Step Six - In for the Long-term?

Monday 18th June 2001

Long-term investing is the most widely accepted and practised method of share investing for New Zealanders and Australians. Unfortunately, the same long-term investment strategies are also deeply misunderstood and often incorrectly applied.

This article will outline longer-term investing, and discuss the investment plan of a long-term, fundamental investor.

Firstly, let's consider where long-term investment fits into the different investment methods we have already discussed in previous "First Steps" articles.

In Step Four, we discussed the importance of having an investment plan for all types of stock market investing. In this article we outlined three steps to every stock market investment. First you must decide what to buy. Next, you must monitor your investment. Finally, you must decide when to sell. A very good way to understand the requirements for long-term investing is to consider how much effort is required at each stage in the investment process.

In the previous article we discussed the trading plan of a short-term trader. Traders spread their efforts across the three stages of each trade evenly. Traders typically use a group of set criteria for buying, have a plan for monitoring the trade, and then have set criteria for selling. Careful management and an active selling approach can control even a bad purchase when trading.

Long-term investors must have a different emphasis when planning their share investments. Investors typically have to exert a greater amount of effort in the first stage of their investment plan. Buying the right shares is critical and choosing which shares to purchase involves careful research and planning. Monitoring and selling is also important, however buying carefully will allow your long-term strategies to function properly.

There are many methods that are used to select shares for long-term portfolios, but we will investigate the two main approaches.

Firstly, in this article, we will look at some ways to identify companies with strong growth potential. This is sometimes called "growth investing". Next week we will discuss the strategy of buying shares based upon the value of the company.

Growth investing means buying shares in companies that tend to grow substantially faster than others. In most cases this involves buying young companies with high potential, or old companies with a new approach to their business activities. It is important to understand that this is not decided by guessing. It is possible to measure how fast a company is growing. The idea is that growth in earnings and/or revenues will directly correlate into growth of the share price.

The main factor to consider when looking for growth shares is earnings. Earnings are the amount of profit that the company makes each year from its business activities.

Earnings are usually expressed as an Earnings Per Share ratio or EPS, which is simply net profit after tax divided by the number of shares on issue. It is important to understand that other similar ratios exist such as Earnings Before Interest and Tax (EBIT) per share. To simplify things we will focus on Earnings Per Share.

Every share will have an EPS figure that investors can compare against other companies. In a very basic strategy, a growth investor might decide to look for companies with an EPS growth rate of 20%.

This would suggest that the companies' profits are growing at a rate of 20% annually. It would therefore be safe to assume that this growth would be reflected in the share price of that company, which in turn should result in profit for the investor.

This strategy has been used for many years and many investors have successfully built substantial wealth from investing in fast growing companies. However it is important to understand that investing for growth also involves special risks and may not be suitable for all investors.

There are several pitfalls that many new growth investors fall into.

For one thing, it is important when comparing one growth stock with another to make sure you are comparing apples with apples, because specific sectors of the market often have very different growth rates. For example, an EPS growth rate of 20% might be average for a biotechnology share, but quite exceptional for a building company.

Growth companies are often more volatile than slower growing companies. Announcements and profit warnings are carefully scrutinised by analysts and investors. It is also important to understand that a growing company often re-invests its profits. For investors this could mean little or no dividend payment, and no ongoing income. Growth investors rely heavily on the market to realise the increasing value of their growth investments.

Because of the volatile nature of growth shares it is important to have a carefully planned exit strategy. Remember that the reason you buy a share is often the same reason you should use to sell the same share. For Growth investors, this means monitoring the ongoing earnings of the companies that they are invested in and making a selling decision when the company ceases to grow.

No company will continue to grow forever, and the growth companies of today can become the stagnant companies of tomorrow. However, if you are careful in planning your investments, you can take advantage of the growth and realise your profit when the growing stops. Your success relies on your plan.

The next article will focus on investing in companies that are currently undervalued by the market. This long-term value strategy involves searching for shares that you can purchase cheaper than the current value of the company's assets. Careful planning and monitoring can provide value investors with long-term sustainable profits from this style of investing.

This article was written by Nick McCaw from Intelligent Investing

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