By David Le Cornu and Jamie Mourant, of Ravenscroft
WHEN Bananarama and the Fun Boy 3 released the song in 1982, they probably didn’t think the words would be used to offer guidance to equity investors. Fast forward 41 years and we would urge anyone who is investing directly into the shares of individual businesses to carefully consider these wise words.
Investment wisdom and regulation informs us that equity investment is, by its nature, high risk. It certainly can be, but we would argue that by doing some hard work and following some common-sense rules you can improve your chances of success and the consistency of your investment returns.
Only invest in business that you understand: If you are considering investing in the shares of a company, you should learn as much as you can about the business and only invest if you understand what it does and how it makes its money. This may sound obvious but we know many people who, at one point or another, invested in a business because ‘a friend recommended it’, or they were fearful of missing out on the next big thing. Friends’ ‘tips’ (unless they are doing detailed research or happen to be Warren Buffet) and FOMO investments tend to deliver random returns.
Focus upon proven, profitable businesses: The reality is that, over time, some businesses will fail, and failures tend to be swifter among young businesses and unprofitable businesses. Typically, a proven, profitable business would take much longer to fail, allowing investors chances to spot the problem and exit before their money disappeared.
Deconstruct the balance sheet and focus upon cashflow: Companies employ exceptionally bright people to prepare their accounts and they tend to paint the rosiest picture they can (within legal limitations). Very clever things can be done within balance sheets to adjust the earnings and profitability of a business. You can bypass most of the accounting chicanery if you focus upon cashflows. This approach should give a more accurate snapshot of the health of the business and its performance.
Challenge the company statement and consider future relevance: Read the company statement with a healthy dose of scepticism. Unless there has just been a change in senior management, the messaging in the company statement tends to err on the side of positive. Think about the longer-term prospects of the business. What does the competitive landscape look like? Will the business still be as relevant in five or more years as it is now?
Value the business and implement a strong valuation discipline: You need to place a value on a business before you invest in it. This is done by considering your research and predicting the dividends and growth you expect from the investment over your intended investment timeframe. This must then be discounted to give you a present-day value for the investment. Only if the share price is sufficiently below your value calculation should it be bought. This process should be repeated and your valuation updated each time the company reports. When the share price gets close to, or above, your calculated value, the valuation process should be repeated and if your valuation hasn’t risen, consideration should be given to reducing or selling the investment.
Diversify, don’t ‘diworsify’: Investment academics all agree it is sensible to spread your money among a number of investments to reduce risk. However, there is disagreement about what the optimal number is. While you want to reduce the risk of all of your investments rising or falling in value at the same pace and time, the reality is that proper research takes a lot of time and effort. Therefore, spreading investment across the shares of 25 to 35 businesses seems sensible for direct equity investors. To improve your chances of success, restrict investment to businesses where you have had the time to do, and are confident in, your research. Diversifying beyond this point is likely to be ‘diworsification’ and reduce your investment returns.
Does the approach work? There is no getting around it – investing does require a degree of work and commitment. Alternatively, you may want to consider investing into an equity fund, of which there are plenty to choose from. The managers of these funds should employ most of the guidelines outlined here. Our favourite equity fund employs a similar approach and has a compound annual growth rate since January 2012 in excess of 11% per annum while displaying lower drawdowns than equity markets during periods of stress such as Q1 2020 -8% and in 2022 -4% (Source: Ravenscroft Global Blue Chip Fund factsheet.)
If you have any questions about this or would like to talk to someone about investing, please contact the team at Ravenscroft, who would be delighted to hear from you.
FINANCIAL PROMOTION: The value of investments and the income derived from them may go down as well as up and you may not receive back all the money which you invested. Any information relating to past performance of an investment service is not a guide to future performance