Jam Today

Monday, 11th November 2013 11:00 - by Moosh

Over the last year, I have been bumbling my way through fundamentals research.

Much of my investing history since I first began investing 5 years ago had been technically (chart) based, without a thought to company fundamentals.  Admittedly, most of the success I have had has been in loss-making AIM-listed companies.  Other than the net asset value (NAV) as a guide, many of the price rises were basically news-driven once a trend had been established.  If companies failed to become cash-generative at the price peak, the price inevitably dropped as share dilution after share dilution occurred to raise cash to keep companies afloat.  Once a downtrend was in full flow, short-sellers took hold and prices bottomed out again.

The above experience resulted in a portfolio value which was choppy in nature with no steady growth.  This in part was also due to my need to test different strategies along the way to see which one suited me the best, but now I have settled on a strategy that I am comfortable with.

Now, you would think that if I could quite happily make profit in loss-making companies, then investing in profit-making companies should be a piece of cake.  This is where I am currently at, hence why I call today’s post ‘Jam Today’, since most of the rises in loss-makers go up on ‘Jam Tomorrow’ hype, and in many cases the jam rarely ever appears.  Frankly, I am tired of hype.  The posts from now on will be entirely based on fundamentals, without a single reference to the technical analysis view.

So when it comes to fundamentals research, where do you start?  Where did I start?  Initially, I thought it best that I get my head around the concept of the (share) price/earnings (PE) ratio and whether it could be useful to me in determining whether the current share price of a company is reasonable or not.¹  My basic understanding of how to use PE ratio is that a PE ratio below 10 may imply a company is undervalued, a PE ratio within the range of 10-20 is generally considered as fair value, while anything above a PE ratio of 20-30 could be considered as overvalued, although some may suggest that a super high PE ratio occurs when investors are buying something in the hope that future earnings will rise too.

For my own purposes in my ‘jam today’ scenario, I want to be keeping my eyes open for companies which could be deemed undervalued based on PE ratio, and where there is a strong argument for short to medium term growth in earnings which should be obvious from current operations rather than trying to pin hopes on what could happen in the future.  These criteria may seem like I am being a bit too picky, but that’s my right isn’t it?  After all, it’s my capital and I want to be sure that I’m focussing my time and capital at the right companies so that I can gain on my investment - so I can afford to, and should, be picky.

PE ratio isn’t the be-all and end-all of fundamentals research, but it’s a start.  I have also been looking at dividend investing to get an idea of what fundamentals a dividend investor might be looking for and to see how they may be thinking when it comes to investing, and I have come to the conclusion that I would want a company to be initially showing me consistent growth in earnings and dividends, and where the current share price doesn’t overvalue the PE ratio, before I dig deeper into the fundamentals and read up on the latest regulatory news and recent reports and accounts.  With respect to dividends, there are two aspects which are important to me – the dividend yield (I would be looking for a better return from the dividend than, say, a bank) and the dividend cover (how well the dividend to be paid out is covered by earnings) – industry standard suggests a dividend cover of 2 to be suitable, although personally, I would probably accept a dividend cover of 1.5-2 if other fundamental characteristics support a bullish argument.¹

So now I am armed with a few basics in fundamental analysis – PE ratio, dividend yield, and dividend cover – how useful are they to me in reality?

The initial test is to find a FTSE share which has consistent growth in earnings (and revenues) and dividends, and where the dividend cover is reasonable.  After a few minutes of box-filling and waiting for the internet to do its thing, up popped Sainsbury (TIDM: SBRY), with the last 5 years showing growth in revenues, adjusted earnings per share, and dividend per share.  The dividend yield has dotted about between 4.2%-5.3%, with dividend cover varying between 1.61-1.84.  The PE ratio is currently within a fair value range so I wouldn’t consider it overvalued for my investing needs.²  Based on this, I decided to take the plunge and bought a small amount of SBRY shares and will see how things pan out.

If my fundamentals research is on the right track, then I will see an eventual gain in my investment.  If I missed something in my research then I will return to see where I may have gone wrong or what information I might have missed so that I can fine-tune my research for the next investment.

I want jam, and I want it today.

References

1. The Dividend Investor – Rodney Hobson
2. http://www.lse.co.uk/share-fundamentals.asp?shareprice=SBRY&share=sainsbury(j)

The Writer's views are their own, not a representation of London South East's. No advice is inferred or given. If you require financial advice, please seek an Independent Financial Adviser.