Investing

The equity portion of an investment portfolio is possibly the bit that excites people the most. A good one can pay dividends, literally, while a bad one can leave investors with a sour taste for years.

Prescott Securities’ principal, Nick Loxton, says to start by knowing the market you are investing in. In Australia, the top companies in the benchmark All Ordinaries Index are the banks and resource giants Rio and BHP.

“You need to know whether you want to invest in these companies, which tend to reflect the overall mood of the stockmarket. An alternative to these is to pick stocks that are out of favour but you have identified as being good companies to invest in,” Loxton says.

Loxton advocates investing in companies you understand.

“If you are in the banks, Woolworths or Telstra, then these are companies you might use the services of regularly. If the share price gets knocked around you might have a better understanding of why,” he says.

Bell Direct chief executive officer Arnie Selvarajah also says investors should invest in companies they know and understand.

Sector allocation

“Start with which sectors you think are doing better or will perform better over the next three to five years and then drill down to which stocks within those sectors you know and think will be winners,” says Selvarajah.

“You might be a client or you might shop there: if you can physically experience what the business does then you will get a feeling for which company might be a better investment,” he says.

It is always advisable to do your research on a company. The fundamentals of a company such as the strength of its balance sheet in terms of cash flow and debt are one way.

Do the numbers

The financial data contained in a company’s annual report can be used to analyse some useful ratios like earnings per share (EPS), price-earnings ratio (P/E), and dividend yield. These can be used to compare one company with its competitors or other companies in the market.

The P/E ratio (price per share divided by earning per share) is basically the number of years based on current earnings that it will take for a share to pay for itself.

A high or low P/E relative to peer companies will indicate that the company is over or underpriced by the market.

The dividend yield (dividend per share divided by price per share) is a measure of how much cash flow you are getting for each dollar invested. In the absence of capital growth it is the return you get for your investment.

Remember your age

“The PE is one measure of which stocks are cheap and which aren’t. A younger investor might focus on the price and the capital growth potential whereas an older investor looking for income might focus on the dividend yield,” says Selvarajah.

While the ASX designates that an investor has to hold a minimum $500 parcel of a company’s shares, there is no hard and fast rule about how many stocks someone should invest in or how much in total they should invest.

An investor could start with $2500 invested in one or two stocks and build on it over time, says Nick Loxton.

Selvarajah says $150,000 spread across six to 10 companies might seem reasonable to some, but draws the line at 20 to 40 stocks in a portfolio.

“It leads to analysis paralysis. It is too hard to research and manage too many stocks,” he says.

Maintaining balance

Where it was once de rigeur to “buy and hold” equities, today’s preference is to buy, review and rebalance.

“What we have seen since 2007 is that if you are actively looking at your portfolio and massaging and balancing then you have more ability to make money in the market,” Selvarajah says.

“Every three months reassess the sectors you have invested in and the stocks you have bought. There is a lot of volatility in the market and with that volatility comes opportunities,” he says.

Somewhere to start

As a building block for a core Australian equity portfolio, UBS suggested the following 10 stocks in 2011 as a starting point for most investor risk profiles.

The focus is on quality large cap companies with a combination of cyclicals and defensives and includes financial services group AMP, BHP, Commonwealth Bank, National Australia Bank, Origin Energy, Rio Tinto, Transurban Group, Westfield, Woolworths and Woodside Petroleum.