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Smart Investor: how to analyse investment targets

Justifying 'gut-feeling' decisions is all too easy, says Smart Investor, making a consistent approach essential.

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by Smart Investor on Nov 08, 2011 at 02:01

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Smart Investor: how to analyse investment targets

A consistent approach to analysing investment targets leads to meaningful comparisons and better decisions.

Moving the goalposts

When it comes to the question of whether to buy shares in a particular company, it's always possible to find reasons why you should invest. This applies to every listed company in the UK and is a fact that, in my early days of investing, caused me to make a number of poor investments.

Of course, my big mistake was that I lacked a plan. Instead of assessing companies based on a range of factual information such as return on equity, gearing, interest cover and cash flow, I used different measures for each company; even ignoring any ratios that did not fit in with my own ‘expert’ view of the company.

For instance, I would analyse (if you can call it that) a retailer, perhaps something like Marks & Spencer (MKS.L) or Next (NXT.L). I would look at things such as like-for-like sales, general retail sales figures, price-to-earnings ratio and even wander into one of their shops for 10-15 minutes to see if there was any ‘activity’ at the tills. I would base some of my ‘analysis’ on quite ridiculous methods such as whether my own purchases/dealings with the company were satisfactory or otherwise.

Then, when analysing another company in a different sector, I would use completely different methods. For example, if I were ‘analysing’ a technology company I would try to estimate how successful their product could be in future and whether there was much competition or any rival technology in existence. Furthermore, I would disregard some of the methods used when analysing other industries, for instance a high price-to-earnings ratio would be fine for a tech company but not for a retailer.

Consistency is key

The only thing that was consistent about my ‘analysis’ was that it was inconsistent.

This was in my early days of investing and, since then, I have found that a consistent, organised and methodical approach to analysing companies is not only far more accurate and successful, but provides a great deal more confidence and sanity.

For example, let’s assume you used the methods described above when ‘analysing’ a retail or tech stock and, after investing in it, the share price fell dramatically. As a result of you having little grip on the facts reported in the company accounts, you are likely to become fearful and may even consider selling your holding. At best you are likely to worry about what could happen next.

However, if you had checked even a small number of ratios and had found the company to be financially sound, performing well (the company – not the share price) and reasonably priced then you will inevitably feel much more comfortable about short-term share-price movements. This added ‘sanity’ should not be underestimated. Thorough analysis of facts and figures rather than ‘punts’ or gut-feeling is likely to lead to higher profits, and it could help you sleep better too.

Beat the pros

Unfortunately, my own experience of financial services professionals leads me to believe that the ‘analysis’ described at the start of this article appears to be quite widely practiced. Fortunately, there are exceptions, and Citywire is a great way of keeping track of which funds and fund managers have demonstrated a sound approach to investment.

However, my own belief is that you, the private investor, have it within you to do a better job than the professionals. Investing is not complicated but does require a certain level of discipline: if you can stick to the facts and leave your emotions at the door, you will have a decent chance of generating satisfactory returns.

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6 comments so far. Why not have your say?

Thanks for yet another common sense, clearly written article.

You've explained some of the ratios you like to use, for example, to assess the debt and risk of a company; maybe you'd like to do some articles explaining your interpretation of ratios one at a time.

I look forward to what you have to say on corporate bonds; just worked out a few facts re. the euro bonds I hold and have these figures.

1. Average annual interest as a percentage of maturity value = 7.88%

2. Average annual interest as a percentage of price paid = 11.349%

3. Average price paid = 69.435 cents per euro nominal value

4. Maturity value/Purchase cost = 44.02%

5. Lowest coupon = 4.95%, highest coupon = 11.25%

6. Lowest annual interest based on purchase price = 8.94%

7. Highest annual interest based on purchase price = 15.31%

I still have to update the yields on present market values; obviously if prices are now less than paid the yield will have gone UP and if the market price is higher than what I paid the yield on the market value will have gone DOWN compared with what I paid for a particular bond.

The bonds held will have a substantial capital gain if held to maturity (44.02%) provided none default. The yield to maturity is obviously far higher than the annual interest yields I have shown but my annual income from these bonds is of prime importance and, with a good annual yield, it is possible to reinvest from the income generated to increase both income and maturity values.

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@Robert Court

Would be very interested to see a breakdown of your portfolio ( No £ values! )

My Stocks and Shares ISA is predominantly Prefs and Corporate bonds but all UK based - so would be interested in more details of your Euro bonds as the returns ( and risk? ) seem far greater.

Thanks

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Re Marks & Spencer and Next you refer to " like for like " sales. I presume this is to take out sales in new outlets so that a direct comparison can be made with the prior year outlets. Is this, however, a justified comparison?

I ask the question because,as an example, in my own locality Asda opened a new store in the neighbouring town . The 2 stores are a maximum of 2 miles apart. Custom will undoubtedly have shifted from the original store to the new but overall sales in the area will have risen substantially.

In light of that increase it doesn't seem logical to discount the overall performance because the original stores' turnover has reduced.

Would Smart Investor p[lease comment.

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@ Jaymark

I worked in retail for a spell. Like for Like (L-L) means just that - you ignore the new stores of less than one year from opening and you also adjust the previous years comparison for store closures and stores that were not opened one year then but are now.

Now the interesting bit the L-L period. No hard and fast rules when I was there and not aware of any changes since. This means that you can give any period provided you state what the period was, compare it with the same period last year and (I think) it covers at least part of the same period disclosed the previous year. Thus one year we dropped a poor week which the previous year was a good week (fickle shoppers!) and instead of reporting L-L of say +1% we could report +4%.

For investing I always look at L-L with a large pinch of salt!!

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The ratio analysis and facts of comapny will help to understand the company performance . However stock market valuation of company against Net asset of comapny different and hence how do you value the comapny?( use pe or some multiplier to sales, ne asset etc).These multipliers are market driven.

In my opinion investing in market and sleepless night is driven by many factors and hence do analysis but take the PUNT .

Market is made up of buyers and sellars for the SAME comapny.

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Robert Court

Nov 09, 2011 at 07:12

David Tate

Ok, but the price I paid for them is what counts as it affects both the annual interest return AND capital gain on maturity.

EUR

4.75% BARCLAYS PLC 2020-49

6.258% SNS REAL GROEP NV 2017-49

6.644% AXA 2011-49

8.5% LABCO SAS 2018

9.25% GROUPE BPCE 2015-49

9.375% EUROPCAR GROUPE 2013-2018

11.25% SNS BANK NV 2019-49

The above give an annual interest only income [i.e. excluding any capital gain to maturity] of 11.349% net of all trading costs based on actual purchase costs.

GBP

9.334% LBG CAPITAL 2020 yielding 10.497% annual interest based on average purchase cost of 88.92.

I am NOT happy with the above and am moving to a better spread between the banking and non-banking sectors and increasing the number of bonds held to 20+

39.47% in non-banking as % of maturity value at present is too low.

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