A 5-step strategy for investing outperformance
Nothing is certain in the world of investing, but I know my chances of success are much greater if I stick to an investment strategy.
A very personal fit
Over the last decade, I've tried most approaches to investing and read many books on the subject, absorbing advice from the investing greats such as Warren Buffett, Peter Lynch, Jim Slater, Benjamin Graham, David Dreman and Anthony Bolton.
Perhaps you've read what the famous successful stock market money managers have to say too. If so, you've probably noticed that sometimes those gurus agree and sometimes they offer what seems like contradictory advice. That's why it seems important to settle into an investing approach that works for us individually. After some trial and error, I reckon most investors can settle into a self-assembled strategy that fits as comfortably as a favourite pair of trousers.
What works for me
Here are the five steps I take to try to find winning shares:
1) Quality
Of all the hundreds of companies listed on the stock market only a handful operate with good quality underlying businesses. I look for several quantifiable things, such as:
A record of trading profits
Good and rising cash generation
Decent profit margins
Good returns on equity and on capital employed
Modest debt levels, and...
A sustainable and rising dividend
I also think about qualitative aspects of the business, such as its market, its potential opportunities and its sustainability.
It's also important to see that the directors have invested a decent chunk of their own money into the shares of the firm – if they don't believe they will succeed, why should I?
2) Value
After quality, I look for good value.
Many quality firms sell at a high price, but paying up increases the downside risk. Just look at the London-listed banks, supermarkets and commodity firms to see the potential for things to work out differently than expected.
My mission is to find quality, growing businesses before the market rerates their valuations upwards. That way I stand to gain from the growth of the underlying business and a valuation rerating. To find good value I look at the usual ratios such as:
Price-to-cash flow
Price-to-earnings
Price-to-assets
Dividend yield
Price/earnings to earnings growth rate (PEG)
Every situation is different, so there's a fair amount of judgement and comparison needed to make a decent job of assessing whether a valuation indicates good value.
Even after balancing quality with value, I still don't pile-in and buy, not before satisfying step three.
3) Momentum
I think it unwise to buy a falling share price, even when the quality and value seems to stack up.
Better to wait for confirmation from the chart that my opinion about a firm might be correct. So I look for share prices that seem to be turning up, perhaps indicated by a few higher lows, or a bowl shape on the chart that might be telling me the share has passed its nadir.
Such momentum on the chart is best combined with support from positive news flow and improving financial indicators.
4) Size
I tend to favour smaller companies because a business expanding from a small base can grow quickly and go far, taking its share price with it. That said, even elephants put on a fair old turn of speed when they want to, so sometimes I invest in firms with larger market capitalisations.
5) Sell
The 'magic' ingredient for investing success is time.
To deliver in my portfolio, good businesses need time to grow, so I plan to hold shares for the long haul.
That said, I sell a company's shares if anything happens to make me doubt my own research. I'll also sell some of my holding if the valuation seems to get too far ahead, or if my profits are so large that the position skews the balance of my portfolio too much.
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