We all want to make money from shares, but how we do that in practice?
As investors, the objective that we all have, from buying shares, is to make money. Some time ago I wrote an article titled How I Find Bargain Shares. If you follow this advice then you should be able to find shares with the potential to make you a profit. However, how do you decide which ones are the right ones to buy?
The question that all investors need to ask, but often don't, is how any share will make them money.
At its most basic there are only two ways to make money from shares:
- increases in the share price
- dividends (or other forms of payment) paid by the company
The real question you need to ask for every share therefore is why you expect either of these to occur in the future. What your answer is, will define what type of investor you are.
It's cheap, but is it a bargain?
Value investors buy shares that are cheap in the belief that other investors will eventually come to recognise it, buy them and the share price will therefore go up. That 'investor' could also be a competitor, venture capitalist or a management buyout team who offer to buy your shares at a premium to take over the company completely.
Cheap of course is a subjective term. It could, for example, mean cheap in relation to earnings or in relation to assets. Unfortunately many cheap stocks remain cheap forever (if forever exists in the stock market). These are known as 'value traps'.
The best type of cheap is where there is value in the company which isn't obviously apparent. This could include a valuable property, recorded in its accounts a low historic cost, which is surplus to requirements or a loss making activity which is depressing overall profitability, but which could be sold or closed.
Sometimes the stock market takes an unduly pessimistic view of the sustainability of a company's profits in the future. Similarly when a company has suffered a setback the market may overreact -- the so called 'crisis play'. Or it could simply be that the share price is depressed by a large seller of shares which has taken a strategic decision to dump its holding. All are potential 'value plays'.
Searching for value has been likened to looking through the stock exchange's rubbish bins hoping to find something thrown away by mistake. It's worth bearing in mind however, that most of what is in the bin really is rubbish.
Onwards and, err, upwards?
Growth investors, on the other hand, are looking for expanding companies that they expect to deliver increasing profits or asset values in the future. As these increase, so should the share price.
At its most realistic level, this is 'GARP' investing; Growth At a Reasonable Price. These are companies which will deliver a consistent and regular increase in profits, but which are valued at a reasonable price. In this respect, a reasonable price would be a low price earnings ratio.
Companies generally grow because they are gaining market share or increasing efficiencies through being more competitive than others in their sector, or because they operate in a growing market (or indeed both). It's important therefore to differentiate between real growth and cyclical growth.
Many industries such as construction and engineering go through cycles and apparent growth may just be the recovery phase from the last downturn. It's also important to cut through the hype of management talk. Not all companies are quite as successful as their management would have us believe.
The sky's the limit, isn't it?
At the extreme of growth investing is blue sky investing; looking for those companies with a new killer product or innovation that will revolutionise an industry. Get it right and the share price could increase ten or a hundred fold -- the next Microsoft or Apple. This is the attraction of sectors such as drug development and technology. Unfortunately most companies in these situations simply do not make it. Ask investors in Voller Energy (LSE: VLR).
Many mining and oil stocks fall into this category, with investors hoping for that big lucrative discovery. Investors in Gulf Keystone Petroleum (LSE: GKP) were one such recent lucky bunch!
Getting sentimental over share prices
Followers of technical analysis believe it is pointless to analyse companies' financial information. As all information known to the market is already reflected in the share price, the only factor that will influence it therefore is change in investors' sentiment. Reading investors' sentiment can be achieved by analysing share price movements and particular graphs of them.
Technical analysis is not widely followed on The Motley Fool, although it has its own active bulletin board.
Share price, what share price?
All the preceding techniques rely on an increase in the share price to reward investors for holding the shares. That ultimately relies on other investors buying the shares and on them making rational decisions about the value of companies. Yield investors aren't prepared to do this. Instead they depend for their return on the payment of dividends by companies.
I've written numerously about companies I believe offer great potential in this area. The criteria I believe are important for sustainable dividends are low debt (or even better, cash and buckets of it) and sustainable earnings.
One variant of the high yield approach is set out on the High Yield Portfolio board. Only large capitalisation companies are considered and diversification between sectors is the key to reducing risk.
Whatever type of investor you are, it's important to know why you are buying a share. Otherwise you are relying on hope; tips from the shoe shine boy and buying what everyone else is. In my experience that's unlikely to make you money.
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