The Motley Fool’s Sonia Rehill rifles through her mailbox for more of your investing questions
The Motley Fool's Sonia Rehill rifles through her mailbox for more of your investing questions. Sonia is joined by David Kuo who describes what a normal portfolio should look like. They also look at how to find a good fund and the concepts of adjusted profit and organic revenues. In this episode they also explain how to find shares that offer growth and income, the investing theory of "yield on cost" and some common misconceptions about Self-Select ISAs.
If there is a question about investing that you would like answered, please email Sonia at foolishquestions@fool.co.uk. If you would like to listen to previous episodes of Ask A Foolish Question, you can find them here.
You can download or listen to this podcast here.
Sonia:
Welcome to Ask A Foolish Question, The Motley Fool's podcast dedicated to help answer all your investing questions. I am Sonia Rehill, and with me to answer all your questions is David Kuo. Hello, David.
David:
Hello, Sonia.
Sonia:
How are you on this lovely sunny day?
David:
I'm enjoying the sunshine. It's been a long time since we've had some sunshine.
Sonia:
I just hope it stays now, for a little while longer.
David:
Well, I hope it stays at least for the Olympics, so the tourists coming to London can enjoy the sunshine.
Sonia:
So, what a week it's been, or should I say, what a busy month it's been in the investing world for company results, and there's more to come, isn't there?
David:
Well, it's been blistering as far as I'm concerned. There have been some good results, some not so good results, but all in all this is exactly what investors want to digest at the moment, just to find out what's good and what's not so good in the market.
Sonia:
With that in mind, let's start with our first question. I want to take a look at some accounting terminology that's caught my attention while I was pondering over the half-yearly results of Unilever (LSE: ULVR) and British American Tobacco (LSE: BATS) earlier this week. What is the difference between adjusted profit from operations, and simply profit from operations? – I mean, what are they adjusting for?
David:
Well, I know that it is quite confusing for people when they have a look at accounts, and ultimately you have to understand that a business is dynamic – all sorts of things are happening within that business. So let's say, for instance, you have a company that has been generating quite steady revenues, and quite steady profits over a certain period of time, and then all of a sudden something drastic happens in that business. It has had to reduce the number of workers in its workforce, and that has cost it an awful lot of money, because it has to pay redundancy. Now, thankfully this doesn't happen all the time. It's an exceptional charge that the company has to actually make in that particular year. So in order to make the accounts more reflective about what is going on in the business, it has to adjust for that exceptional cost, and as I say, thankfully the company doesn't have to make people redundant all the time, and if it does so, then of course that wouldn't be an exceptional occurrence within that company. So anyway, what it has to do is to adjust for those profits, so that you as an investor can see that, apart from that exceptional charge, everything in the company has been going OK.
Sonia:
So the profit is the net profit, or the pre-tax profit – is that right?
David:
Well, that's right – that is the profit right at the bottom of the profit and loss account that most of us look at, but when you see that figure, let's say, for instance, a company has been make quite steady profits – 10 million, 20 million, 30 million; you expect next year to be 40 million. Lo and behold, it's not 40 million at all, but in fact it is 30 million. Now, you would say, what has gone on at this company? Why hasn't it grown its profits? Well, it would have been 40 million, had it not had to make an exceptional charge of £10 million to account for the redundancy that it's made. So therefore what you actually do is, you look at the adjusted profits of the company, you adjust for those exceptionals, and then you say, as far as I'm concerned that company is doing OK.
Sonia:
OK, so what does "organic" revenue mean, as opposed to just total revenue then, David?
David:
OK, right – instead of looking at the bottom line profit, we are now looking at the top line sales, which is where the revenues turn up. Now, as far as the company is concerned, again it may have an operation that is quite steady. It's generating revenues of 100 million, 110, 120 – you would expect next year's to be 130 million, but lo and behold, something goes on in that company. You find that the revenues are not 130 million, but 200 million. You would say, wow – this is a great company, it's suddenly grown its revenues, but it hasn't actually grown its revenues because of organic growth, but in fact it has grown its revenues by that exceptional amount, because it went out and bought another business, which then throws your calculations into a kind of turmoil. I mean, it's quite nice to suddenly have an increase in its revenues, but you need to account for those revenues and say, what would the organic revenues had been, had it not been for the company going out and making that acquisition? – because you want to know what the company normally would have done, if it didn't go out and buy something in order to boost its top line sales.
Sonia:
So if I was looking at a company annual report, should I be looking at the organic revenue, or the total revenue?
David:
Well, that's a great question, Sonia. It really sort of depends, because you want to know why did it actually go out and make that acquisition in the first place?
Sonia:
So I look at both?
David:
Well, you would need to look at both, just to get a better feel for the company. Let's say, for instance, that the organic revenue, for illustration purposes, went from 100 million, 110, 120, 120, 120, 120, then you would say that the organic revenues in this company has plateaued somehow, which would then explain why it had to go out and buy another business in order to boost its top line sales, because otherwise its revenues would be flat forever, and that isn't what investors want to see. Investors want to see the company growing its sales, and also growing its profits. So this is kind of related to the first question that you asked about the adjusted profits, and the pre-tax profits and the net profits. So you want to have a feel for the underlying business; you want to have a feel for the organic revenues of the company, whether or not that's growing; and why it has simply had to go out and acquire another business in order to boost those top line sales.
Sonia:
How about underlying sales? – what do we mean by that? Is that just the sales from the normal operation?
David:
Right, that is very very closely related to the second question about organic revenues. You want to know what is the underlying trend within that company. You do not want to actually, for instance, want to see sudden increases or decreases, and if you do, you want to adjust for that, or the company will adjust for those exceptional increases in the revenue for you anyway, just to give you an idea of what the underlying sales would be, had it not either, for instance, disposed of a business, or went out and bought a business. So whether you're looking at adjusted profit, organic revenues or underlying sales, you want to know how the business as a whole is performing, without having those exceptionals.
Sonia:
Our next question is from a novice investor, Rick wants to know, what does a normal portfolio look like, and why? How much should you hold in different asset classes? Is there a typical portfolio?
David:
Right – first of all, let's define what asset classes are. In investing terms, there are only four main asset classes. There's properties, shares, bonds and cash, and ultimately what you want to do is to have some kind of diversification, so you have all four of them within your portfolio. Now, we can probably group shares and property as one group, and then we have cash and bonds as another group, and I'm going to give you a very very quick formula – it's called the rule of 100. Now, essentially what you do is, you take your age, and you subtract it from 100, and that then should tell you how much of your portfolio should be allocated to shares and property. So let's say you are 30 years of age, you take 100 minus 30, leaving you 70, so 70% of your portfolio should be in shares/property, and the other 30%, the other third of your portfolio, should then be in cash and bonds. So there is no such thing as a normal portfolio, but what you do have is a portfolio that is related in some ways to your age.
Sonia:
And it's pretty balanced, right?
David:
It is balanced in the sense that it reflects the amount of risk you can afford to take at a particular stage in your life. So if you are 30 years of age, you can afford to take slightly more risk, so therefore your portfolio should be weighted more heavily towards shares and property. But then again, if you are 70 years of age, then of course that portfolio will be reversed: 30% of your portfolio will then be in shares and property, 70% will be in cash, because if, for instance, heaven forbid anything were to happen in the market, you would not have the time that a 30-year-old would have in order to wait for the market to recover. So within that 70%, you then need to diversify again. You've already got the diversification in terms of asset allocation, now you need to diversify that 70% for that 30-year-old in shares and property into another group of diversification again. Ultimately what you need to do is to find approximately maybe 10 or 20 different shares that you can invest in.
Sonia:
Rick's follow up question is, how do you know which funds to invest in? There are millions out there, so do you make a simple choice based on risk, or the profile of the fund manager, or any other criteria?
David:
It really depends on what you want to get out of investing. Quite often, people will pick funds because they are trying to invest in certain areas of the market that they do not either have knowledge of, or they find quite difficult to get access to. If you remember, Sonia, many months ago we talked to a fund manager from Charlemagne Capital, and he was talking primarily about investing in the north African and the central African markets. Now, it is very difficult for a private investor to buy shares in that area, in that region. So what you will then need is a fund manager who has access to investing in that area, to make it easier for you. Of course, the one thing you need to focus on is the charges that the fund manager will make to help you make those investments in the first place, and of course those charges will gradually eat into the returns that you hope to achieve from those investments. So I suppose what I'm actually sort of saying here is that the first thing you need to focus on is the charges, to make sure that you are not over-paying, in order to get access into those markets. Also have a look to see whether or not there are exchanged-traded funds, which are a cheaper way of investing in certain markets, rather than to use a fund manager yourself; then, after that, the world is essentially your oyster. You may want to have some access to the Asian market, you want to have some access to the Japanese market, or the Australian market – you have to decide for yourself how you want to allocate your portfolio. You may think, for instance, that the North American market is particularly attractive, so then you will seek out an exchange-traded fund that would give you exposure to the North American market.
Sonia:
So should we look at the profile of the fund manager, or their track record?
David:
That is a very lazy way to invest in funds, but as we say here at The Motley Fool, past performance is no guide to the future. So just because a fund manager performed well last year and the year before, does not necessarily mean that he's going to perform well next year and the year after, so you mustn't rely too much on past performance. Of course, there are some fund managers that have done exceedingly well over the long term, Neil Woodford being a good example, and of course Anthony Bolton, but as we saw in the case of Anthony Bolton, he did well in the UK, now he's over in China and he's not doing so well, so you can't rely on the reputation of the fund manager to say that just because Anthony Bolton did well in the UK, he's going to do well in China.
Sonia:
So some cautionary advice there.
David:
Well, hopefully yes, but by all means have a look to see how you want to allocate your portfolio, and see if there's a cheaper way of doing it, rather than to pay a fund manager, who will just trouser your money anyway.
Sonia:
We have a question now from Nicholas. He has emailed us from South Africa. He says, "David, you have often praised income investing as the best way to invest in shares, whereas another Motley Fool, like Nate Weisshaar, has said he's a value investor, and looks for long-term growth. Are there any shares that offer both good dividends and great long-term growth? If so, can you give us some examples?"
David:
What a great question! – that's really putting me on the spot. Again, what I would actually sort of say is, and point you in the direction of a podcast that we had here at The Motley Fool a few months ago with a fund manager called Jane Coffey. Now, Jane Coffey is a PEG investor, she's a GARP investor. GARP stands for Growth At a Reasonable Price, and the PEG ratio that we look at is the Price to Earnings to Growth ratio. Essentially what you do is, you take the PE ratio, and you divide it by the earnings growth, and that will give you a number, one single number. What you're looking for is a PEG ratio of less than one. That will tell you that a company may be highly rated; in other words, a growth share, but at the same time the earnings is keeping pace with the PE ratio, so you're looking for that PEG ratio of less than one. If you can find companies whose PE ratio is less than one, then you will have found yourself a growth company that is relatively cheap.
Sonia:
So can you give us any examples, David?
David:
Now, I was looking at the pharmaceutical industry recently, and I came across one company – it's called Hikma (LSE: HIK). Hikma is a Jordanian drugs company. Now essentially, what Hikma does is, it goes out and it actually picks up drugs that have come off patent from the big pharmaceutical businesses. I looked at the PEG ratio for Hikma, and it has a PEG ratio of 0.5. It is growing its sales, its profits are growing quite quickly. Its PE ratio is quite high, but because when you take the PE, and you divide it by the earnings growth, it has a PEG of 0.5. It also pays a dividend as well, so therefore this would be a company that is worthwhile investigating a little bit more, I think.
Sonia:
Of course, do your own research as well, Nicholas.
David:
Definitely, and it is quite enjoyable to do, and it is not that difficult to do, Nicholas. So go out and have a look at those PE ratios, look at the earnings growth. You can do it on a spreadsheet, divide one by the other, and if the figure comes out to be less than one, then you are probably on your way to finding a good GARP share.
Sonia:
Now David, in a previous podcast, we discussed share prices. Benjamin asks if you could elaborate on your reasoning for not caring about how much you originally purchased a particular share for, and prefer to focus on the current price instead. Surely you will be interested in how the share price is performing at some point in time, David?
David:
Yes, I am interested in how the share price is performing, but not relative to what I actually bought it for. There's a big difference between the two. Let's say, for instance, I invest £100 in a particular share, and that share pays me £5 in dividends every year. That dividend yield is 5%. So if the share price were to fall from £100 to £50, I still get £5 dividend. I only bought it so that I can get £5 a year from this company. Now the dividend yield is 10%, because there's £5 on £50, the current share price, but I have no intentions of selling. I only want the £5 from the company. So whether the share price is £50, £100 or £150 is completely irrelevant to me. What I am interested in is whether or not the share price at £50 reflects the value of the company itself. Now, as far as the market is concerned, if the shares have fallen from £100 to £50, it means that the value of the company has halved. Now, does it deserve to halve in value? The answer is probably, in most cases, no, because the market is fluctuating all the time. If I became so fixated with the share price going up and down all the time, rather than focusing on the value of the company, then I would be distracted from what I'm doing. I am an income investor – I just want to make sure that the company can afford to pay me that £5 in dividends in every year. If, for whatever reason, it can't afford to, then I will sell the share. Now, whether that share then is £50 or £150 is irrelevant to me, because as an income investor, I want £5. Now, if the company cannot afford to pay me the £5, then I will sell the share.
Sonia:
OK, so now, if you were a value investor, would that change the situation in any way?
David:
Well, of course it would, Sonia, because a value investor would be looking at something completely different. The value investor would say, I bought the shares at £100 because I think it will actually go up to £200, so the value investor is very focused on what he paid for the share, and what the share price is worth today and in the future. Now, if the share price were to go from £100 to £200, the value investor would sell the shares immediately, because the value investor would say, I have made £100 on this share.
Sonia:
Similarly a growth investor would do the same as well, right?
David:
A growth investor would be quite focused on the share price, because he wants to see that share price growing over time. I, as an income investor, am not interested, because all I want is £5. Because I've paid £100 on that, my yield on cost; in other words, the yield that I get, is based on the cost price that I paid for that company, which is £100. So I just simply want £5 from the business all the time.
Sonia:
Benjamin – I hope that gives you something to think about there.
David:
Yes, Benjamin – I think you first of all need to decide what kind of investor you are. If you're an income investor, then you are not that interested in the share price. All you want to do is to make sure that the company keeps on paying you a dividend. Oddly enough, you want the share price to fall, because when that £5 hits your bank account, if the share price were to fall, you could buy more units. You don't really want the share price to rise, unlike the growth investor and the value investor, who is looking for the share price appreciation.
Sonia:
Our next question is from Jeremy. He has recently opened a SIPP, and is currently consolidating about £21,000' worth of other pensions into this. He's 41 years old, and while he realises he is behind where he should be in terms of his contributions, he is only going to be able to add £50 per month into his pension going forward. He's looking for something a bit risky, to hopefully make the most of this small amount. The £21,000 that he has, he's investing in mostly dividend-paying blue chips. Do you have any suggestions, such as funds or unit trusts that he should consider?
David:
First of all, Jeremy, congratulations for handling your own pension. For those people who don't know, a SIPP is a Self-Invested Personal Pension. It means that Jeremy is now taking charge of his own finances. Yes, Jeremy, you are 41 years of age, and you are putting £50 a month into your pension, but don't dismiss that. You are only putting £50 a month now, which is £600 a year; next year, if your salary were to increase, then you could afford a little bit more, but don't forget that you are making £50 a month now, and that £50 will start to grow. You still have another 20 years before you need to draw your pension, so that money will be growing as from today. Now, I've looked at some of your blue chips - BAT, Diageo (LSE: DGE), GlaxoSmithKline (LSE: GSK) – for dividends. Don't forget that BAT is also a good growth share at the same time. So, just because BAT pays a dividend doesn't mean it's a boring company. It is increasing its dividend currently at a rate of around 13% a year, so it means that next year it is going to be paying 13% more in its dividends than this year. Now, if you think about it, because it's paying an increase in dividends of 13%, its share price should follow that, so therefore the share price will increase as well. So don't dismiss the fact that sometimes these companies are seen as income companies – they are also good growth companies at the same time. Now, do I have any recommendations for funds and unit trusts – I would say, carry on doing what you're doing at the moment. You haven't given me your entire portfolio, and I fully understand why you don't want to do that, but BAT, Diageo, Glaxo – yes, have a look to see what else you have in your portfolio, and you'll probably find you haven't got a bad collection of shares. Aim for something around sort of 12, 15 or maybe 20 shares in total, and keep on dripping money into that, and I think you will look back when you are 65 years of age and say, what a clever choice I made.
Sonia:
So the £21,000 he's already investing in these blue chips, that's a really good starting point.
David:
It is a tremendous starting point, Jeremy, so therefore that £21,000 will be growing at approximately maybe 8 or 9% a year, every year, in real terms, until you are 60 odd years of age. So therefore you really have a good starting block to build your pension on, and then you're adding more money towards that, and don't forget that as time goes on, try and increase that amount from £50 a month to maybe £55 or £60 a month, and that will soon build you a pretty decent pension.
Sonia:
OK. Our next question is about net asset value. Sam asks, "How do companies value their assets? Is their valuation really ‘marked to market', or their own estimation, without a neutral third party's verification? Are their annual report figures trustworthy?"
David:
Well, hopefully they are trustworthy, but you have to remember that net asset values can be quite complicated. If you are a property company, you might have loads and loads of properties within your portfolio, and it is first of all quite expensive to get the net asset values done on all those properties, and you would tend to do it in a kind of rotation process. So this year you might do this group of properties, next year you might do another group of properties. So let's say you are a property company, like Land Securities (LSE: LAND). You will have loads of properties all over the place, and investors are looking at the net asset value and saying, is the share price reflective of what the net asset value of that company is? But as far as Land Securities is concerned, if it has to keep on doing a net asset value calculation every three months or six months on all its portfolio, it is a very costly process. So it might say, this year we'll be doing this group of properties; next year we'll be doing another group of properties. What you make, Sam, is a very interesting point, and that is, sometimes the net asset value may not reflect what the share price is reflecting at the same time. So if you know something about a company, in particular a property company, that it hasn't valued Asset A, for instance, a building out in Oxford Street, for a couple of years, then you could say, maybe the net asset value is not reflecting what the share price is, and it could be a good buying opportunity for you. And as far as the annual report is concerned, yes, I think they are accurate up to a point. It's a bit like me or you saying, how much is my house worth today? Well, the last time I valued it was probably about seven years ago, and so I can probably take a pretty good stab as to what the value is today, based on the next-door-neighbour selling his or her house at a certain price. But as far as whether I am 100% accurate as to what my value is – no, I think the answer is probably not.
Sonia:
We have a couple of questions about ISAs. The first is from Greg. He asks, if he were to invest the full amount into a shares ISA in a given tax year, and the shares performed really well, is he able to sell the entire holding and re-invest the profits back into that ISA without exceeding the annual limit?
David:
Of course you can. Ultimately, what you can do within the ISA is to do whatever you want. If I have £10,000' worth of shares in my ISA today, and I want to change it completely, I could actually sell all of those shares, but what I mustn't do is to take that money out of the ISA. It's got to stay in the ISA and then I can do with it whatever I want. This is something that some people might decide that they want to do. They've bought a portfolio of shares, and it's all sitting inside the ISA, but they want a complete change. They've actually decided that they no longer want to be, for instance, a value investor; they want to be an income investor, so they sell all of their shares, and then they slowly start acquiring new shares, but you mustn't take the money out of the ISA. Leave it in there, and you can do with it whatever you want to. The ISA is an envelope, so what you do inside that envelope is entirely up to you. You can buy, sell; you can liquidate the whole lot. Don't take the money out of the ISA, because if you do, then you are constrained by what you actually then put in as fresh contributions into the ISA.
Sonia:
And finally, we have a question from your namesake, David. He would like to know if cash held in a stocks and shares ISA receives no interest, and inflation eats away at the value, should you always have it invested in something? – For example, if not in shares, then gilts? Should you really chop and change the assets held, or is there a case for holding cash?
David:
Oh, namesake – I thought you meant there was another guy out there called Kuo, but I'm glad you cleared that one up, Sonia. Well, yes – I mean, the whole idea of having a stocks and shares ISA is so that you can invest in stocks and shares. You don't really want that money to stay as cash for too long. But I can understand that, if you haven't found a suitable investment, then that money has to stay as cash, until you find something that is good. You don't want to rush into buying any old stock just for the sake of getting it into shares. So yes, by all means have money sitting within the ISA as cash, and when you see an opportunity, you can actually use that for buying the shares that you want.
Sonia:
Thank you for those answers, Dr Kuo. We've covered a lot of questions today.
David:
Dr Kuo? Not Dr No?
Sonia:
Dr Kuo, the man in the know!
You have been listening to Ask A Foolish Question. If you would like to get a question in for the next episode, please email me at foolishquestions@fool.co.uk. If you would like to find out how you can make your portfolio grow, download a free report called Ten Steps To Making A Million In The Market at fool.co.uk/questions.
Thanks for listening, and happy investing.
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