When I first started investing I was bewildered by all of the information out there. It seemed like everything was conflicting – Warren Buffett believed in value stocks, and somebody else would say value stocks were rubbish. Who was right? Well, everybody can be. There are a lot of strategies that work in the stock market and nothing is ever black and white.
Work out your targets
When starting out, it’s important to be realistic about one’s targets. Wanting to double your money in two weeks is unrealistic, and the amount of risk required to hit that reward is, more often than not, going to result in large losses.
But that doesn’t mean you can’t aim to double your money. In fact, with a small portfolio we have the advantage of only having money to invest in our very best ideas. Whereas someone with a large portfolio may have thirty or even fifty stocks, we can pick just four stocks and invest £2,500 in each.
Do you want to be active?
If you want to be active, then you need to look at the costs of dealing and any ongoing portfolio charges. Most investors tend to over-trade and damage their own performance, and so very often the best thing to do is to hold onto the stocks they already own.
Those who bought Fevertree in the IPO at 170p probably thought they had done very well when the stock hit 1,000p, earning them over five times their money. But Fevertree continued to rally and hit a peak of over 4,000p last year!
Revenue is vanity, profit is sanity, cash is reality
When starting out investing we can afford to take on higher risk. One mistake I made when starting out was not paying enough attention to how cash moves through the business. One can do this by studying the cash flow statements, alongside the income statement and the balance sheet. You can find these when a company reports its interim or final results, and cash tells the real story.
For example, a company may be highly profitable on paper, but the cash might not be getting collected. A builder may take payment on completion, but the moment the job is accepted the builder books it as a profit. What if the customer decides not to pay? The work has been done, the profit has been booked, but the cash isn’t there!
Growth companies that are profitable and cash generative mean that the business is not reliant on shareholder funding to keep the lights on and pay director salaries. Look for businesses with strong management ownership too, as we want our executives to be entrepreneurial rather than clock-punchers.
Look at the company’s return on capital employed (ROCE) – this is the company’s own interest rate. What rate of return does the company generate when it invests in itself? Companies that generate high ROCE ratios have generally performed well in the stock market.