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What every beginner needs to know about picking stocks

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Even more so during these highly volatile times, it's important to understand what kind of investor you are, and how that should inform your stock picking decisions.

Here's a breakdown of what to look for in a stock based on your investment objectives.

Income

how to choose a company to invest in shares

Australians are obsessed with dividends. Either as a result or because of this obsession, many Australian companies pay dividends, usually twice a year.

Calculating a company's dividend payout ratio is the typical way investors gauge how friendly a company is towards dividends. There's a few ways to do it, but the most common is to divide the total dividends paid by the company's net income or its earnings per share. The higher the ratio, the more dividend 'friendly' the company is.

However, investing for dividend yield can blind your view of a stock's quality. Paying out dividends is not an obligation, unlike a bond coupon or the interest you receive for keeping your money in the bank.

Many income investors have been lured to the market in the search of high yields, only to be disappointed in recent times as covid-19 saw a massive pullback in prices and eroded their capital base.

"Most income investors - unlike growth investors - are short-term focused," says Elio D'Amato, executive director of research firm Lincoln Indicators.

"And rightly so. If they are investing in the market for income then the dependability of the dividend every six months (or in the case of REITs every three months) is crucial as most income investors seek the yield to meet living expenses and to fund their retirement."

However, blindly seeking stocks that pay the highest yield is a strategy fraught with danger. Yield is a function of price, so if the price falls the dividend yield improves.

"Higher yields mean there has been larger falls, but the price decline may in fact be reflective of an underlying issue within the business," says D'Amato.

To avoid this, D'Amato says investors should look for dividend stocks that have demonstrated strong profit growth. It should never be about chasing yield at all costs, he says.

It's also worth remembering that paying out dividends does little for a company's organic growth, since every dollar of dividend paid out to shareholders is one less the company can re-invest to drive revenue. Sometimes companies even borrow money to pay out dividends if their cash flow doesn't facilitate it.

Moreover, the value of dividend stocks can quickly evaporate when interest rates and bond yields become a more attractive, and safer, bet. And if the dividend is cut, you can be left with a stock that isn't providing income and has depreciated in value.

Investing for growth

Growth investing strategies look for stocks that have the potential for high future growth. For this reason they're usually emerging companies in existing markets or established companies in emerging markets. Often they're touted as the next big market disruptor, such as Amazon on Netflix.

With growth companies, it's less about what they currently earn and more about their potential to earn in future years.

Many don't yet turn a profit - instead they fund their growth through debt or equity, and any money they do make is invested back into the business.

Growth stocks are high risk and high reward. They have the potential for mouth-watering returns, but also are usually highly volatile - they tend to outperform during a bear market, but conversely underperform during bull markets.

It's no surprise, moreover, that if you're investing for reliable income, growth stocks are not the friend for you - they generally don't pay dividends either.

Value

Value investors capitalise on the difference between a stock's intrinsic value and the price it's trading at in the market. The idea is that you buy stocks at less than their intrinsic value, what notable economist and investor Benjamin Graham termed as "the margin of safety".

Now more than ever, value and price are moving in opposite directions. The back end of March clearly showed "an asset's price can diverge from its value and remain that way for an extended period of time," says Drew Meredith from Wattle Partners.

"At present, this is occurring across nearly all asset classes from bonds to equities and commodities. They may not be solely focused around valuing a company, but more so around determining the 'investability' of a company."

Value investing isn't for the faint hearted.

"Prices can swing from periods of euphoria to despair very quickly with little concern placed on the current valuation," says D'Amato.

"Take the current market for example. In the lead up to the peak there were many stocks that were overvalued.

"Since then we have had a correction, not only eroding the previous premiums, but rather than returning to fair value, we are seeing large discounts appear as well as prices continue to fall."

For a stock to be 'cheap,' it has to have a current market price which doesn't reflect the more positive opinion of those that are analysing the business.

"This can occur because the market (as reflected by the current price) may have an even more pessimistic view on the business and its prospects, and will therefore discount it," says D'Amato.

On the flip side, a company that is a great business and has seen its share price appreciate strongly will often be considered as 'overvalued'.

However, investors who sit on the sidelines and avoid a great company because of valuation are also left to lament as price continues to run and the stock retains its quality and becomes more expensive, he says.

So how do you establish the value of a company?

There are many ways to go about it, but most of them have to do with understanding their earnings, cashflow, and debt.

Price to earnings (P/E)

Possibly the most widely used measure of value is a company's price to earnings ratio, calculated as the price of its stock divided by the amount the company earns per share.

Like any valuation metric, it needs to be understood in context.

For example, Ned Bell from Bell Asset Management calculates a total expected return (TER) for every name that it considers investible.

"We do that by applying a target P/E multiple to our earnings per share (EPS) estimates two years from now, which gives us a target price. The difference between the target price and current price is our TER," says Bell.

Price/earnings to growth (PEG)

Some professional investors incorporate the PE ratio into a growth forecast by using a price/earnings to growth, or PEG, ratio. It's calculated by dividing a company's PE ratio by its expected earnings growth over one, two or even five years.

"We value the PEG ratio more than the PE ratio as it gives an idea as to where a company is heading," says Meredith.

"Traditionally, a low PE ratio suggested a discounted company, but the same company with a high PEG ratio may indicate its earnings are likely to fall in the coming years. PEG's are best used to compare within industries, with a result under one preferred on simple valuation terms."

Return on capital (ROC)

ROC is effectively a measure of how well a business is using the capital you have invested to generate returns. This one is measured as net profit less dividends, divided by the value of the company's debt and equity.

"The most important use of this data is comparing it to a company's weighted average cost of capital (WACC) - being the cost of debt and equity used to fund its operations," says Meredith.

"If the return on capital is lower than the weighted average cost of capital, then the company isn't really benefitting its shareholders."

Leverage

Another important factor often used to assist in valuation is a company's leverage - the amount they're financed through borrowed funds.

Meredith believes that focusing on a company's leverage may be the difference between a failing and profitable investment decision.

"The term 'Zombie companies' has increased in popularity lately, driven by the huge amounts of low cost debt available to businesses. In this case, we measure a company's leverage or solvency by dividing their earnings before interest and tax (EBIT) by their annual interest payment. Clearly, those companies whose earnings are below the interest on their debt will be the first to face pressure in a difficult economic environment," he says.

Cashflow

Cash is kind, as the saying goes. This well-worn phrase applies to stock valuation.

Two common methods for gauging a company's cashflow is the free cash flow (FCF) and discounted cash flow (DCF).

FCF is calculated by subtracting capital expenditures from operating cash flow (the amount of cash brought in within a given time frame).

"It tells you whether a company is actually able to turn its revenue into cash to pay its bills, or simply paying a large cost to acquire new customers," says Meredith.

Macro filters

Value investing relies on "bottom-up" analysis, of which most of the above metrics are. But it also involves "top-down" analysis.

Bell Asset Management, for example, begins by focusing on the bottom 28% of the MSCI World Index and then applying a filter for companies that have generated more than 15% return on equity (similar to ROC, but using investor equity rather than capital) for three consecutive years.

This leaves about 700 companies. After some further prioritisation and judgemental quality assessments - they end up with roughly 150 companies from which to invest.

In a similar way, Fairlight Asset Management screens out sectors with too much debt, such as property or agriculture, and highly cyclical businesses, such as banks and oil and gas businesses. Businesses that fail ESG filters are also screened out.

Fairlight also focuses on developed international markets, such as the US, Europe, the UK, and Japan, where currency can help buffer equity market drawdowns.

After this step, Fairlight removes businesses that generate low ROC (low cash generative companies). Those carrying too much debt or issuing excess equity to fund acquisitions or compensate management are also eliminated.

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David Thornton is a journalist at Money magazine. He previously worked at Your Money, covering market news as producer of Trading Day Live. Before that, he covered business and finance news at The Constant Investor. David holds a Masters of International Relations from the University of Melbourne.
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