How to create your own share portfolio
Armed with common sense, and a few simple rules, it’s possible for just about anyone to put together their own share portfolio.
You can build your own set of investing rules – but make sure you stick to them. Here are a few suggestions to assist you in choosing your first investments:
Invest in businesses you understand
You need to know how a company makes its money. If this isn’t clear, don’t invest. This is one of Warren Buffett’s simple rules, which he has stuck to resolutely over the years. Most of us can understand what a supermarket company like Sainsbury’s does – many might struggle to understand a technology or engineering business.
Bigger companies can be safer than smaller ones
You might make a fortune buying the shares of an unknown small company, but you can lose all your money as well, as small businesses tend to have a higher failure rate. Sticking to the shares of established companies that have been around for a long time – such as those in the FTSE 350 index – can be a safer bet.
Make sure a company can grow its profits
Profit growth is the key to making good money from shares. It is usually better to pay a bit more for a share with good growth potential than to buy a share that looks cheaper but cannot grow.
This is because shares tend to be valued on a multiple of their profits. As long as the multiple isn’t too high (which can be a sign a share is expensive), if profits can grow there’s a reasonable chance the share price will too.
Insist on a long track record of continuous dividend payments
A company needs to have a consistent level of profits and cash flow to pay a dividend to its shareholders. This makes dividend payments a good signal of company health. A company that has paid a dividend for a long period of time – ten years, say – can end up being a better and safer investment than a company that has not.
Avoid companies with lots of debt
Debt is your enemy. A company has to pay interest on its borrowings before it can pay money to shareholders. The more debt it has, the more interest it has to pay – and the more risky its shares tend to be. If profits fall sharply, then debt can wipe shareholders out. To avoid sleepless nights, buy shares in companies that can comfortably pay interest on borrowings. You might set a minimum interest cover (the number of times a company’s trading profits cover the interest bill) – of at least five times, for example.
Be prepared to own a share for at least 5 years
This means you’ll worry less about the ups and downs of the stock market, as there is usually more time for good times to offset bad times.
Reinvest your dividends
Using your dividend income to buy more shares can be a great way to build up your nest egg. History has shown dividend income and its reinvestment has made up a large chunk of the money made from owning shares. This makes you less reliant on the stock market going up as well.
Your ISA and SIPP provider can set up your accounts so dividends are automatically reinvested for you.
Invest in a business that gets a good bang for its buck
You should look at companies in the same way as you look at savings accounts. Ones earning high rates of interest on their money invested (known as return on capital employed – or ROCE) tend to be good businesses. Do this by aiming for a ROCE of at least 15 per cent.
Make sure profits consistently turn into cash
Companies can be profitable but generate very little surplus cash. Cash is the lifeblood of any business. Without it, bills and dividends cannot be paid. Avoiding companies with consistently weak cash flow is usually a good thing to do. Look for companies that can turn at least two thirds of their profits into cash.
Don’t pay too much for a share
This is probably the biggest mistake investors make. Too often, paying too much for the latest hot share is the road to losses when expectations of big profits are never met.
Avoid this pitfall by setting yourself a rule for how much you will pay for a share. For example, you could set a limit of 15x current earnings (a PE of 15) or 20 times ten year average earnings. Whatever rule you set, stick to it.
Phil Oakley is an analyst at investment software firm ShareScope.