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Its future prospects that matter, but past data helps.

Photo of Michael Kemp By Michael Kemp, author

The Holy Grail for most sharemarket investors is to achieve market-beating returns. If that's your goal it is important to realize you will be pitting your stock-picking skills against plenty of savvy investment professionals who have devoted their careers to the process.

That might sound a bit like shaking the dust off your old High School tennis racquet and taking on Roger Federer. But the reality is, armed with some solid investment principles the investment game does not have to be so one-sided.

To help you on the road to success, this article examines some common mistakes investors make when analysing companies.

1. Blindly relying on historical data

Common sense tells us that investing is all about the future. After all, we only invest money today in the expectation we will receive more back later. But one of the toughest questions in investing, and also in trading, is how do we get a handle on what's going to happen in the future?

Eighteenth-century politician Patrick Henry addressed this issue when he said, "I know no way of judging the future but by the past." He was not referring specifically to the sharemarket but it is certainly how the market behaves. How often do you see the share price of a company soar or collapse immediately following the release of a surprise profit result? Which shows that the market judges future profitability, embodied in the current share price, by past results.

So the question must be asked: when analysing companies, does past performance provide a useful guide to future performance? Like most things to do with investing, there's a dichotomy of opinion on this issue. Consider the findings of sharemarket researcher Ian Little, who concluded from his 1962 study on company earnings growth that: "Any unbiased reader of this chapter must come to the conclusion that there is no tendency for previous behaviour to be repeated in the future."

Confused? I don't blame you. Personally I deal with the problem by varying my use of the rearview mirror depending on the company I'm looking at. For example:

  • I place more faith in historical data as a guide to the future if the company is operating in a relatively stable business sector (for example, utilities and consumer staples).
  • I also place more faith in historical data if the company has greater control over the prices it charges for the goods and services it sells and has a dominant position in its sector.
  • When considering cyclical businesses such as mining, building and discretionary retail, I tend to look at long-term averages of historical data (10 years), so as to "flatten out" cyclical variations.
  • Finally, all this rear gazing needs to be tempered with a solid appreciation of the dynamics of the business, its future prospects, the competitive forces within the sector in which it operates, and a balanced view on what the future could possibly deliver. In other words, understanding the company is essential

The mistake many investors make is to rely solely on historical data. They plug it into "black box" formulae, and then trust the output. But as investment great Ben Graham said: "There must be plausible grounds for believing that this average or this trend is a dependable guide to the future."

2. Selecting stocks simply because they have a low Price Earnings (PE) ratio

There are several challenges. First there is the often stated problem of how the PE ratio is calculated - by dividing the current share price by the last reported earnings per share. The problem is the numerator (the current market price) is continually updated but the denominator (the earnings per share) is only as current as the last financial statement. Therefore, price-sensitive information, released since the last earnings report, will be incorporated into the numerator but not the denominator.

That means recent bad news can see a conventionally calculated PE fall, sending out a false signal that the company's shares are cheap. In an attempt to overcome this deficiency, the PE is often calculated using estimates of future rather than historical earnings.

Second, a less appreciated problem is that PE ratios of companies are rarely directly comparable. That is because the PE ratio is dependent upon a number of variables; for example, market expectations regarding the company's return on equity, growth in earnings, and its operating and financial risk.

Vary these and the "justifiable" or "fair" PE also varies. And because it is extremely unlikely that any two companies carry the same combination of these variables, comparability based solely on the PE ratio is ill considered.

3. Chasing dividend yield

I appreciate that the size of a company's dividend is important to many investors, particularly retirees. But selecting a single stock purely on the basis of its dividend yield (annual dividend divided by the current share price) is a mistake many investors make.

The first problem is, like the PE, it is calculated using measures that are mismatched with respect to time. It is typically calculated by dividing the historical annual dividend by the current share price. Perversely, the dividend yield can increase following an announcement indicating the future dividend could fall (if the announcement causes the current share price to fall).

It might also surprise some shareholders to learn that it is not always in their best interests to receive a dividend. If their company is bristling with new investment opportunities, all capable of delivering a great return on reinvested funds, then shareholders should prefer profits to be retained by the company rather than paid out as a dividend.

If management can profitably reinvest the money, what shareholders lose as a current dividend should be more than compensated for by future appreciation in the share price.

One of the world's most successful companies, Berkshire Hathaway, has not paid a dividend since 1967. It's CEO, Warren Buffett, has been heard to say: "If you want a dividend then just sell some shares." At the current market price of US$223,600 per share, you would not have to sell many shares to be paid back those dividends you think you missed out on.

4. Paying too much for growth

A common mistake investors make is to select stocks based purely on performance metrics. I hear people say, "Choose stocks with high return on equity and high earnings growth metrics." That's fine, but a great company does not equate to a great investment if the market is offering it at an outrageous price. Sometimes a company with lesser performance metrics represents a better investment simply because it is being offered at an attractive price relative to its potential future returns.

One thing I have noticed over the years is that a past record of high earnings growth and a high return on equity are like steroids for a company's share price. But when the company's return on equity eventually falters (commonly because of increasing competition as other companies are attracted to that high margin business space) and/or the earnings growth slows, as it almost invariably does, the share price collapses.

This often leads investors to believe there is something fundamentally wrong with the company. Often the company is sound and it is just that the market had previously overpriced it.

I have covered these and many more investing issues in much greater depth in my new book, 'UnCommon Sense (Investment Wisdom since the Stock Market's Dawn)', which is due in bookshops in a few months.

About the author

Michael Kemp is chief analyst at The Barefoot Blueprint.

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