Learning how to manage your money is one of the most important skills you will ever learn, and the sooner the better.
If you don’t have time to do this, you can always pay someone to do it. There are plenty of financial advisors and investment funds out there, some better than others, that will tell you where to put your money.
At first glance, it can seem like a no-brainer to simply let the experts take care of your money. After all, you wouldn’t attempt to fix your own pipes, you’d call a plumber, someone with specialized knowledge
However, there are a few problems associated with investment funds and financial advisors. Their interests, may not be necessarily aligned with yours, and on top of that, you are subjecting yourself to some hefty fees.
Let’s take a closer look
The problem with Investment Funds
Mutual funds, usually, charge annual fees in the form of an investment expense ratio. This means they charge you a fixed percentage of your investment every year. If you are investing 1000 pounds, this means they will take 10. However, if you are investing £250.000 you will be paying £2500. That’s a lot of money.
On top of that, funds may charge you a fee when they buy the stocks for you or when they sell them, in other words, when you want to cash out.
We normally refer to these as upfront load and back-end load.
The upfront load is the amount of money some mutual funds charge for buying your shares. For example, if you invest £10,000 in a fund that charges 2% upfront load, £200 is deducted right away and only £9,800 is invested.
Back-end load, or redemption fee, is the amount of money some mutual funds charge for selling your shares. For example, if you are selling £10,000 out of a fund that charges 3% back-end load, you’ll walk away with only £9,700.
When a fund is given money by a client, it can’t just leave it sitting around, the fund has to invest the money pretty much as soon as it gets it.
This means that, often, the fund will have to make purchases that it might not have considered otherwise, simply because of the way the fund works.
The fund manager will be forced to buy shares at a price higher than he/she would like. He cannot afford to wait for the price to change.
Moreover, funds will usually be somewhat “limited” in the stocks they can actually buy. A fund normally has a specific way or sector they invest in. Using their clients money in a different way, even if it’s a good investment, would be dishonest. For example, if it’s a “Small Value Fund”, the manager cannot buy a “Large Growth” stock even if it represents a better buying opportunity.
Although we have explained the virtues of diversification before, too much of it can be a bad thing. Because of the point explained above, it’s common for fund managers to end up buying too many stocks, instead of focusing on the more profitable stocks.
Just how funds are forced to buy shares, they are also forced at times to sell shares. When people want to redeem their money, the fund is forced to sell shares to get cash. They might have to sell when it’s not the best moment. In fact, many funds go under because of this phenomenon.
During a market correction or bear market, lots of people will want to extract their money from the fund, this is likely the worst time to get out of the market, and it will force the fund and all its participants to share the burden.
Lastly, mutual funds have some downfalls when it comes to taxes. You could owe tax even if the value of your investment is going down! When a fund sells a stock for a profit they must pay annual capital gains distribution, more precisely, you have to pay capital gains tax. If your timing is bad, for example, you buy just before the fund makes its capital gains distribution or you buy during the year that the fund manager is taking a lot of profit, you could end up paying a very big tax bill.
For this, and many other reasons, I always recommend people to read and learn. Even when I am giving someone advice, I wouldn’t want them to just take it for granted. When I make a stock pick, it’s as much a recommendation as it is an invitation for you to research that stock thoroughly.
In the rest of this article, I’ll be showing you how to do just that.
Researching and picking stocks: Fundamentals
I’ve explained my investment philosophy already. I don’t believe in short-cuts or miracle investments. I believe in the importance of saving and investing, over a long-term, in companies that add value to society. I do this, not only because it makes me money, but because it actually feels like a noble cause. By investing in a good company, you are contributing to bringing happiness and well-being to people.
The fundamental point of value investing, and I’m probably quoting a few people here, “buying the company, not the stock”.
A company is much more than just a bunch of numbers. It’s a living, breathing entity. Every day things are happening, changing, and they are all relevant to its future performance and value. Value investing is an ongoing thing, it’s not enough to pick a good company, you have to follow it regularly, keep up with news and changes, especially in things such as leadership.
So don’t be shy about using any and all information you have to make judgments about the company and develop an opinion.
Having said this, numbers are a very important factor in your decision. While numbers don’t explain everything, everything can be explained by numbers. Looking at a companies balance sheet and earnings will always be the best way to find out how healthy it is.
So let’s look in depth at how this works.
The P/E ratio: This measures a company’s current share price relative to its per-share earnings. It’s calculated by dividing the market value per share by earnings per share. A good rule of thumb for value investors is to look for stocks with a P/E less than 40% of the stock’s highest P/E over the previous five years. Generally, we are looking for a low P/E ratio.
In recent years, P/E ratios have gone through the roof. Companies such as Yelp have P/E ratios of over 400. This could be symptomatic of a market bubble in the makings. On the other hand, certain companies have proven that these valuations are justified in the long-run.
Price-to-book (P/B) ratio: This metric compares a stock’s market value to its book value and is calculated by dividing the current closing price by the latest quarter’s book value per share. Typically, value investors seek companies with P/B ratios that fall below industry averages. The book value is simply a sum of all the assets things the company owns which have value)
Analysts use this comparison to differentiate between the true value of a publicly traded company and investor speculation. For example, a company with no assets and a visionary plan that is able to drum up a lot of hype can have investors drooling over it. Thus, causing the stock price to increase quarter over quarter. The book value of the company hasn’t changed though. The business still has no assets.
A P/B ratio above 1 indicates that the investors are willing to pay more for the company than its net assets are worth. This could indicate that the company has healthy future profit projections and the investors are willing to pay a premium for that possibility.
If the market book ratio is less than 1, on the other hand, the company’s stock price is selling for less than their assets are actually worth. This company is undervalued for some reason. Investors could theoretically buy all of the outstanding shares of the company, liquidate the assets, and earn a profit because the assets are worth more than the cumulative stock price. Although in reality, this strategy probably wouldn’t work.
Debt/equity (D/E) ratio: D/E measures a company’s financial leverage and is calculated by dividing its total liabilities by its stockholders’ equity. Equity is equivalent to the funds provided by shareholders. Liabilities are things that the company still has to pay for. A debt to the bank, to a supplier etc. We are essentially comparing how much of the company is financed by the owners and how much is financed by creditors. Remember though, that this ratio, like the P/E ratio, is industry specific, so we can’t use it to compare companies from different industries.
Companies with a higher debt to equity ratio are riskier than companies with a lower ratio. Unlike equity, the debt must be repaid to the lender. Until the debts are repaid, interest payments must also be made to the lender.
Earnings growth of at least 7%: Furthermore, there should be no more than two years of declining earnings of 5% or more, during the past 10 years.
These are some of the most important things to look at and will give you a good indication of where the company is at.
Finally, remember to always give yourself a margin of safety. What does this mean? If you have done your homework and had determined the intrinsic value of a company to be £25, it doesn’t mean you have to buy it for £24. Something like 20-21 is probably a more prudent buying price. Give yourself a margin of error.
Finding and sifting through all this information is almost as hard as knowing what to do with it, if not harder.
The easiest way of getting it is going to the source. Visit the companies´ websites and find the shareholder’s section. It will be filled with reports and financial statements. If you can’t find anything, don’t be afraid to email or call a company directly and ask them.
Public records of business activity are also available in most cities and are available to the public upon request.
Find a list of companies and just work your way through. Or even better, make a list of companies you are personally interested in and try to find out more about them.
However, be wary of the information given to you by a company itself, as it won’t be completely truthful and will probably try to highlight the strong points while hiding its weaknesses. Learning to detect these accounting tricks is an art in itself.
Lastly, If you are interested in learning more about value investing I invite you to purchase or download any or all of the following books.
- The Intelligent Investor by Ben Graham
- Security Analysis by Ben Graham and David Dodd
- The Super-Investors of Graham-and-Doddsville by Warren Buffett
- Antifragile by Nassim Talib
- Irrational Exuberance by Robert Shiller
- Conscious Capitalism by John Mackey
- The Education of a Value Investor: My Transformative Quest for Wealth, Wisdom, Enlightenment by Guy Spier