Sonia and David tackle the 'Ask A Foolish Question' mailbag.
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Sonia:
Welcome to Ask A Foolish Question, The Motley Fool's podcast dedicated to help answer all your investing questions. I'm Sonia Rehill, and joining me is David Kuo.
David:
Hello, Sonia!
Sonia:
So David, I have around ten questions lined up for you – are you ready?
David:
I am ready – I am all strapped in.
Sonia:
Wonderful. We'll cover a few investing basics to begin with.
David:
OK.
Sonia:
Great, OK, so let's start off with, what do hedge funds do?
David:
Ooh, what a question, Sonia. I mean, hedge funds are very secretive organisations, and they don't really let people have a look at what they do, mainly because they have thesis that they build around certain investing things, and effectively what they try and do is to ensure that they invest in one product, and another product, so that whatever happens to the market, they will hopefully make money. So I'll give you an example: let's say you want to take a position on oil, and you don't really know whether or not oil prices will go up or go down, but you think that it will do something. So effectively, what you might do is to buy shares in Ryanair. Now, what would happen, if oil prices were to come down, to Ryanair's profitability?
Sonia:
Ryanair's profits would increase.
David:
That's right, because oil will be cheaper, aviation fuel will be cheaper, so therefore Ryanair's profits would go up. What would happen if oil prices were to go up, though?
Sonia:
It would be more expensive for Ryanair to buy oil.
David:
That's right – the exact opposite would happen, so Ryanair would make less profits, and the share price would go down. So the way you would hedge this would be to buy shares in Royal Dutch Shell, or BP, or one of the oil companies. Now, what would happen to Royal Dutch Shell's profitability if oil prices were to come down?
Sonia:
Its profits would come down as well.
David:
That's right, but if you remember, what you said earlier on was, if oil prices came down, Ryanair's profits would go up. So if you have two shares, Ryanair and Royal Dutch Shell, they would work in opposite directions, depending upon what happens to oil prices. So if oil prices were to go up, profits at Ryanair would come down, but Royal Dutch Shell shares, the oil company shares, would go up, and so therefore you've balanced one with the other. So what are you doing? – you are:
Sonia:
Hedging your bets.
David:
That's right – you are hedging one against the other, and this is what hedge funds try and do all the time. They sit down, and they think, what would happen to a sector, what would happen to a commodity, what would happen to something, if something else were to happen, and they try to hedge one against the other.
Sonia:
Wonderful – thank you. The next question is from Sarah, she wants to know, what was the cause of the minor crash that happened in August last year?
David:
Ooh, I think it was a little bit more than a minor crash. What happened in August last year was that the FTSE fell from 5,900 points to 4,800 points, so that's actually quite a big drop of 1,100 points. Really what happened in August last year was that investors, traders, the market, was just very concerned about what was happening to the European sovereign debts. They were afraid that Greece might default on its debts, so therefore what would happen to the Eurozone? That was number one.
The other thing that happened around that time of year was the US debt downgrade. They were very concerned that if American treasuries were downgraded, what would then happen to the US economy? So because there was so much fear in the market, everybody just fled, everybody just left, and as a result of that, the FTSE fell from 5,900 to 4,800, and it wasn't just in the UK – it was a global thing. It was happening all around the world – everybody just deserted the stock market. But – I tell you what – the stock market is now back up at 5,341, so good news for everyone.
Sonia:
OK. Can you tell us, David, what is meant by the phrase “the market hates uncertainty”?
David:
OK right, this is a very wise saying, and what it's saying is that the market likes to know what is going to be happening tomorrow, but unfortunately the markets are just generally uncertain. I can't tell you whether or not the stock market will be higher or lower tomorrow. I can't tell you what is going to be happening in the Eurozone. I can't tell you what is going to be happening in China. So therefore there is always uncertainty in the market.
But what analysts like to do is to put numbers into their spreadsheets. They want to know that, if they were buying shares in a company, let's say GlaxoSmithKline, they would like to know what are GlaxoSmithKline's profits likely to be in 2013, 2014, 2015, and only by having that information are they able to discount all of those profits back to today, to come up with a valuation for GlaxoSmithKline.
Now, they can't do that for whatever reason, because they don't know what is happening to interest rates, or what is happening to sales at GlaxoSmithKline, then that creates the uncertainty which makes it very difficult for them to come up with a valuation for this particular company, and when that were to happen, they would say that, right, the risks are greater now than they were before, and so therefore I'm going to mark the share price down, which is why you tend to find, when things are very uncertain, the risk premium starts to increase, and so therefore the share price starts to fall.
Sonia:
What is a profit warning?
David:
OK, this is actually very closely linked to the last question. Now, a company has to give guidance to the analysts over what they think the profits are going to be next year, or the year after, and analysts rely on this information coming out from companies, which is why many analysts talk to chief executives, they talk to chief financial officers, to get a gauge as to how the company's performing. Only when they have some guidance as to what is going to be happening to the profits can they use those profits, future profits as well, to discount the future profits back to today, to come up with a valuation for the company.
Now, if a company said, we think we are going to be making 100 million pounds' worth of profits next year, analysts can use that figure to try and work out what the share price should be today. Now, if the company then turns round and says, you know we told you we were going to make £100 million? – well, it's not quite, because we had some pretty awful weather, and so therefore retail sales aren't as good as we thought they were going to be. So instead of £100 million, it's going to be £90 million. So therefore they have issued a profits warning, and the analysts then go back, plug the £90 million back into their spreadsheets, to come up with what they think the valuation should be today. So consequently, when they have a profits warning, the analyst have to recalculate to think what the company is worth now, and obviously it'll be lower than what they were previously, and the share price falls. So a profit warning is generally accompanied by a share price fall.
Sonia:
OK, I have an email about buying shares ex-dividend. It's an email from Craig. He understands why the price of an individual share drops the day after the ex-dividend date by approximately the dividend paid. However, is this in general a good time to buy shares in these companies, taking a purely long-term view of five years plus, and accepting you will not receive the next dividend payment? – as he's not looking for income, but growth?
David:
OK, interesting question, Sonia, and Craig, you are asking a question that a lot of investors ask. Let me first of all explain why a share falls, when it goes ex-dividend. Let's say you have a share that is worth a pound, and the company's expected to pay a 10p dividend. When the company goes ex-dividend, the share price will fall to 90p, because you don't qualify for the 10p dividend. So effectively, prior to it going ex-dividend, the shares are worth 90p, but you're going to be getting the 10p dividend, which is why they're worth a pound. After it goes ex-dividend, the shares fall to 90p, because you're not going to be getting the 10p dividend.
Now let's say after that, the company is expected to pay a 20p dividend the following year. So over the next twelve months, the share price will gradually climb from 90p to 110p, because, at the end of the year, it's going to be paying you a 20p dividend on your 90p share, so 90 plus 20 gives you 110. So the shares will grow in value, over the next twelve months.
So going back to your question, Craig, is it a good time to buy the share after it's gone ex-dividend, the answer is no, because when it's gone ex-dividend, you're not going to be getting the dividend, so therefore you haven't got the extra money to invest. If you bought it before it goes ex-dividend, the day that it goes ex-dividend, the share price will fall, but you will be getting the dividend which you can then re-invest back into the same shares again, or you can buy something else, so it makes absolutely no difference. It's a bit like sort of taking one step forward, and then one step back.
Sonia:
OK, my next question is about level two data – that sounds very technical. It's from Ash, he asks: is level two data all that helpful in trading as it's made out to be? If it is, how does it help?
David:
OK, Ash – most brokers will only provide you with very basic data, when you want to buy and sell shares. What they will tell you is what the bid and the offer price is; in other words, how much would you get if you were to sell a share, or to buy a share – how much would it cost you to buy the share. In addition to that, they will also give you information about the highs and the lows for the day, and the mid-price for the share. So those five pieces of information will allow you to judge whether or not it is a good time to buy the shares.
With level two data, you get additional information, and it will tell you whether or not there are some big sellers or big buyers in the market. So let's take, for instance, a share like Vodafone. Now, if you wanted to buy Vodafone shares, with level one data you would simply get the bid, the offer, the high, the low and the mid price. With the level two data, what you would be getting also is information about a big seller coming into the market, somebody who might be selling half a million Vodafone shares.
Now, if you knew that was going to be happening sometime today, and you also knew what price this seller was going to be selling these half a million Vodafone shares at, then you could simply say, I'll tell you what – I'll just hang on and wait until these shares come onto the market, because there's going to be such a big shedload of shares coming onto the market, it's going to cause the share price to fall. So for a trader, it is quite important to have the level two data, but it will cost you more money to buy that.
For the long term investor, however, it doesn't really make a jot of difference, because we are looking at what the share price is likely to be in five years' time. So if we think that Vodafone shares are good value today, then we will buy. The fact that it's going to drop a couple of pennies later on is completely irrelevant to us, because we want to know whether or not it is a good buy today, because we have no intentions of selling it for another maybe five or seven years.
Sonia:
OK. Next is a question from Josh. He's currently investing in a FTSE index tracker. He wants to know, what happens to the dividends for these shares? – are they re-invested into the tracker? If so, is this done annually, or as each company pays its individual dividend?
David:
OK Josh, now, when you talk about your FTSE index tracker, you have to be very careful about what kind of FTSE index tracker you have bought. Have you bought one that's got accumulation, or have you got one that's got distribution units? Now, there is a big difference between accumulation and distribution. With the distribution index tracker, when the dividends are paid out to you, they are paid out to you – nothing else is done with them. So the money will either end up in your trading account or in your bank account, so those are the distribution units.
The accumulation units, on the other hand, are when the FTSE index tracker pays out those dividends, those dividends, the cash, is used for re-investing back into the tracker again. So over time, the amount of money that you have in the tracker will grow, simply because you are buying more and more units. Now, is this done annually, or as the company pays its individual dividend? – it really depends. If the company thinks that, at the end of each quarter, which is generally when iShares pays out its dividends, that money could sit to one side, and then be re-invested back into the tracker again when it is suitable. Now, the company will also have to consider what it needs to do with the cash, because if some people were to sell their index tracker, they have to try and find the money from somewhere, and that money could be coming out from the dividends. So that pool of money will be sitting there, and things will be done with that pool of money, and it is up to the index tracker manager to decide when he wants to re-invest that money.
Sonia:
My next question is from Tim. This is also something that I want to know. Tim has noticed, in recent weeks, that some companies, like Astra Zeneca, have bought back big chunks of their own shares. Is this a good sign, as they think the price is quite low? Or is there a bearish reason why companies might do this?
David:
Well, it's not just you and Tim who want to know about this, but I think lots of people want to know about this as well – why do companies buy back their own shares? Now, if a company is quite profitable, and it has generated a huge amount of cash, and it's sitting on this cash, and it thinks, I don't quite know how to allocate this cash. I could use this money for investing in new projects; I could use this money and pay off debt; I could use this money and just leave it sitting this bank account; or I could just use this money for paying out as dividends to investors. The company has to decide, what is the best way of allocating this cash. If it looks at projects, and it thinks, the returns from these projects aren't particularly attractive, then it will say, I won't put it into a project at all. I won't buy a new factory, I won't refurbish the head office, because it is not generating a decent enough return to justify me using this cash.
So therefore it might say, what shall I do with this money? – and it will have a look at its own business and say, do you know what? – the best place to invest this money is back in my own shares, so effectively what it is doing, it is going back out into the market and saying, I'm going to be buying back my own shares, because that is the best place to put this investment. So that is why they buy back their own shares, although there are arguments here, because some investors will say, rather than buy back your own shares, why don't you just pay it out as dividends to other investors? It is a dilemma that a lot of companies are facing right now, because they have a lot of profits. They have a lot of cash sitting on the sidelines, they don't know what to do with it. Now, ideally it would be great if they reinvested this money back into either the UK economy, the European economy, or the global economy, and make their businesses grow, but they're saying, we don't know whether or not the returns from those are going to be justifiable to investors. So some of them are saying, let's just go back and buy our own shares, or some of them are saying, let's just give a special dividend to investors. They've got too much cash, Sonia.
Sonia:
Good for them.
David:
Well, exactly – it's great, except the governments want them to go and spend that cash, but they don't really want to.
Sonia:
And now for my final question, David – it's from Rob. There's two parts to this. Rob is referring to a previous podcast, in which you said, if a company were to say make ten million today, but in the future it is making 20 million a year, then I would say that the company has a pretty good chance of being worth twice as much as it is today. Rob wants to know how he can essentially time his investment. How can he calculate or estimate what a company is likely to earn in future, and then convert this into a reasonable share price today?
David:
OK Sonia and Rob, this is something that we do hear at The Motley Fool on a daily, weekly, monthly basis. We look at companies, we look at their business models, we look at their profit/loss accounts, we look at their balance sheets, and what we effectively are trying to do here, Rob, is to look at a business and say, what do I think the sales will be next year, the year after, and we project that forward for about five or ten years. Then we have a look at how much it costs to generate those sales over the next five or ten years, and we subtract from the sales the cost of delivering those sales, to end up with a profit. Then we have a look at how much of those profits they are likely to distribute to investors in the form of dividends. So with all those bits of information, we can model the business.
We put them all into a spreadsheet, and then we start discounting all those future profits into what it is worth today. In other words, we use discount cashflow models, in order to arrive at a value for the company now. Then we have a look at the value of the company divided by the number of shares that are in existence, to end up with a share price that we think the company is valued at according to our calculations. Now, if our value is markedly different to what the market thinks it is worth, then we can either say it is a buy or it is not a buy. Now, if our valuation comes up with a value for the company that is less than what the market thinks, then we would say, yes – this is a good time to buy those shares, because in the next five or ten years, provided our thesis is correct, it would be a good buy. But if our valuation shows that it is overvalued, then we would say it is not a good time to buy the shares.
So as far as timing your investments are concerned, if you think the shares are worth more than what the market thinks, then now is a good time to start buying the shares. Whether you spread your investment over a period of time, or whether you buy it all in one go, that is entirely up to you. Some people say that if you want to invest £1,000, the best way of doing it is to invest it in tranches of about £300 each, and then buy £300 lots of shares over a period of time, because the market can be quite volatile.
Sonia:
The second part of Rob's question refers to what indicators he should follow? He mentions there's lots of ratios, which are quite confusing. What should he be looking for that would indicate a low-risk investment?
David:
OK, there are lots of things that you need to look out for, Rob, and debt to equity is certainly one of them. Other things that you may want to consider might be price to sales, or PE ratios, or the yields – all of these things are various ratios that will give you some idea as to whether or not an investment is high risk or low risk. But apart from that, you should also be looking at things like the business itself. What is the management like? What competitive advantage does the company have? Does it have a moat around its business? Is it able to cope with rises in interest rates? – all of these things are various factors that you need to consider before you make your investment.
Now, there is no one-size-fit-all unfortunately, because some industries just generally have a very high debt to equity – there's nothing they can do about it, and a good example of that might be property companies – they just have loads and loads of debt. So you have to be very careful about trying to fit one lot of criteria into all the various industries. It is very difficult to do.
So what I would suggest, Rob, if you are interested in analysing shares, is to look at one particular sector. Let's say, for instance, you've picked the housebuilding sector, and just have a look at all the various housebuilders, and then you will be able to sort of build a picture of what housebuilders, how they run their businesses, and does one company have more debt that others, or are all of them pretty much the same? – and that will give you some feel as to what a sector is like, and then just move from sector to sector. Move to the retail sector and have a look at that; look at the hospitality sector; look at the pharmaceutical sector – they're all different.
Sonia:
Well, I hope that's answered your question, Rob. We've come to the end of this podcast now, David – thank you very much. There was a lot to go through there, and you've made it so easy to understand.
David:
Well, it was really hard work today, Sonia. I'm going to make myself a cup of tea now.
Sonia:
Yeah, you definitely deserve it, and we hope to have you back on again next time.
David:
Oh, thank you very much.
Sonia:
Now, if you have an investing question you would like David or any of our Foolish experts to answer, please email me at foolishquestions@fool.co.uk, and if you're new to investing, you can read our Investment For Beginners' series. You can also follow The Motley Fool on Twitter @TheMotleyFoolUK, and find us on Facebook. Thanks for listening, and until next time, happy investing!
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