SMSF Investing Education & Strategies

DIY Shares - Value Investing Education articles

How to buy shares as a value investor

By Roger Montgomery

In the share market, even the most experienced financial, property, or medical professional falls into the same traps frequented by the new investor – tending to buy too early, pay too much, hold on too long and cross their fingers in the hope share prices will miraculously rise. More disconcertingly, many of them freeze when prices drop – precisely the time they should be jubilant.

So how exactly should you go about buying shares ?

The first thing is to change the way you think about the stock market. If you bet on shares that rise and fall, the way you might bet on black or red at the casino, you aren’t investing at all. You are speculating. You are likely to be excited when prices rise, and despondent or panicked when they don’t.

Investors see things differently. An investor sees a share as a claim over the income and net assets of the company. An investor sees shares for what they really are, not casino chips but ownership stakes in businesses. When prices fall, an investor gets excited because low prices mean more of a good thing can be purchased at even more attractive prices.

Once you have reframed your understanding of shares, the next step is to identify great businesses and avoid the mediocre ones. This is easier than you think. Suppose you and I start a business with 2 billion dollars of our own money and $3 billion dollars from the bank. We run the business for a decade, after which our annual profits are about $100 million. Doesn’t sound like a great result, does it ? Adding salt to the wound, what if I told you that over the past decade we have injected a further $2 billion or our own money and borrowed another $3 billion.

If you can see this is not the sort of business you would like to own, you are well on your way to being a true investor and making some decent returns. You see, the above example is not a hypothetical example, it is actually an iconic Australian company and its share price has done little in 10 years. Investors know that over the long term, share prices tend to follow the performance of the business. If you focus on the business, buying the good ones and avoiding the mediocre and disastrous, the share prices tend to look after themselves.

The final step is valuing a business and only “great” businesses should be considered for purchase. Great businesses – my A1’s – are those able to sustain high rates of return on incremental equity for many years, while employing little or no debt. They also have capable management who understand how to allocate capital and, more importantly, the best can survive a period where poor management might be in control. When the price is below the value, take advantage of that rare opportunity and ignore the mood of the market at the time.

So how do you determine the value of a business ? In 1981, none other than Warren Buffet outlined the steps, and for companies that pay all their earnings out as a dividend it is relatively simple.

The formula is:

Return on equity divided by your required post tax return times the equity per share.

Using this model a business that can generate a high rate of return on equity is worth more than a business that cannot. This is rational.

A year or so ago (as at June 2010) I applied the formula to Telstra. It had about 93c of equity per share that generated a return of 35% to 40% , of which it pays most, if not all as a dividend. Assuming an 11% required post tax return, Telstra was worth:

0.35 / 0.11 x 0.93 = $2.95. The shares were trading at about $3.20 then and I concluded they were no “bargain”.

As many would know, as as the time of writing (June 2010) the stock market has rallied strongly over the past year and yet Telstra’s shares are lower today than they were a year ago. It seams the valuation method could just be worth paying attention to.

Roger Montgomery shares his step-by-step guide to valuing the best stocks and buying them for less than they're worth in his new book, Value.able, available exclusively at www.rogermontgomery.com. Roger also shares his stock market insights at this blog http://blog.rogermontgomery.com

Investors should obtain relevant and specific professional advice before making any investment decision. The information contained herein does not take into account the investment objectives, financial situation or needs of any particular investor. Before making an investment decision investors should consider, with or without the assistance of a licensed advisor, whether the information contained herein is appropriate in light of their particular investment needs, objectives and financial circumstances.

The articles herein contain the current opinions of the author only. The author’s opinions are subject to change without notice. This article is distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. No part of this article may be reproduced in any form, or referred to in any other publication, without express written permission of the author.