Investing in individual stocks creates an idiosyncratic risk which is difficult to avoid. So do your homework on companies and watch out for red flags.
Key mistakes with share investing (afr.com)
Capital markets have enjoyed a carnival-like atmosphere over the past 16 months. The extraordinary policy stimulus, the development of vaccines and the democratisation of capital markets through low-cost digital broking apps has seen new entrants flood into global stock markets. And generally, investors have enjoyed terrific returns.
However, studies continually show that picking individual stocks that turn out to be winners versus the broader market is an exceedingly difficult task. While in hindsight the success stories appear blatantly obvious, the reality is that the likely winners ahead are almost always either very risky or very expensive.
Even if a winner can be identified, the outperformance generally manifests itself only over longer time periods. Instant gratification is not the norm in capital markets.
So while market theory is based on the premise that capital markets are efficient and information is processed instantly and rationally, behavioural economists would argue that people act irrationally. In a period where markets have been so strong, with minimal and short-lived pullbacks, many new investors have not experienced any losses during their short investment careers. Without the battle scars and haunting losses, it is difficult to develop the skill to temper excessive risk-taking.
Unfortunately some important lessons in the investment markets are only learnt the hard way.
With markets at record levels, many seasoned investors feel particularly cautious about putting money to work in the back half of 2021. The Australian equity market rises on average around 9 per cent a year and stocks have already risen 12 per cent in calendar 2021. This year has proven much stronger than most people anticipated, and investors have been overcoming the natural instinct to sell in 2021.
In August, investors’ attention switches to the Australian corporate earnings season. Corporate earnings are likely to have risen by nearly 50 per cent in 2020-21 after collapsing by 35 per cent in 2019-20. These improvements will be driven by elevated commodity prices, as well as booming housing and a fiscal-fuelled rebound in consumption. Dividends are expected to continue recovering.
While earnings are expected to grow a further 10 per cent in 2021-22, recent lockdowns and breakouts of the delta strain are increasing the uncertainty surrounding the outlook for 2021-22.
So with valuations full and uncertainty rising, perhaps it’s time to act a little more like credit professionals who focus their attention on identifying and avoiding the losers. In credit markets, you either get your capital back with a little extra interest or you get completely wiped out via a default.
Investing in individual stocks creates an idiosyncratic risk which is difficult to avoid. So it’s incredibly important to do your homework on companies and watch out for a few red flags that could be a signpost of trouble brewing.
- First, accrual accounting and increased creativity in presenting results has made it increasingly difficult to determine the true strength of underlying businesses. Very complex structures or limited disclosure are often used to hide underperforming business lines.
- Rising debt levels can be a sign that companies are struggling to collect receivables and fund activities through reserves. Never underestimate the power of focusing on the actual cash.
- With the growth outlook less certain, look for companies that are making acquisitions in new regions or outside their core areas of strength. Successfully executing an acquisition within a home market and core sector is hard enough without venturing into new territories which significantly increase the chances of failure. Australian companies have a very poor track record of venturing offshore and extracting synergies in home country acquisitions.
- Finally, the quality and leadership of executive teams cannot be overstated when looking at individual companies. Excessive churn among the executive team is a serious red flag. No executive wants to leave a company with excellent prospects and growth opportunities. Leadership is responsible for establishing the culture, strategy and executing plans. Leaders need to be curious and optimistic, champion diversity, flexibility and inclusion. The differentiator between great and ordinary is having the people and discipline to execute flawlessly.