Secrets of the share race

Secrets of the share race
November 20, 2011

IT'S the only race where you can back the winner after it's started, place a new bet in the middle of it or quit losers well before the finish.

That's why Geoff Wilson, one of Australia's best fund managers, loves the sharemarket, though it's a marvel that so many still lose their shirts.

The portfolio of his listed investment company WAM Capital has returned more than 20 per cent a year since it started 13 years ago.

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Now we have the inside dope from Matthew Kidman, Wilson's former right-hand man turned financial author. Wilson's racing analogy is in his book Bulls, Bears and a Croupier (published by Wiley, $34.95), which lets us in on the secrets.

One is that they get it wrong half the time.

Kidman says the trick is to cut your losses quickly - if a stock drops 10 per cent ''from the average cost of purchase'' it's sold - though there's no denying the ones they get right must be something else.

The truth is you can be right but wrong at the same time. Or to be more exact, have the right idea but get your timing wrong.

''It doesn't always pay to be right,'' he writes.

Nor does it pay to stay.

''I have come to the conclusion that most companies listed on the sharemarket are rubbish - they just have good periods,'' he writes.

Although blue-chip stocks ''have some fabulous periods'' these are invariably ''followed by long and unexplained lean periods''.

So Kidman says treat the market like a game of snakes and ladders. ''Your job is to jump from ladder to ladder.''

A reader will be struck by how many contacts a professional fund manager has - getting tips from brokers first hand and a foot in the door of chief executive's offices - yet Kidman says it is ordinary investors who have the advantage.

They can be more fleet-footed, can move in and out of cash and can deviate as much as they like from any sharemarket index.

But where to start?

''If I was to select a single financial indicator,'' Kidman says, it would be ''the earnings forecast for the year ahead, simply because the rest of the market is so sensitive to it''.

In fact, he argues ''an investor should never buy shares if a company has recently downgraded its earnings forecasts by more than 10 per cent''.

The other figure to watch is the price-earnings (P/E) ratio, which you can get off the sharemarket list or a broking website.  This tells you whether a stock is cheap (the lower the better) or not, though it's not infallible.

Usually used to compare stocks, for Kidman P/Es are more useful against themselves.

A stock's historic P/E will tell you whether it's a bargain or not. A sudden spike suggests it's on a roll that won't last.

Perversely, cyclical stocks - those that move most closely with household spending such as retailers - will often have a high P/E in bad times and low P/E in good times.

The reason is that when they're at their peak, the market anticipates a correction coming, so marks them down.

Another insight into market logic is the way that analysts can be unanimously wrong about a stock (think ABC Learning Centres).

''Stockbrokers will place price targets for the stock near the current share-price level and when the P/E ratio goes from, say, 10 to a head spinning 20, the analysts will generally follow with their valuations of the business.''

And so everybody gets sucked into the vortex.

But in the end it's the quality of management that makes the difference and it's a hard call.

Don't think chief executives with a decent shareholding will have the same interests as you, either. They have their own agenda and, in any case, are also responsible for employees and customers.

And don't be your own worst enemy by being subjective about your stocks.

Kidman says: ''View your portfolio as if you had inherited it from someone else.''

Read more: http://www.theage.com.au/money/secrets-of-the-share-race-20111119-1no0a.html#ixzz1h4jnqX6n