Strategies for Investment (II)
The theoretical relationship between dividend and earnings equity valuations explains why a few select statistics published in the press provide a disciplined framework for analysing corporate performance as a guide to future investment. However, as we shall now explain, there is more to buying and selling shares than the interpretation of stock exchange listings.
With time to scrutinize company reports, press-media comment and financial websites, anyone can identify market forces (other than yield, growth, EPS and the P/E ratio) which are believed to drive equity prices and market sentiment, that are commonly used by professional analysts, particularly in the short term.
(a) Takeover Activity
Companies grow organically or by acquisition. Speculation that predators are about to pounce on a takeover target can provide investors with instant gains if its share price rises. So, how do you spot a takeover?
If a firm has exhausted its investment potential it may be a target. If it has met the demand for its products or services but is profitable and cash rich, it may be a predator seeking to diversify away from its core technology to maintain growth. Alternatively, consolidation between equal partners (currently in competition) may be the key issue, creating future opportunities for economies of scale.
If we ignore profitable going-concern activities, target companies can also be worth more "dead than alive", particularly if they are sitting on copyrights (which prompted the Chinese takeover of Britain's last major carmaker, the loss making MG-Rover). Another way of identifying vulnerability is to look at a company's net asset value per share (NAV). This is measured by the assets owned by the firm, less its liabilities, divided by the number of shares in issue. If the NAV per share is higher than the current share price, asset strippers may be ready to pounce. One of the major attractions for predators is an undervalued property portfolio that can be sold off, or redeveloped. Venture capitalists particularly, seek companies whose shares are infrequently traded with corporate assets they regard as undervalued. So, if consortia or financial institutions start to increase their holdings in such companies, particularly if they take a seat on the Board, it may signal a takeover.
Irrespective of whether markets are volatile or stable, riding on the back of any takeover is a risky strategy that is only advisable for the speculative, short-term investor. As we shall discover in Part Four, even if two companies are a "perfect fit", you may need to buy immediately before a bid and sell quickly before the takeover occurs, because thereafter price invariably falls back. History also tells us that post-takeover, holding shares for the long haul is unwise. Very few acquisitions succeed, usually because of a lack of strategic pre-planning by the predator company.
(b) Profit Warnings
Companies issue profit warnings when their results are likely to be below expectations. Shares in firms that issue warnings usually fall by an average of 20 percent on the day of publication but 30 percent is not unusual. So, should you hold stocks that have plummeted after a warning in the hope of revival?
Part of stock market law is that profit warnings come in threes. If investors adhere to the "golden rule" of selling high and buying low, they should therefore sell on the first and buy on the third, particularly if new management is parachuted in to aid recovery.
But there are exceptions to these rules that also defy logic. During the the1990s, many technology firms issued more than three warnings, but their prices continued to rise spectacularly. Some also recovered spectacularly after the bubble burst, notably Marconi (the UK defense contractor) from an all time low of 6 % pence. Although the stock was well below its peak of £12.00 in 2002, the trading high for the twelve months to June 2005 was still a creditable £6.30 when the company became a takeover target. The question to ask (and seek out in your research of press and media comment) is whether profit warnings relate to short-term factors that can be overcome, or fundamental strategic problems that may be insurmountable.
(c) Director's Dealings
Legally, directors in many developed Western economies have to disclose when they buy or sell shares in their companies to avoid accusations of insider trading. Their deals are also published regularly in the financial press drawn from commercial websites such as digitallook.com and hemscott.com. Because directors have in-depth knowledge of their companies, it therefore pays to track their every move. Dealings are a useful source of information, good as well as bad, particularly if a new product innovation or investment has been announced, or a share issue is in the offering, notably a take-over or management buy-out. A high level of buying often coincides with the start of a rally. In the past, market upswings have been prefaced by as many as fifteen director purchases for one sale.
(d) Employee Ownership Schemes
Firms with wider employee-share ownership tend to be top performers, particularly in bullish markets. Staff that possesses shares obviously has a vested interest in generating new ideas to maintain long-term growth and overcome the competition. Data reported periodically in the financial press reveals that investing in companies where employees hold at least three percent of the equity and 25 percent of the workforce own shares seems to be the key.
(e) Research and Development Expenditure
Companies that continually spend on profitable research and development (R and D) should grow the fastest, even in rising global markets fuelled by irrational expectations. For example, during the dot.com boom, £1,000 invested each year in a fund that tracked the FT-SE 100 over the five years leading up to the millennium would have generated a creditable £6,400. However, if your investment strategy was restricted to the 40 Footsie companies with the highest R and D record, you would have made nearly £26,000.
(f) Analysts Upgrades and Downgrades
In their quest to beat the market, financial services worldwide continually analyse corporate data and produce research reports for their investment fund managers and clients. These expert reports contain profit forecasts for companies and upgrade or downgrade them when the market changes, typically with a one-word conclusion, buy, sell or hold.
Those of you with time to dig out past data from websites such as reuters.com and digitallook.com will often find that professional analysts change their minds, usually when a company's results have exceeded their predictions. Upgraded profit forecasts are termed an outperform recommendation. But because many of the original results leave the professionals baffled, their revised forecasts (say from "sell" to "hold") often understate how much they expect the company's future performance to improve or revive. When the next results emerge, the former is termed an earnings surprise, the latter is a dead cat bounce. Both often produce a rise in share price.
Thus, investors can profit by acquiring shares in firms that have been upgraded on numerous occasions, say over a twelvemonth period. A downgrade can also have a significant, detrimental impact on share price, even from "buy" to "hold". But remember that like profit warnings, downgrades, may be due to short-term factors, rather than trading fundamentals.