Introduction – Putting the odds in your favour
IF YOU WANT to grow your wealth over the long term, you need to invest. Common stocks – shares in listed companies – are one of the most effective ways to do so, boasting long-term performance that is hard to match. As a result, they play a core role in most investment portfolios.
But how do you go about investing in common stocks successfully?
What about beating the market average?
Can it be done reliably – and safely, with your wealth protected from risk of substantial loss?
I think it can. I have achieved returns of just over 15% a year; this is substantially better than the UK and world equity markets, which delivered returns of 5.2% and 6.9% per year respectively, over the same period. The superior returns were also achieved with lower risk of loss, with the largest drawdown on the portfolio being less than 12.5% compared with 47.7% and 52.8% drawdowns on UK and world equity markets, respectively. The approach I have used to do so is set out in this book so that anyone else can follow it too.
This is not the only way to make money from investing. But it is, in my view, a sensible, effective and enjoyable one – based on some simple and logical principles, and some easy-to-follow methods.
The purpose of this book is to set out this system and its methods in a practical, no-nonsense guide, so that anyone who reads it will be able to successfully invest in company shares, with the aim of achieving superior returns compared to the market average – all while protecting their wealth from the risk of substantial loss.
It is written for individual investors and entrepreneurs interested in taking responsibility for their own investing – and who value independent thinking and decision making.
I will explain how to implement my investment approach without the need for substantial professional help or years of specialised training. The system is designed to fundamentally improve the odds of growing your wealth by focusing on the key factors that ultimately deliver investment success, with good portfolio management to limit potential losses. This is achieved by taking an analytical approach that combines looking at company numbers and key qualitative aspects that are good indicators of the future performance of a given investment.
Creating an equity edge
An equity edge is an investment strategy that allows a dynamic portfolio of shares to outperform the overall market over the long term. That is, there is an edge if the portfolio achieves higher returns than the market average with similar or less risk of loss.
The rate of return on your investments determines how quickly your wealth will grow. Achieving higher returns over the medium to long term means you grow your wealth more rapidly than the market – attaining a higher absolute level of wealth sooner.
The investment strategy described in this book creates an equity edge by using:
· focused business information analysis
· effective risk management
· market charting, which allows you to take advantage of underlying market price cycles.
Analysing key information to assess the strengths and weaknesses of companies and their likely return potential over the medium to long term can provide an analytic edge. Analysis allows you to draw informed conclusions about companies and make better investment decisions. Selecting quality companies that can reliably grow earnings and create market value over long time horizons helps to provide consistent returns. More importantly, avoiding the poorest companies which are steadily destroying market value helps to avoid losses and achieve market outperformance.
While there are many smart professional investors who can analyse the same information and reach similar conclusions, skewed incentives and different investment time horizons mean that the analytical advantage is not fully competed away. Asset managers are generally evaluated and compensated on their performance over short periods of less than a year. This often means that even if a company is very cheap, if there is no obvious catalyst that will cause the share price to rise over the short term, they won’t buy it. It’s therefore a huge advantage to be able to invest in companies that are likely to have the best returns over a longer time horizon.
The adoption of effective risk management rules means the risk of loss from a single company or from a widespread drawdown is limited. This ensures that your wealth avoids permanent damage and that you can recover from losses relatively quickly.
Drawdowns and volatility can harm long-term returns and cause investors to make mistakes due to behavioural biases. The rules are built into this book’s investment strategy to help limit behavioural mistakes through systematic application.
If an investment continues to be loss making, the risk rules may eventually classify the investment as a mistake. Shares in the company will be promptly sold to cut losses, while money is reallocated to better performing companies. Conversely, when individual investments move into profit, some of these profits will be locked in, ensuring a gain can no longer become a loss. This allows portfolio profits to be run while losses are limited.
It is critical to manage overall risk to reduce time spent in drawdowns. Bear (or down) markets are a painful reality of the economic cycle and can devastate portfolio value if left unchecked. The risk rules naturally de-risk the portfolio in severe bear markets, such as the 2008 great financial crisis, by reducing equity allocations as the downturn begins.
By taking an agile approach, investors can enhance their compound and risk-adjusted returns over a complete market cycle using market charting. Market charting allows you to examine price movements to understand current price trends and where markets are in their respective price cycles.
When a market is trending down, company share prices tend to fall as market sentiment remains bearish. During these periods, additional purchases of company shares are put on hold while some existing holdings, according to selling rules, may be sold (to limit losses or take profits) – thus moving more of the portfolio into cash. This helps to limit short-term losses from a widespread market drawdown and ensures the portfolio is better positioned for a market recovery.
When markets begin to recover, investors can take advantage of improving sentiment and general upward market price momentum by reinvesting cash in high-quality companies. Such circumstances increase the likelihood of investments moving into profit sooner rather than later.
A framework for your investment decisions
The following chapters are structured to provide a framework for arriving at investment decisions and managing an equity portfolio.
The structure of the book breaks down the investing process into five key stages:
1. Selecting quality listed companies to invest in.
2. Valuing quality companies to understand whether they are fairly valued.
3. Timing purchases of company shares based on valuation and market charts.
4. Selling company shares using simple rules.
5. Applying risk rules to ensure the portfolio is well diversified and the risk of loss is limited.
These are all crucial steps in determining what to invest in and for how long.
Selecting quality companies involves multiple fundamental checks of reported company numbers, which can be used to provide insight into the quality and value of a company. These checks will help you to build an overall impression of the company and decide whether a company is worth investing in.
How to select quality companies and perform fundamental checks is explained in chapters 2 to 10.
Chapter 2: Screening for Company Shares
This chapter focuses on using screening tools to narrow down the list of companies to research, eliminating those companies with poor fundamentals. This leaves a more focused list of companies to research.
Chapter 3: Earnings Checks
This chapter looks at whether a company has reliably made a profit and whether the company is able to steadily grow profits over time. Normally you will want to avoid loss-making companies.
Chapter 4: Sales Checks
Company sales are an important measure of a company’s performance and prospects. Looking at underlying trends in revenue streams provides insight on business efficiency, profitability and sustainable success.
Chapter 5: Cash-flow Checks
Cash flow analysis measures how much cash is generated and spent by a business over a period. An examination of cash flow provides a sense of whether revenues are generating sufficient cash to cover expenses, and whether stated profits are backed by positive cash flow generation.
Chapter 6: Dividend Checks
Dividend checks are used to ensure that companies paying a dividend will be able to reliably continue to pay the dividend and grow payments over time.
Chapter 7: Debt and Solvency Checks
A strong balance sheet can ensure that a company is able to survive a market downturn and has a low probability of bankruptcy. The debt and solvency checks help to ensure company debt levels are manageable and that the near-term likelihood of financial distress is low.
Chapter 8: Competitive-advantage Checks
This chapter shows how to assess whether a company has a superior business position based on the company’s accounting numbers.
Chapter 9: Book Price and Valuation Ratios
This chapter discusses how to interpret book value ratios, as well as how to come to an overall view on valuation, based on a broad spectrum of valuation ratios.
Chapter 10: Qualitative Analysis
Qualitative analysis helps to build an understanding of a company and what they do. Leadership and the prospects of a company can be assessed, and the strengths and weaknesses determined. This includes major risks, which could have a substantial negative impact on the business (threats) and positive catalysts for growth (opportunities). This helps to further narrow down the buy list of companies.
The valuation of company shares is covered in chapters 11 and 12.
Chapter 11: Broker Valuations
This chapter shows you how to use broker views on earnings, sales and dividends to produce a consensus price forecast for a company over the next two years, as well as how to construct a price range the shares are expected to trade within. This provides a short-term consensus view on whether the current share price offers good value or not.
Chapter 12: Long-term Fair Value
This chapter shows you how to produce an independent, long-term valuation of a company’s shares using a variety of methods. The estimated valuation can then help you to assess the possible returns that might be generated from an investment in the company at the current share price. You can then make an informed decision about whether there is sufficient margin of safety to make an investment worthwhile.
Strategies for timing the purchase of shares are covered in chapter 13.
Chapter 13: Charting for Investors
The use of charts and technical analysis is a valuable tool that can help you understand the current market and company price trends. This allows you to avoid price drawdowns and identify more opportune periods in which to invest.
There are three key strategies for buying shares at an advantageous time. Their aim is to limit the short-term downside risk and take advantage of positive price momentum, which makes it more likely that an investment will move quickly into profit.
Chapter 14 covers when to sell shares.
Chapter 14: When to Sell Shares
This chapter outlines some rules that can be followed to systematically decide when to sell shares. Application of these rules provides a simple decision-making process that can help avoid common investment mistakes, while removing some of the uncertainty and stress involved with making selling decisions.
Chapter 15 covers risk management through investment allocation.
Chapter 15: Managing Investment Allocation
Managing the allocation of investments within the portfolio is one of the most important aspects of investing successfully in the stock market. This chapter explains some simple allocation guidelines that ensure losses are limited, which in turn serves to help maximise long-term returns. Following these guidelines will help you to reduce the fear of a loss and avoid costly mistakes that can severely damage portfolio value.
Chapter 16: Bringing it all Together
This chapter discusses the day-to-day running of the system and how you can apply it to the share portfolios that you manage.
The resources and tools you will need
In order to analyse companies and follow the markets you need access to information. While a large proportion of this information is free, the tools and information that add the most value are those you need to pay for.
Screening and data websites
Screening and data websites select and gather quantitative information about listed companies. They provide a convenient way to research a company and assess whether it is worth investing in.
There are many free screening services, but screening criteria is normally limited, meaning more work is required to narrow down a selection of quality companies. My preference is to use paid services, which provide a greater selection of criteria – including more sophisticated criteria, such as indicators for balance sheet health, bankruptcy risk and earnings manipulation. These additions generate a more refined list of companies likely to be worth investing in.
Stockopedia
Currently, I use the screening service called Stockopedia (www.stockopedia.com). Stockopedia offers a range of regional screening services, covering the UK, US, Europe, Canada, Australasia and Developed Asia (Japan, Hong Kong, Singapore, Taiwan and South Korea). Since companies in the largest developed markets are covered here, the screening tools are suitable for most investors.
Alternative screening services
Other potential paid screening services include SharePad (www.sharescope.co.uk), Zacks (www.zacks.com) and UncleStock (www.unclestock.com).
While you won’t be able to use them to fully implement the screens listed in chapter 2, free screening services worth checking out are: Finviz (www.finviz.com) and Yahoo! Finance (finance.yahoo.com/screener).
Morningstar
One of the main sources of company data, Morningstar (www.morningstar.co.uk), can be used to carry out detailed quantitative analysis and produce valuations. It covers most listed companies across developed regions. This premium service provides up to ten years of financial accounts, along with key ratios and metrics calculated for each company. The information is standardised, making it easier to carry out analysis.
The service also provides access to independent analyst research, including research on many listed UK and international companies. However, focus tends to be on medium to large companies.
Financial news
Financial news can be used to maintain a general understanding of the market, as well as keep investors informed of the latest developments in companies. Reading articles about what is benefitting or hurting a sector or industry can help you make better investing decisions.
The Financial Times (www.ft.com) and Bloomberg (www.bloomberg.com) offer a range of articles on the broader market and sectors, alongside discussion about the larger listed companies and events affecting them. However, these news sources have little coverage of smaller companies.
The Economist (www.economist.com) is useful to gain a broader perspective on current affairs. Main articles each week provide thoughtful commentary that may be helpful when thinking about what might affect the companies you invest in.
Company news
The main magazines covering listed company shares in the UK are the Investors Chronicle (IC) (www.investorschronicle.co.uk) and Shares (www.sharesmagazine.co.uk). Both contain commentary on small and large companies, and are useful resources to keep up-to-date on company news.
These news sources provide a concise, historic summary of company performance and investor sentiment – useful knowledge when undertaking qualitative analysis of a company (as outlined in chapter 10). Look for compelling investment stories within the magazines; if any companies you are interested in appear, you may decide to prioritise their further research.
Charting software
There are several free websites that offer share price charts. Most of them are able to replicate the charts used in chapter 13, where charting strategies are outlined.
My preferred websites are TradingViews (www.tradingviews.com) and StockCharts (www.stockcharts.com). These websites cover listed companies in most regions and have a large selection of technical indicators that can be applied. The daily and weekly chart layouts and indicators used in this book can be replicated for free using TradingViews.
The Equity Edge website and newsletter
The Equity Edge website (www.theequityedge.com) offers a subscription service designed to provide all the information you need to implement the analysis and strategies outlined in this book in one place, including company research and information on actual portfolios being run using the system. The subscription service provides access to research content, with a focus on UK and US listed companies.
Members receive a monthly newsletter containing market commentary and the latest company research and investment opportunities. Research for each company includes key numbers and summary statistics mentioned in this book, as well as commentary outlining our interpretation of the analysis and our view on the company. The current buy lists for income, value and growth companies are also provided, with links to company research.
Summary
Building an equity edge through quantitative and qualitative business analysis, effective risk management and charting can lead to superior returns to the overall market, over the long term, with lower overall risk. The following chapters present a detailed guide on how to implement an investment system that effectively develops an edge.