How do you stop yourself making mistakes in share selection?
To say there's a surfeit of advice out there on which shares to buy into is an understatement and then some.
Every man and his dog "know" where the future value lies. Private investors with a limited investment pot, meanwhile, can get quickly tempted into this investment then that, running around like headless chickens as they're suckered in by the latest good-looking temptress of a share. How do I know all this? Because I'm guilty of it myself of course.
The question is what to do about it. There are various strategies designed to take the emotion out of share selection. Knowing which one is right for you is a matter of personal judgement and individual circumstances.
Far too many factors come into play here such as your age, risk profile, percentage of overall wealth invested etc., to make a "one size fits all" advice set, but as a starter for ten, how about running the following checks over your potential investments to make sure they comply? Believe me, it will rule out most likely losers:
Good value?
Looking at the balance sheet, earnings history and your own belief in future earnings prospects; is the company fundamentally good value?
This may sound overly simple, but many investors have made the mistake of putting less effort into researching a company and considering all the variables that contribute to a weighted risk-reward decision than we have into buying a new washing machine.
Personally, if a company doesn't pass my initial fag packet analysis, I leave it out – simple as that.
Income?
It's long been Foolish wisdom to expound the virtues of dividends and the "miracle" of compounding.
Don't just dismiss it as a tired cliché. In some ways, share prices are futures markets for a company's dividend potential. Ruling out any company that doesn't pay a healthy dividend and looks unlikely to for a year or two yet will simultaneously rule out most losers.
Cash flowing freely?
Companies go out of business because they can't pay their bills as they've run out of cash. Ultimately, a company's value reflects its ability to generate cash.
Free cash flow is the cash left over for the benefit of shareholders. If a company generates cash beyond what it needs to maintain the business, its capital value is likely to grow over time. Using a price to cash-flow valuation as an integral part of your overall analysis will help rule out total losses.
Earnings?
As Peter Lynch says in "One Up On Wall Street", when deciding on a share: "What you're asking here is what makes a company valuable, and why it will be more valuable tomorrow than it is today. There are many theories, but to me, it always comes down to earnings and assets. Especially earnings".
Find companies that have demonstrated the ability to generate earnings whatever the economy throws at them. If it's jam-tomorrow you're looking at, be at least a little cynical and temper your judgement accordingly. Be particularly wary of companies which are continually on the verge of a new dawn -- or which repeatedly need to come up with new and innovative products to maintain those earnings.
No debt / low debt?
Increasing debt to fuel the rapid expansion of a successful and groundbreaking business may be no bad thing. But on the whole, excessive debt should be positively shunned by investors.
There are plenty exciting businesses around with no debt, and plenty of cash and other assets.
Operating owners?
Look for companies where the directors hold a reasonable (but preferably not controlling …) stake -- then ensure that they aren't paying themselves inflated salaries and emoluments.
Aligning your interests with those of director-owners usually pays off in the long term.
Understood?
If you don't really understand exactly how the company makes its profits and what it does, it's probably best left alone. We can't all understand the detail of course, but if you still don't understand the essence of the business despite several attempts to do so (and we've all been there!) then walk metaphorically quickly away.
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