FIN203 Topic 7: Investing in shares

Active overlays

A fundamental investor might also utilise other active management techniques to gain insight into share prices and the market. For example, a value-orientated Australian equity manager might employ technical analysis as a trigger for when to start investing in an underappreciated stock or might have a quantitative filter at the start of their process. Technical and quant investors might also utilise fundamental overlays as well. Such processes can help an investor to 'triangulate' their various investment opportunities into best ideas.

Neutral investing

A neutral or core investor is not likely to pay too much attention to overall value or growth 'tilts', relying more on their overall bottom-up analysis of individual companies. The neutral investor is primarily concerned about the fundamentals of the company and how that is likely to translate into a return on investment (whether it be via a bargain price, steady income, good growth prospects or some other avenue).

Quant investing

An investor that utilises quantitative strategies to invest in shares will spend most of their research time on finding significant and exploitable patterns, or anomalies, in the market. The idea of quantitative investing is to then build automated trading systems and algorithms to buy and sell shares based on these market biases. Common quantitative anomalies include: • book-to-value outperformance bias • smaller company outperformance bias • day-of-the-week biases.

How to interpret the dividend yield

Analysts assess a company's DY by comparing it to similar companies, to industry averages, to the market as a whole, as well as to the company's DY of previous years. We would expect a normal risk-return relationship to exist (i.e. the higher the risk of the income, the higher the return (in this case, DY) we would expect the market to require). Consequently, a relatively low DY may reflect expectations of sound capital growth and quality earnings, while a high DY may indicate a low capacity for growth or uncertainty about future dividends in the minds of investors. Dividend cover must also be considered when comparing dividends (e.g. where two companies with similar prospects both yield say 6%, but one has a dividend cover of 2.2 times and the other has 1.5 times). To reiterate, dividend yields (and earnings yields) are theoretical returns only, as they assume a continuation of the existing dividend policy of the company, as well as sufficient net assets, cash flow and profitability to satisfy the solvency related tests in section 254T of the Corporations Act. The current market price of shares fluctuates daily. Any ratios based on market price must be used with care due to the numerous factors influencing market prices. Expectations in relation to the future flow of dividends are only one such share price driver. The DY is the income yield per annum to the investor (pretax) if shares are purchased on the stockmarket at the CMP. DY and market interest rates are related. With a fall in market interest rates (e.g. government bond rates), we would expect DYs to fall. This could occur through a rise in the CMP of stocks, as investors move funds from the bond market to the stockmarket. However, we cannot make a direct comparison between such fixed interest market rates and the DY, as the DY does not represent the total return of the share investment to the investor since it does not account for any capital gains or losses. In addition, dividends often carry imputed tax (franking) credits. As a result, care must be taken when comparing DYs with interest rates on fixed interest‑type investments. A degree of care must also be exercised when comparing DYs between different equity investments. For example: • Some companies are viewed as 'income' stocks and we would expect these stocks to have a relatively high DY compared to resource stocks that focus on exploration activities and are regarded as more 'speculative' in nature. • The DY might reflect the stage of the company's growth (for instance, in the early stage of a company's life, we would expect a relatively low DY compared to a mature and solid cash flow generating company). • Dividend yields between countries may not be directly comparable. For example, the US market generally has a lower DY relative to the Australian market, which partly reflects lower payouts of profits (i.e. lower dividend payout ratio) as well as lower bond yields in the US. The DY will obviously change as the share price moves. In times of high share prices, yields will typically be low if dividends are not increasing at the same rate as share prices. Conversely, the yield will increase if the share price falls. In calculating dividend yields, professional investors use estimates of dividends for current and future periods, rather than dividends which relate to past periods. As always, the key to investment analysis is to make judgments based on the prospects of an investment, not just on its history.

Financial forecasts and fundamental evaluation

Based on the above information and after consideration of the above risk variables, estimates can be made of the likely: • size and direction of corporate revenues, margins and interest rates • earnings and dividends of a company • financial condition of a company's balance sheet (i.e. gearing). In addition to forecasting the financial performance of the economy, industry and company, any fundamental assessment of a company's value must also be informed by the factors that translate the financial performance into asset values. What are the expected earnings worth? Some of the better known methods of calculating these asset values using the above earnings and dividend information include: • capitalisation of maintainable earnings • dividend discount model • discounted cash flows (DCFs). Students should note that most of the available valuation methods involve making numerous assumptions regarding various financial variables for the company being valued. These variables include forecasting revenues, operating margins, cashflows, debt positions, dividends, stock beta, interest rates and terminal growth rates. The outcome of these valuation models is quite sensitive to these inputs and can fluctuate significantly based on the accuracy of the input forecasts.

Contrarian investing

Contrarian investing is an investment style based on the premise that a stock or market is not going to move in the direction that is anticipated by the majority of market participants. Contrarian investors are independent thinkers who tend to move against the crowd. The contrarian approach is based on a belief that fundamental analysis and technical analysis tend to create a consensus approach to values, which are not always accurate. The idea is that stock prices are sometimes beaten down for reasons that do not correspond with a firm's longterm earnings potential. Conversely, stock prices are sometimes inflated based on hype that exceeds a realistic assessment of a firm's longterm earnings potential. Consequently, contrarians bet against popular investment trends, which appear to the contrarian to have gone too far.

Deep value

Deep value investing is related to 'margin of safety'. Deep value investing involves only investing in shares which are steeply discounted or display a 'margin of safety'. Such stocks are likely to have little downside, but have a large, potential upside

How to interpret EPS

EPS can be interpreted in two ways: • As a measure of entitlement: Net profit measures the total earnings generated by the company, whereas EPS demonstrates the proportion of these earnings that are attributable to each ordinary share on issue. EPS also has a relationship to dividend per share (DPS). Companies will often set a target dividend payout ratio. For instance, a company with a target 70% dividend payout ratio will aim to pay DPS equivalent to 70% of each year's EPS. • As a measure of value: EPS is commonly related to a company's share price to determine the time required (in years) to cover the share price (or an investor's purchase price if they are buying today) from EPS (refer to price/earnings ratio discussion below). However, EPS is one of several factors which drive share prices. Some elements which investors consider when assessing 'value' include: - the rate of EPS growth — both historic and forecast as well as relative to industry peers - the volatility in EPS and the nature of significant items - the dividend payout ratio - the level of franking - the quality of the earnings stream - the quality of management - the size and liquidity of the company - the opportunities available to the company for organic growth, acquisitions and strategic alliances - the potential for a takeover, merger or privatisation.

Earnings per share

Earnings per share (EPS) measures the earnings that are attributed to each equivalent ordinary share over a 12‑month period. It is one of the most commonly used performance statistics for publicly listed companies. It is a widely available measure owing to its inclusion in listed company financial reports. Forecast EPS figures also feature prominently in sell‑side analyst reports.

Economic moats

Economic moat is a term that was first used by Warren Buffet. An economic moat is the competitive advantage one company has over companies in the same industry. This is usually created by some kind of barrier to entry (hence the name 'moat') such as a pervasive brand or high initial capital costs

Key variables for fundamental analysis

Factors which may impact an industry sector include: • government legislation • technological innovation and new discoveries • competitive structure of the Industry. The level of internal competition across industries varies with the number of competitors, the ease of substitution of products or services, the market power or otherwise of the customers, the barriers to entry and the barriers to exit. Industry structure is often analysed within a Porter framework. Michael Porter, whose academic work in the 1980s was considered a significant breakthrough in strategic thinking, suggested that there are only three bases for gaining market advantage. Porter (1985) said that competitive advantage came from: • cost leadership — when 'a firm sets out to be the lowcost producer in its industry ... Lowcost producers typically sell a standard, or no frills product and place considerable emphasis on reaping scale or absolute cost advantages from all sources' (Porter 1985 pp. 12-13) • differentiation — when 'a firm seeks to be unique in its industry along some dimensions that are widely valued by buyers. It selects one or more attributes that many buyers in an industry perceive as important, and uniquely positions itself to meet those needs' (Porter 1985 p. 14) • focus — when 'the focuser selects a segment or group of segments in the industry and tailors its strategy to serving them to the exclusion of others' (Porter 1985 p. 15). Porter's point is that organisations need to operate according to some form of competitive strategy. Ideally, the strategy will offer customers something they value (e.g. lower prices, additional perceived value or specialisation and expertise). This is what the organisation then takes into the market and communicates to target customers (and audiences).

Fundamental analysis

Fundamental analysis operates on the premise that all stocks have inherent determinable values that are frequently but temporarily incorrectly priced by the market. The fundamental analyst will therefore evaluate stocks with a view to determining which stocks are at any point mispriced and therefore represent attractive investment opportunities. Implicit in the approach of fundamental assessment or evaluation of a company is the capacity to quantify the expected returns from an investment. Such quantifications of expected returns lend themselves to a ready comparison with returns expected from other stocks as well as other asset classes including cash and bonds. The fundamental analysis of company values has been around for decades and was popularised by the text of Graham and Dodd (Security Analysis) published in 1934. Fundamental analysis involves both an assessment of a company's financial performance and a valuation of that performance. A fundamental investor is only as good as the research that lets them identify opportunities in mispriced securities.

GARP investing

Growth at a reasonable price (GARP) is an investment style that tries to combine the best of both worlds from the value and growth investment styles. GARP investors look for businesses with a strong growth profile, but will only buy them if they are available at a reasonable price.

Growth investing

Growth investing involves selecting stocks with good growth potential. Growth investors emphasise higher than average compounding growth in earnings or assets. In other words, a growth investor will focus more on future earnings. Growth investors are focused on future potential with much less concern for the current price. These stocks generally trade at very high valuation ratios (high earnings multiples and low dividend yields).

Margin of safety

In investment the 'margin of safety' refers to investing in a security with a market price which is significantly below its intrinsic value. Intrinsic value is a concept based on the theoretical 'true worth' of an asset and is determined by its past record and potential earning power. Intrinsic value may exceed the value that could be realised by selling the asset.

How to interpret PER

Taking a relatively simplistic view, if a company is trading on a lower PER than its peers, then its share price could have the potential to rise such that it trades on an equivalent PER to its peers. A relatively low PER may indicate that it is a potential 'value' buy. However, further analysis would be required for an analyst or investor to establish the reasons for its apparent lower market rating relative to its peers and consequently, the potential for a 're‑rating'. A low PER relative to companies operating in the same industry may indicate that investors believe that the company is growing at a slower rate than the industry or that the quality of its earnings is low relative to its peers or that it has a higher level of earnings risk. A high PER indicates that either a better performance is expected from the company in the future relative to its peers or that it is being valued for its asset backing (i.e. brand names, mastheads etc.) and not its earning potential. Comparisons are often made to market average PERs. The most common practice is to compare the company being reviewed with its industry peers and also against the overall market. Analysts will also calculate PERs based on a company's forecast EPS for the forthcoming years (usually one to three years). The analyst must decide whether or not, in their opinion, the market has 'priced' the stock correctly. Broadly speaking, if the analyst believes that the market is undervaluing the stock, a 'buy' recommendation will be made to investors. Alternatively, if the market is overvaluing a stock, a 'sell' recommendation will be issued. 'Hold' recommendations are usually made if a stock is trading at or close to the analyst's valuation (i.e. the analyst believes it is appropriately priced).

Technical analysis

Technical analysis might be simply described as the study of price and volume data and their derivatives with a view to predicting future market behaviour at the micro or macro levels. It is applicable wherever there are freely traded markets, be they shares, commodities and currencies, or options and futures contracts. The underlying theory of this approach is: • the price/volume relationships give a clue to inherent strength or weakness • price series describe trends and patterns from which certain conclusions can be drawn on an empirical basis. It must be noted that these basic premises of technical analysis are inconsistent with the weak form of the efficient market hypothesis, which has found widespread support in the academic literature on investment markets. Technical analysts range from purists to those who believe that charts are one useful tool among many in making investment decisions. For the purist, all that needs to be known about markets is revealed in the charts; any fundamental information impinging on, for example, the nature of a company's business or its financial statements and management forecasts, or the price‑to‑earnings multiple, yield or asset backing of the inherent shares is worthless baggage that has no value in price forecasting. Technical analysts generally belong to groups of believers in particular systems or methods. These include those who hold that markets follow readable paths (e.g. the patterns described by Edwards, McGee and Bassetti in Technical analysis of stock trends to the intricacies of the Elliott wave principle, the work of Gann, the derivatives developed by Welles Wilder in New concepts in technical trading systems and others). However, many chart watchers are content to simply follow the development of trends, being aware of the relative strength of, for example, one share to another or to the market, or one commodity to another. Technical analysis tends to have more influence in the futures markets than the physical because of the rapidity of trading in futures and the absence of minutebyminute changes in the underlying fundamentals influencing commodities, bonds, foreign exchange and share index contracts.

Price/earnings ratio (PER)

The PER must be used carefully. It is often quoted (especially in the financial press) as the current market price (CMP) divided by the EPS for the previous financial year. The difficulty is that if the prospects of the company are significantly different from its historic performance, the PER will give a distorted view. The CMP is effectively a summary of the market's view of the company's prospects. Comparing this with what has occurred historically may be misleading. The price/earnings ratio (PER or PE ratio) is a gauge of market value. It indicates the time required (in years) for an investor to cover the current share price (or purchase price assuming they are buying at the current share price) from EPS. It is a means of converting earnings and share prices of companies to a comparable base. Therefore, it is a useful comparative tool. Most analysts and investors commonly refer to the PER to gain a sense of how the stock is valued both relative to its peers and the broader market. As a general rule, the PER is a good means of measuring the market's perceptions of risk and return for a particular company. It also provides a perception of future earnings growth expectations for the company. Share prices fluctuate daily, reflecting both stock and general market influences. In turn, a company's PER will not remain static.

Value vs growth styles

The two most common styles are value and growth. Relative value and growth strategies tend to have a negative correlation, i.e. when value outperforms, growth underperforms and vice versa. For example, the tech boom year of 1999 was a terrible year for value investors, yet was a great year for growth investors. This was followed by several years of value outperformance during the socalled 'tech wreck' years from 2000 to 2004. The mining boom then led to several years of strong growth outperformance in the second half of the decade, 2006 to 2010. And over the first few years of this decade, value stocks have generally outperformed as investors have cautiously stepped back into equities following the global financial crisis. According to research by Bernstein Research, large cap value managers in the US outperformed large cap growth managers by an annual average amount of 1.7% in the period 1969 to 2005 (BernsteinResearch 2007). Value investors argue that a short-term focus can often push stock prices to low levels, which creates great buying opportunities for value investors. From a historical trends perspective, growth investing generally provides exposure to higher returns in rising markets, whilst exhibiting a higher risk profile. A value investing approach tends to underperform during market upturn whilst outperforming in downturns.

Yield

The yield on a share is the dividend received and is usually expressed as an annual percentage. Yield stocks are often referred to in the media and these are shares that pay a higher rate of dividend. Dividend yield The dividend yield (DY) is the theoretical income return (pretax) on an investment in shares if they are purchased on the stockmarket at the prevailing price. It is a theoretical return because it assumes that the existing dividend rate (DPS) continues.

Thematic investing

Topdown investors are also described as themebased investors. Topdown or theme‑based processes are more often employed within the context of growth investing. In contrast, the only source of decisionmaking for a pure value investor is a fundamental assessment of the worth of a company relative to the current stock price (a bottomup approach).

Topic learning outcomes

Topic learning outcomes On completing this topic, students should be able to: • analyse the risks and returns from investing in shares • explain various investment styles • evaluate a company's performance using the results of financial ratios • assess a company's earnings quality • recommend an equity investment.

Value investing

Value investing involves selecting stocks that the market has underpriced relative to their 'true' value. Value investors emphasise a high level of current earnings or asset values relative to market price. Value investing typically refers to the purchase of shares in companies that have: • low pricetoearnings ratios • a high level of asset backing (low price: book ratio) • high dividend yields, or • a mixture of all three.

Company stock specific factors

• Management: management factors include strategic direction and corporate governance, experience, expertise, teamwork and track record. • Market position: considerations include maintainable market share, pricing power and maintainable corporate earnings. • Operating leverage: the extent to which sales, and therefore earnings, respond to changes in economic environment via changes in labour and capital productivity is significant in evaluating a company. • Financial leverage: look also at the extent to which operating leverage is magnified by fixed cost financing, and the impact of this leveraging on capital adequacy under the various economic and operating environments. • Solvency: finally, check out the ability to meet current monetary obligations with existing cash flows and/or lines of credit.