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Fundamentals
Stock Lab: Guide to analysing stocks (Part 2)
Toni Case - October 1, 2007
The best tennis players in the world don’t all sport the same style and investors, likewise, shouldn’t think that a specific style of investing wins every game. To be a successful investor you firstly have to choose a style of investing that suits you, and then it’s a matter of perfecting this style.
Last week we looked at the fundamental analysis schools of growth and value investing. Ask most fund managers around town what school they belong to and chances are it’s one or the other. Some analysts combine flavours of both schools, such as tracking down growth stocks (remember these are stocks with the potential to significantly boost future earnings) and then wait for a dip in the share price to buy cheaply, which is the hallmark of the value investing school. This approach is typical of the GARP school of investing (Growth At A Reasonable Price) - there’ll be more on this later.
Income – the desire for dividends
Some investors enjoy the comfort of receiving a dividend cheque in the mail, and are happy to buy shares in companies that guarantee (well, almost guarantee, as nothing is certain in investing) a regular income stream of dividends over the years.
The often-said phrase that you are better off buying shares in the big banks that pay healthy dividends than keeping your savings in a bank account fairly squarely sums up income investing.
A company that pays dividends – or a proportion of its profits to shareholders – must be fairly large and established since smaller companies reinvest most of their profits back into the business, and typically don’t have a cent to spare for shareholders.
But high-dividend paying companies are hardly chart-toppers, so don’t expect these companies to blow your socks off with share price rises. Rather, a steadily rising share price is a good result for a high-dividend paying stock.
The dividend yield (not the dividend) is the most important figure for the income investor. So don’t go around hunting for a stock that pays a $4 per share annual dividend but instead look to the dividend yield, which is the annual dividend per share (say $4) divided by the share price (let’s say $100), or 4%.
It’s hardly a stretch to see the benefits of investing in a stock paying a solid dividend yield. In short, an investor with $100,000 in a stock offering a 4 per cent dividend yield will pocket $4,000 a year in income, not to mention any franking credits to further boost gains.
A word of warning for income investors hunting for the perfect high-yielding stock: a company with a struggling share price can sport a high dividend yield (since share price is the denominator in our dividend yield calculation) so always ensure that the company is healthy, with good prospects for future share price gains. There’s no point buying a stock with a high dividend yield for one year that consequently lowers or stops paying dividends in the future, or worse still, has a plummeting share price. It’s always handy to check the company’s history in paying dividends as a guide to how reliable it’ll be in the future.
GARP – Growth at a reasonable price
If both value and growth-styles of investing have attributes that you like then GARP, or growth at a reasonable price, combines elements of both.
GARP investors seek out companies that have exhibited strong earnings growth in the past, with the prospects for continued earnings growth in the future. But they also like a bargain.
Similarly to the growth-style of investing, a GARP investor will often agree to buy a stock with a high price/earnings (P/E) ratio with the view that strong future earnings will boost the share price over time. However, unlike the bullish growth investor, the GARP style buys stocks with an eye to value. They don’t like to overpay. A company trading at 30 or 40 times earnings, for instance, would be too expensive for the typical GARP practitioner.
Since GARP investors are often more conservative then growth investors, they often perform worse during bull markets (take the past four years as an example), but relatively better during market corrections. However, in contrast to the true value investor, who bargain hunts during market bears – buying when everyone is selling – the GARP investor will typically do worse than the true value punter when the turnaround comes. In short, the performance of the GARP investor should almost sit in the middle of value and growth to generate more consistent returns over time.
Next week
In next week’s Stock Lab: Guide to analysing stocks we investigate why the school of fundamental analysis is under attack by technical analysts who argue that fundamentalists are simply wasting their time. They say that investors and traders only need to study the charts.
More articles from this week's newsletter:
Stocks: Fund manager stock pick for the long haul: VDM Group
CS stock lab: Guide to analysing stocks - part 2
Superannuation: Does your super fund stack up?
CFDs: MF Global buys BrokerOne
Leverage: Comparing margin loans and instalment warrants
Stock of the week: Sirtex Medical stands out
Warrants: The commodities trader's no.1 resource
Smart investing: Neglect can lead to money regrets
Analyst report: LPTs still hot property?
Commodities: Miners not taking advantage of the gold bull
Whatever your views, you can discuss this article - or any of Toni's articles - on our message board Your 2 Cents.
Toni Case is the editor of CompareShares.com.au and is Australia’s first journalist to specialise on Contracts for Difference (CFDs). She was a staff writer for Shares, Personal Investor and Asset Magazines, and today is a regular columnist with the Australian Financial Review. She is a qualified financial adviser, and has an Economics (Honours) degree from Sydney University.
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