Make money in the markets the common sense way

Posted on: 14 September 2010 by Clem Chambers

A lot of people look to begin investing in stocks but find it hard to find a place to start. For a beginner things look complicated. To start with it can be a bit bothersome to open a stock brokerage account. With all the new rules to stop money laundering, getting ready can be laborious.

Financial markets

Then, once this is done and the account has money in it, where should an investor begin?

The obvious place is to look for tips in the newspapers but this can be like putting your faith in a stranger. So how should a novice investor start selecting stocks on their own?

There is a tried and tested way: it’s called value investing. Valuing investing is investing in shares worth intrinsically more than their current price.

It might seem funny that there can be “cheap” stocks but anyone who tracks shares long enough will notice a fairly big ebb and flow in any given share price even within the timeframe of a year. Shares can be cheap and there can be many reasons for this. I’ll list a few:

  • A share might be in a sector that is unfashionable. We can all track stocks that are flavour of the month, the high flying stocks that have hefty valuations and are “expensive.” The opposite is also true for the ugly duckling stocks. They are unloved and cheap yet can still have solid businesses. You can buy into them cheaply and wait for the market to catch on.
  • A company can have suffered a temporary problem and the market, often being driven by fear, will mark it down very heavily. In due course the company can recover lost ground.
  • A company can be very boring, with its management failing to hype its profile. A company that fails to get itself profile invites predators, so an investor need only stake out the company and wait for a takeover.

These are a few examples of how companies can get cheap.
Having explained this, the question becomes: how do you find companies that fit this bill?
This is where the P/E ratio comes in. Roughly speaking, a P/E is how many years it takes to buy a company with its own profits. So a 10 P/E means the company is worth 10 times its profits.

The smaller a company’s P/E, the lower the value of a company as the ratio to its yearly profits. So if the P/E is 100, it takes a hundred years of profits to buy the company. If the P/E is five then it only takes five years. A low P/E often indicates potential cheapness.

While the P/E is derived from past performance in the UK, Americans tend to look at the future estimates of profits. The UK way is best as while the future is unreliable, the past isn’t.

There are a few wrinkles. A company that did not make money last year has no P/E and one that made a little might have a giant one of 1000. A company that has imploded recently but made profits last year may have a P/E of one.

However a P/E under 10 is a good place to start looking for cheap but solid companies.
Then there is a dividend. A beginner investor should be keeping it simple and the existence of a dividend is a good sign a company has cash to spare - the bigger the dividend, the better. Again an imploding company may have had a dividend last year and based on that, it might seem it could pay a 15% dividend or some such huge pay out. You should always make sure nothing has gone horribly wrong before you invest.

Even so, some of the UK’s finest companies are paying six, seven or even eight percent dividends.
At this point you may be wondering how you get this information. It’s widely available on the web and has all these kinds of figures for free. It even has a tool to strip away companies that don’t fit your investment criteria; a tool called FilterX. There are other places on the net you can go too. A quick play with Google should throw up some alternatives.

So to start off, pull up all the companies in the UK with a P/E less than 10, and to avoid the silly end, exclude those with a P/E less than three.

Then you would strip out all the companies with no dividends and refine the remaining to those with a dividend less than 10% but over 1%.

Because you are starting out, it’s best to stick to investing in the big boys, so you would discard any company with a Market Cap (the company’s total market value) less than £500 million.
As I write, there are 23 companies on the London Stock Exchange that fit the bill; companies including the likes of Vodafone and AstraZeneca.

However the job is not over; you still have to look into the companies to make sure you approve of them. To do this you read the market news called RNS.

RNS is the official news of the company released through the stock exchange. ADVFN has over ten years of RNS so you can get a company’s history chapter and verse. You can trawl the internet too.

BP is on the list of 23 and it might be a smart buy, or it may be a stupid one. With 23 stocks to choose from, only by rummaging in the news can you properly decide.

One good indication you’re on to something is that the directors of the company are buying shares. You can find this in the RNS too. It’s obviously a good sign if the directors are filling their boots!

Next, list the candidates together and rate them by the factors you like, out of 10. So a company could be a nine score on dividend, a six on P/E, a three on directors’ buys, a four on overall company size and a seven on some other selection criteria you are using. Multiply the scores out and consider buying the highest scoring one or two.

Remember the list will be changing over time, so there is no hurry to jump in. What’s more the research will stick and develop your skills.

Don’t be put off by how simple this is. The best way to make money in the market is with common sense.

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