A sensible approach to SMSF stock market investing
by Chris Batchelor, CFA (Certified Financial Analyst)
Successful investing on the stock market for SMSF trustees needn’t be confusing, overwhelming and time-consuming, or require a finance degree.
A typical business starts with a savvy idea, at least one shareholder, cash and a sustainable business model. Staff may be employed and dividends may be paid.
So why do we approach investing in companies listed on the stock exchange differently from acquiring a 50% stake in the local newsagent?
Both represent part-ownership of a business.
The story of a company, regardless of whether the business is owned by one shareholder or many – its history of earnings, dividends, equity, debt, cash flow and capital growth – is told the same way.
And that’s the golden rule of sensible investing: approach the share market as you would the acquisition of a private business.
Look at shares in listed companies as a claim over the income and assets of the company. See the shares for what they really are – ownership stakes in a business.
So how do you identify the great businesses and avoid those high-risk companies that can lead to permanent losses?
When you begin to evaluate companies ask yourself this question: Would I be prepared to own the entire business?
Are profits rising? Am I comfortable with the level of debt? And what about profitability? Are profits increasing without the need for additional funding?
Attractive businesses are able to produce rising profits without the need for debt or dilutive capital raisings. Such companies produce increasingly profitable returns on equity without increasing risk.
The very best businesses are also able to reduce their level of debt whilst increasing profits. Take a look at Domino’s Pizza Enterprises, CSL, REA Group, Super Retail Group, Carsales.com, IRESS Market Technologies, Fleetwood Corporation, ARB Corporation, Breville Group and Reckon Limited as examples of companies that have successfully increased profits and profitability whilst reducing debt and minimising the need to raise additional capital from shareholders.
Another factor to consider is cash flow. Does the company spend more money than it generates?
Companies with ample cash on hand are able to pay creditors and employees, invest the excess cash back into the business in order to generate more cash and profits, pay dividends or make acquisitions.
Attractive businesses generate rising profits and improving cash flow. If sustainable, companies that pay cash dividends may also be attractive to investors seeking income.
A company that has not generated enough cash in the year to pay for the business activities it undertook, and any dividends paid to shareholders, is not desirable.
Once you understand the business, its economics and future growth prospects, the final step is to estimate the value of the business to determine an appropriate price to pay for its shares.
Paying too much for a top-quality company can destroy wealth just as quickly as investing in one with excessive debt. Over time, share prices tend to converge with value. Buying shares in a company for $20 when the underlying value is $10 can be dangerous.
Take advantage of those rare opportunities to acquire stakes in top-quality businesses when the share price is less than your estimate of value.
It’s that simple. Learn to identify extraordinary businesses, avoid the bad ones and exercise patience until the opportunity to buy a great business for a bargain price presents itself.
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