gives an industry pricing power, Harvard professor Michael Porter breaks it into five factors (his "forces"). In summary, business sectors with low barriers to entry, powerful customers or suppliers, lots of competition, and easy product substitution all make for low pricing power.
Pick the right ratio for the job
Ratios allow an investor to compare companies side by side without having to wade through pages of detailed financial statements. But you must use the right ones. Knowing which ratio is likely to work best in which situation isn't always easy. But if you screen a sector using the wrong one, you're wasting your time.
The trick is to work out the key financial driver for a particular sector. For example, in asset-intensive sectors such as investment trusts and property firms, the price-to-book ratio will work fine.
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The EV/EBITDA ratio
The EV/EBITDA ratio is a popular measure which analysts use to work out whether a share is cheap or expensive.
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But in low asset intensity, high-growth sectors, such as technology or software, it is useless price-to-sales or the price-to-earnings (p/e) ratio may be a better bet.
Then there is gearing to consider in sectors where companies borrow heavily to fund infrastructure investment, p/e ratios can be distorted. A better bet here might be enterprise value (EV) to earnings before interest, tax, depreciation and amortisation (Ebitda). If this sounds a bit daunting, try my video guides for beginners.
Buy firms with room to grow
When you buy a share you are buying future, not past, growth. But how much headroom does your potential investment have left? For example, once retailers such as Marks & Spencer or Tesco run out of room to expand in Britain, they often branch out overseas.
This can be a minefield, whether in terms of lower brand recognition, lower profit margins, foreign-exchange risks or unforeseen costs linked to different working practices and union rules. Perhaps the product is simple enough to market say, a packet or cigarettes or a mobile phone but the profit per item plummets as soon as it is sold outside Western markets.
The sniff' test
Merkel suggests investors "analyse financial statements" to avoid companies that may be cooking the books using perfectly legitimate accounting rules. That's fine in principle, but in practise, small investors don't always have the time or expertise to analyse accounts in depth.
My top tip would be to stand back and ask yourself one question: "Really?" If a firm (failed insurer AIG, for example) regularly beats its peers on a sales and profits basis, be wary. Equally, be sceptical about bold claims about "increasing returns by 15% a year" (banks have been guilty of this recently). Very few firms achieve double-digit growth for very long.
Also, take a look at two written notes towards the back of the accounts. "Contingent liabilities" describes hidden nasties that may not have hit the numbers yet, while "related parties" reveals non-arms-length deals involving the firm or its directors. Firms that need to devote much space to these notes are best avoided. In fact, ideally you don't want there to be anything at all in these notes.
Manage your portfolio cleverly
Merkel acknowledges that even after quite a bit of homework, "it is genuinely difficult to tell what idea will work best". So he advises putting an equal amount into each stock and rebalancing when a stock moves 20% or more away from its target weighting.
He also advises that you only review your portfolio once a quarter, to avoid being tempted to over-trade and thus waste money. Just rebalance, then log out of your account and relax.
As for how many stocks you should hold, James Montier at GMO reckons a typical fund manager holds 100-160 stocks "madness" in terms of trading costs and time.
By holding just two stocks, says Montier, an investor can cut "non-market" risk (stock-specific risk, rather than the risk of a collapse in which all stocks are trashed) by nearly half. Buy 32 and 96% of that risk is eliminated. So by holding 30 to 40 shares you'll get "the vast majority" of any diversification benefits. The message? Be selective.
