First Steps: Step Ten - Settling in for the Long-term

In the previous article we looked at a basic example of a short-term trade. We demonstrated how to use a trailing stop loss level to track your trade and sell aggressively. Some people prefer this type of investment style because it gives them complete control over their capital.

Short-term trading for immediate capital gain has only recently become commonplace in the New Zealand and Australian markets. Historically we have been more inclined to invest using proven fundamental strategies based around the performance of the actual companies.

Fundamental analysts tend to separate companies into two distinct groups. To be considered as a potential investment, companies must be either showing potential for growth or currently undervalued.

We have discussed each of these conditions in previous articles. This article will focus on constructing a long-term investment plan for buying an undervalued share.

In most cases, value shares tend to outperform growth shares during bear markets, and so are considered a defensive investment. Good fundamental investors will often focus on one type of share depending on the current market conditions. When the markets are strong, growth shares will perform well. When the market is weak, value shares will typically be the best performing investment.

Furthermore, value investing is founded on companies with a solid history of earnings and sales. There is little uncertainty about their operations or future performance.

There are several ways to measure if the market currently undervalues a company. A basic definition of a value company is one that is relatively cheap compared to its earnings and asset backing

The relationship between a share price and the earnings of the company is measured by the Price to Earnings or P/E ratio.

The price to earnings ratio is calculated by dividing the stock's current price by the company's current annual earnings per share.

The resulting ratio usually between 10 and 100 and represents how expensive each share is compared to how much profit the company makes. Another way to understand P/E is that it gives you the number of years that it would take for the company to earn the value of each share.

For example if you bought a share for $1.00 and the company currently makes 10 cents per share in profit each year, then it would take 10 years for you to get your $1.00 per share back.

This is a simplified example but it does show that if the P/E is low, then the company is realistically priced according to the profit that it makes.

The P/E can vary widely between different companies and industries. When you compare P/E ratios it is important to understand that what might be considered as a low P/E in one industry, could be a very high P/E in another industry.

Value stocks tend to have a P/E ratio that is at or below average for that particular industry. It is important to note that weak companies can still have good P/E ratios. If a company has made a profit in its most recent year of business and its price suddenly falls due to major fundamental or economic pressure then the P/E would actually improve. For this reason, value investors do not only rely on the P/E ratio to make investment decisions.

A company's asset backing is the second factor which is important to consider when analysing a value company.

Asset backing is calculated by dividing the net worth of a company by the number of shares outstanding. This is considered to be the value of a company's assets according to an independent accountant's report. It can also be understood as the value of the company's assets a shareholder would theoretically receive if a company were liquidated.

In New Zealand and Australia the asset backing or a share is often reported as the Net Tangible Assets per Share, or NTA/Share.

If a company has a NTA/Share of $1.00 and the share price is currently trading at 80 cents, then you can theoretically buy $1.00 worth of assets for 80 cents. As you can see, this is an obvious indication that a company is fairly valued, or even undervalued.

The final aspect to value investing that can assist you to make a good investment decision is the current dividend yield.

Dividends are the earnings of a company that are paid directly to shareholders. The dividend yield is usually expressed as a percentage.

For example, a company may have a dividend yield of 10%. This means that if the company continues to pay this amount in the future, you will receive a 10% profit each year from owning each share. You can make a decision about what level of dividend yield is necessary for you to consider investing.

If you make dividend yield a requirement, you are basically giving yourself an insurance policy that the company is secure enough to actually return some earnings to shareholders.

If we now put these three factors together we can begin to build up a set of conditions under which we can classify a company as a good value investment.

You might decide to look for companies that have:

- An average or below average P/E ratio compared to the industry average.
- An asset backing (NTA/share) above the current price.
- A dividend yield that is greater than 5%.

This might seem like a very tight set of criteria for investment. Remember that this type of investment is for a medium to long-term timeframe, and you are investing your hard-earned capital. You should be selective and thorough in your research.

A good example of an undervalued company in the New Zealand market in July 2001 is Air New Zealand A. This company has a P/E ratio of 10, a NTA/Share of $2.20, and a dividend yield of 12.4%. The current price of $1.05 suggests that the company is undervalued, but in this particular instance there are many other factors to consider and it is essential to understand the external fundamental influences currently effecting the company's business.

Value investing can be both a rewarding and frustrating investment strategy. The amount of effort that you put in is usually directly proportional to the amount of reward you receive.

This article was written by Nick McCaw from Intelligent Investing.