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Look before you leap: what you need to know about investing in direct shares

Davidson Institute /

Investors looking for flexibility, diversity and even excitement might view the share market as an attractive option. But before delving in, it’s important to have a strategy.

If you are planning to launch an investment portfolio, one of the most common areas of interest, after property, is the share market.

However, while success stories can often encourage people to think investing in stocks is an instant ticket to abundant profits – for example the financial rewards experienced by those who took a chance on Apple in its infancy – it can be one of the trickiest fields of investment to navigate, due to risks over which the investor has no control such a turbulent market or unstable economy.

Matthew Walker, financial planner and chairman of the Association of Real Return Investment Advisers (ARRIA), deals with many clients who are keen to delve into the share market and says that, before embarking on any investment, it’s vital to work out if this approach is right for their short- and long-term goals.

“When a client walks in and says they want to buy some direct shares, the first thing I say is, ‘Why? What do you want to achieve?'”

Walker says that while many people want to manage their own share portfolios, it’s important to remember that only one in 1000 or so investors have the time, knowledge and enthusiasm to deliver returns beyond what fund managers can do, even when taking into account the money they might stand to save on management costs.

Two approaches to buying shares

For those who want to persevere and invest in the share market, there are basic signposts to ensure investors pick the right stocks and create the right portfolios for their specific purposes.

“If there is a good reason to consider direct shares as part of an investment portfolio then we would have a look at which particular ones. There are two approaches to buying shares. One is a top-down approach, taking a macroeconomic view, and the other is a bottom-up approach,” says Walker.

The top down approach takes into consideration big picture elements such as global trends, the state of a country’s economy, interest rates and employment trends, while a bottom-up approach takes into consideration companies you have an interest in and their investment merits.

Walker employs both approaches, applying a macroeconomic view to his decision-making first. This means looking at what’s going on internationally in specific regions – for example China, or Ukraine and the Middle East – or examining the price of specific commodities – for example iron ore.

By looking at big data and taking into account a range of economic issues, Walker is able to identify the industry sectors that might be worth investing in.

“In that top-down approach, you really don’t necessarily drill down into too much detail, you can say, well that sector or that area is attractive, and then work out how you want to get exposure to that.”

Once you start the bottom-up approach, investors need to look at what a company does, how they go about it, their competition and their cashflow.

He warns that analysing specific companies requires rigorous due diligence, which means analysing lots of data.

What to look for: Quality of management

If there is one factor potential investors should pay particular attention to when deciding on a company to invest in its quality of management.

Ask yourself: how do the directors respond to market conditions? What are the macro issues, threats, problems and opportunities that it faces? Considering these questions can often be a good indicator as to how the company’s stocks will perform in the future.

Romano Sala Tenna, a portfolio manager at Katana Asset Management, supports this view and says that, while management teams are a difficult variable to assess, they are critical to the success of the investment.

What to look for: Strong balance sheet and good cashflow

Sala Tenna says the second-most important factor that investors should look for is evidence of a strong balance sheet and good cashflow.

What’s the return on equity – the company profit as a percentage of shareholder equity? Is there high free cashflow (FCF) and low annual capital expenditure costs?

The area where people tend to get unstuck is the number of various systems and ratios available for measuring the financial health and future performance of a company, which all have benefits and drawbacks, but more often than not require considerable analysis.

Liquidity is also something often overlooked, Sala Tenna says, but could be a make or break for investors if they need to exit positions quickly.

Beyond that, he recommends avoiding structurally impaired sectors, unless there is good evidence of their capabilities. Mining services are an example of this, particularly when compared to something like bank stocks.

Service companies that rely on the success of clients, who in turn rely on macroeconomic conditions, can end up with limited power to increase margins because they need to remain competitive and are fast to attract new entrants in the sector.

If investors want positions in those sectors, look for a greater safety margin and take smaller positions.

“If you think about the share market…there are two sides to every trade: winners and losers,” says Walker.

Direct investment as part of a super portfolio

Offering both chartered accountancy as well as financial advisory services, Walker says his firm sees huge numbers of self-managed super funds (SMSFs) and, when examining the figures, suggests that direct investment isn’t an economically justifiable model until an SMSF gets to about $1.5 million.

If investors are looking at direct investment options as part of their super portfolio, he says they are often the types of clients with the time and the passion to give their investment the attention it deserves. The number of ‘off the shelf’ super solutions that investors can now access, however, means that almost any share or managed fund, or exchange-traded fund, is accessible through super.

This article looks at the share market in a general way; if you need specific advice regarding your situation, you should consult an appropriately qualified and registered professional.

 
Davidson Institute