Stockmarket falls provide opportunities


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If you think people are overpaying for houses and apartments, especially in Sydney and Melbourne, you should have a quick look at the stockmarket. The prices some people are paying are way beyond crazy - the housing markets look sane in comparison.

That said, many people like the lack of volatility in property, but this is illusory. Shares appear volatile because they are on the market for sale every single trading day. If your house was on the market every day of the year you would also expect the price to jump around, depending on the mood and appetite of the prospective buyers. But stockmarket volatility is no bad thing. For those who have a strong sense of value of a company's worth, it creates opportunity - for buyers and sellers.

That's why big dips in the market are frequently greeted with whispers of takeovers and big equity positions being accumulated. You are not the only investor running a ruler over companies.

Best time to invest in shares

The problem for most share investors is that they never pick up the balance sheet of the companies they buy into. They never examine the cash flow statement (the one part of an annual report that is usually very difficult to fudge) or try to work out the future funding needs of the companies.

So they get surprised when a company reveals a poor trading period, which sends the share price scuttling south, with the aid of short-sellers profiting as the price is cut.

There are broadly two types of share falls: those triggered by individual company circumstances (which cause it to issue a profit warning or to raise more capital from shareholders) and a broad market decline (caused by nerves about China, interest rates or the overall economic outlook).

The best opportunities are generally found in the broad market falls, because better-performing companies are caught up with the dross. The problem is sorting out the good from the bad.

My starting point is often a company's dividend yield and price earnings (PE) ratio. But be warned: this can be fool's gold. All investors are seeking high dividend yields and low PE ratios. But if a company has structural issues in its business or balance sheet, a high yield and a low PE ratio can also illustrate a share on the rapid decline. Remember that the PE ratios and yields you see published in newspapers and on websites are based on historical information.

Among those companies - from the top 200 - that have seemingly attractive yields and PE ratios are Cash Converters, IOOF and Patties Foods, all of which have been put through the wringer in recent times. You need to study the companies even more closely, because if they recover their reputation or business model the upside could be significant. Look at Qantas shares rising more than 200% in the past 18 months as a classic example. The stockmarket is about the future, not the past. Investors are always trying to interpret what will happen to the economy and how that will affect a company's profits. Stronger profits and higher dividends will inevitably lead to higher share prices - exactly what investors seek.

For this reasons the PEG ratio was created. The "price earnings growth" figure is calculated using the average profit per share forecasts of broking analysts that follow individual companies and then comparing them with the current price. The rule of thumb is that a company with a PEG ratio less than one is considered good value; those with a PEG ratio over one are not such good value. Using Bloomberg data, I have collated the most recent PEG numbers for some of Australia's most popular shares: CBA 3.44, NAB 2.69, Harvey Norman 2.57, Telstra 2.43, Coca-Cola Amatil 2.23, Medibank 1.88, Wesfarmers 1.79 and QBE 1.12.

The closest PEG ratio to the magic number one is QBE Insurance, in which I must declare an interest (perhaps it shows how faithful I've been through its travails).

But, more to the point, banks and many other industrial shares are still vulnerable to falls if there are shocks to the local or global economies. If the shares above are to justify their high ratings, they must deliver surprisingly high profit growth numbers - much higher than the broking analysts are forecasting. If you buy shares at these levels - as with Sydney or Melbourne houses - you are not buying a bargain. You buy assets at a premium that will rely on plenty more going right in the future.

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