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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.
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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by Gavin Lumsden on Dec 10, 2013 at 16:51