It’s fair to say the Australian share market has started 2013 with a bang. It‘s up 9.8% since 1 January. That makes it the best two month start to a calendar year since 1980.

It’s times like these the average punter starts to believe he’s a stock picking guru. Don’t be fooled. As John F Kennedy said back in 1963 ‘a rising tide lifts all boats’. Sure, JFK said it in a different context but the saying is just as aptly applied to the stock market. In a stock market context, the ‘tide’ is a bull market. If you throw some money at any stock the odds are it will go up along with the rest of the market.

There’s another quote that I keep in mind as a sobering reminder that it’s not that easy. Warren Buffet, one of the most successful investors of modern times, said ‘you never know who’s swimming naked until the tide goes out’. In other words, when the market goes down only the good stocks will survive. So if you’ve thrown money at any stock on the way up you’re going to get found out on the way down.

Let’s be honest. Some of us are good at picking stocks. Most of us aren’t. It doesn’t matter whether you’re good, bad or indifferent. The following points can help all of us.

Buy What You Know

Buy what you know and understand. That doesn’t mean just buy stocks whose products you use every day. It can include stocks whose business models you can quickly grasp and evaluate. Warren Buffett used to avoid technology stocks simply because he doubted his ability to fairly and reasonably value them.

Evaluate Earnings

Look at a company’s historical earnings per share. Are recent years typical? If they were unusually high or low, make sure you understand the reason for the anomaly before you purchase.

Debt

Look for too much debt. The lower the debt the less risky the company is.

Don’t Overpay

If earnings are in line with what you expect from previous years, look carefully at the ratio of the share price to the company’s earnings per share — a valuation metric called the “price-to-earnings ratio” or “P/E ratio”. Compare that number with other companies in its industry and its size. The lower the P/E ratio, the more attractive the stock.

Look for a ‘Moat’

A “moat”, in investment parlance, is any long term advantage that would make it difficult or impossible for competitors to take market share away from the company. Examples include an exclusive patent or technology, a long-term pricing advantage, or an extremely strong brand name.

Watch Management

The management team should have a track record of success stretching back years, if possible. Do your due diligence. Find out what senior managers did before joining the company. Did the CFO leave the old firm a month prior to a large earnings restatement? If so, that should be a yellow flag of caution.

Invest With a Margin of Safety

Always invest assuming that a number of your assumptions are going to be wrong. Ensure the investments you choose have some capacity to weather unexpected storms, raise capital in an emergency, or, in a worst case scenario, liquidate itself to pay off shareholders.

Happy investing!

Bye for now

Dan’s Corner

Source: Financial Review 2 March 2013