An introduction to the stock market and investing

When an individual considers investing in the stock market it is vital that they follow a strategy, a plan of attack that has the ability to improve one’s chances of success. As straightforward as it may seem, human beings by nature tend to be ill-disciplined, often throwing away the playbook in search of the quick buck. But in many ways who could blame them? In today’s world there are a plethora of convoluted investment approaches being championed by industry commentators and analysts alike, often confusing the average investor, and leading to over-diversified concocted portfolios that lack structure and logic.

There are over 2000 companies on the ASX split across 10 official industry sectors. These companies can then be split amongst countless sub sectors and bespoke analyst sectors. For example the Financials sector can be split into 4 sub sectors categorised by Banks, Diversified financials, Insurance companies, and Real Estate businesses. Each sectors of the economy is slightly unique with different dynamics at play. It is the ability of an investor to react quickly to economic drivers that allows successful investors to identify profitable investment opportunities, at the right time.

With the onset of the modern day 24hr news cycle, investors can find themselves bombarded with superfluous information. Geopolitical tensions here, central bankers there, blaa-blaa-blaa. In the end of the day investors need to strip investing back to its barest and simplest form. After all the equity market is all about investing in quality businesses, not stocks. Investors often lose sight of what it is they’re actually doing, distracted by the flashing lights and rapid number movements on their trading platform. When you put your money into ‘stocks’, you are purchasing a complete part of a business, entitling you to a portion of that businesses future earnings stream and profits. Businesses that have a track record, or a pattern of delivering results consistently, typically exude certain characteristics and traits that enable them to repeatedly deliver positive outcomes for their shareholders.

As aforementioned there are over 2000 companies on the ASX. But of those companies less than half are profitable. In the investment committee meetings at Kodari Securities we look to avoid handicapping ourselves and use profitability as the base case for any investment opportunity. We then go a step further and aim to identify the businesses with sound and consistent financial metrics that forensically highlight a business’s profitability, operating efficiency, and liquidity over a meaningful period of time. Some of these metrics include headline figures such as Revenue and Net Profit, while financial ratios such as Return on Equity, NPAT margin, Net Gearing and Free Cash Flow all have powerful explanatory significance.

In many ways we believe in keeping things simple. Following the simple structure of identifying sectors of the economy that are booming, before going a step further and selecting established businesses within those sectors that are financially sound. For we believe everything that has and will happen, is a part of a long documented chain of cause and effect. So why buy into ‘fanciful stories’, why complicate things? Why invite excess unknown risks when you can keep it simple and get the desired results?

Let’s consider for a moment the following notion. At one point in the recent past the mining services sector was very much a sector in vogue. After decades in the midst of a Chinese driven commodity super cycle, capital expenditure from the large miners was widespread as they all clambered for a piece of the action. Naturally, it was the mining contractors that stood to benefit from these numerous mining projects, and they did for a while before the music eventually stopped. 2014 marked the beginning of the shift for the mining sector from the construction phase to the production phase. It’s now the once market fancied mining contractors that are hurting the most as they come to terms with large spending cuts from the big miners. To highlight the extent of the challenges facing the industry the Bureau of Resources and Energy Economics estimates the combined value of likely resource projects will decline by 75 per cent, to an estimated $55 billion in the four years to 2018.

Essentially we have a situation now where we have a number of businesses competing for a piece of an ever shrinking pie. As an investor would you be bold enough to stand in the way of that title wave? I assume probably not. That’s a process that can be repeated across the market and applied to other sectors. Very quickly you can see just how an investor can eliminate an entire sector from an investment portfolio. It’s through that process of analysis and elimination that investors can identify economic themes and fundamental changes in the business landscape that ultimately leads investors towards companies with the best opportunities. After all quality businesses in growing sectors have a better probability of delivering reliable earnings, and dividend income growth that will inevitably lead to superior price performance for shareholders.

For an investor that is new to the stock market there are a set of 5 value investing principles that we at KOSEC follow which can help investors focus their attention towards quality in the market. These principles are simple but effective, and have been proven to lower risk and remove uncertainty.

The principles are as follows:

Invest in Businesses, Not Stocks
Focus on the value of a company, not the stock price. You are purchasing a complete portion of a business.

Margin of Safety
Purchase a company whose price is less than the true value. The bigger the gap between the two, the greater the margin of safety.

Invest in High Quality
Invest in businesses with a quality offering, a track record of delivering results, and an experienced management team with maintain momentum going forward.

Identify Sustainable Competitive Advantages
Businesses that have strong brands, dominate pricing power, and lower costs have the best chance at growing earnings and ultimately the company’s value.

Research and Analysis
Always do your homework. Don’t over diversify and hold too many companies. Research and analysis will help you be selective and invest with conviction.
Stock market strategies are often over-complicated and counterproductive to performance. As a general rule investors should focus on simplify things by investing in fundamentally sound businesses that have bright prospects and sustainable business models going forward. By following a structure and a set of principles, investors can reduce risk and increase the probability of achieving higher returns.

For more specialised advice go to www.kosec.com.au