By Tony Young

Tony Young is a former head of research at Credit Suisse First Boston. Tony is now a consultant to Morningstar. The views expressed in this note are not necessarily shared by Morningstar.

This is a confusing time in stock markets. Should I buy now or sell before the market falls further? Is the market going up or down? How have I lost so much money? I thought I was investing in good stocks. What has gone wrong? How many of you have echoed these sentiments over the past six months?

In this time of gloom and doom it is worth revisiting the basics of investing.

Firstly let us address the issue of what is going to happen in the short term. A number of stockbrokers and commentators told us last month in June - there is a good chance of a July rally - the charts look good - stocks will bounce after the end of tax year-end selling. Stocks will bounce after the banks finish selling shares taken as security from the problem margin loan brokers. The Australian fund managers are sitting on high levels of cash and need to invest. Some commentators are telling us that we are entering a period of global recession. Others are saying that the growth out of Brazil, Russia, India and China (BRIC) will result in the markets bouncing back. Oil is going to US$200. Oil is going to US$100. Inflation is a problem and the Reserve Bank will lift interest rates. Times are tough and the Reserve Bank will reduce interest rates. When the market went up in April one broker wrote that the market has bottomed and you should now buy. Now that the ASX has fallen six weeks in a row that same broker last week wrote that we should now stay out of the market. Confusion, confusion, confusion.

RULE NUMBER ONE. SHORT TERM TRADING IS HIGHLY UNCERTAIN AND IS NOT RECOMMENDED FOR INVESTORS. I have not yet found any forecasting tool that can be reliably used to make money from the stock market within any 6-12 month period. Yes, you can make money from short term speculating if you are lucky but you can also make money if you are lucky enough to back the 8 to 1 winner at Dapto Dogs. Luck is a tool for speculators and gamblers, not investors. Fifteen months ago the commentators were telling us that it was different this time and that we were only half way through a bull market. Low inflation, strong BRIC growth, strong superannuation funds inflows etc would maintain the markets strong run. They were so wrong. Now that markets have been falling for a year many of those same commentators are now espousing doom and gloom. Will they be right? I have no idea. The only certainly is that in the short term, the market will go up, go down or move sideways.

On the other hand the one certainty is that the stock market will go up over the longer term no matter when you buy. Of course we all would love to buy on the dips to maximise returns but even those people who bought the market on its high multiple one month prior to the crash in October 1987 are ahead today despite our market falling around 44% in 1987, 19% in 1990, 15% in 2002/3 and currently down 27% from its peak on 1 November 2007. In fact IF YOU PURCHASED THE MARKET IN SEPTEMBER 1987 YOU WOULD BE UP 390% which works out at a return of 8% pa over almost 21 years. This leads to RULE NUMBER TWO. THE LOWEST RISK METHOD FOR INVESTING IS TO BUY EXCELLENT COMPANIES AT ATTRACTIVE PRICES AND BE PREPARED TO TAKE A FIVE YEAR VIEW. It is impossible to predict the exact timing but the odds are great that sometime in any five year period the market will either fairly or possibly overvalue a stock. It is delightful when it happens sooner than later but sometimes you will experience short term pain when you are sitting on short term paper losses. One needs to understand that investing in the stock market is an emotional rollercoaster. In markets such as today's it is easy to be full of self doubt and get caught up in the doom and gloom. Some look for a light at the end of the tunnel. They get excited when the market rallies for a few days only to see it fall again. Such short-termism leads to mistakes. Keep the faith and focus on the longer term. It will get better but we are not fortune tellers and can not pin-point when this will happen. Note there is a brief discussion on what are the characteristics of a good business further on in this article.

RULE NUMBER THREE. ONLY INVEST MONIES THAT YOU CAN ADEQUATELY FINANCE OVER A FIVE YEAR PERIOD. It was stated in the previous paragraph that at some point in any five year period the market will likely fairly or possibly overvalue a stock. It is also likely that in any five year period that markets will experience at least one crisis. In the past couple of decades - we had the 1987 crash, the Russian default crises, the US savings and loans crisis, the Asian markets crisis, the tech wreck and now the sub-prime wreck. Market problems are seen as surprises yet they are reasonably regular (again illustrating the difficulty of short-term trading). You should tailor your personal balance sheet to withstand these crises when they happen. This sub-prime crisis will pass but you can expect another problem in financial markets sometime in the next five to six year and it could happen at any time. Do not make the mistake that once the sub-prime crisis abates that the market will be totally safe for the next few years. If it is part of your strategy to borrow money to invest make sure you have sufficient reserves and cash flow to finance it through these crises.

What is a good company? There are circa 1900 companies/trusts listed on the ASX and being a small market it is difficult to find stocks that one is comfortable in taking a five year investment view. In my view at least 80% of the stocks on the ASX are for the traders and encompass all the risks that go with that style of investing. If one were to ask the question what stocks would Warren Buffett invest in our market - I doubt if the list would even reach thirty stocks. That is a large number of companies that don't make the grade and people are buying and selling these stocks every single day - no wonder we have a turbulent market and one that needed a clean out after so many buoyant years.

"I look for businesses in which I think I can predict what they're going to look like in ten to fifteen years time. Take Wrigley's chewing gum. I don't think the internet is going to change how people chew gum." - Warren Buffett.

A GOOD BUSINESS WILL SELL A PRODUCT OR SERVICE THAT CUSTOMERS WILL WANT OR NEED FOR THE FORSEEABLE FUTURE. IT SHOULD OFFER A GOOD RETURN ON EQUITY, HAVE A STRONG BALANCE SHEET, PRODUCE STRONG CASHFLOW AND BE WELL MANAGED. I recommend that you review your equity portfolios and for each stock ask whether it sells products or services that customers will genuinely want or need in the foreseeable future. More than 50% of the companies on the ASX fail this test. There are many companies with promises, short term offerings and prospects but it is questionable how sustainable their business models are. I am not saying that these are bad companies but suggest they represent higher risk investments. With a truly good sustainable business it is simple to understand where future earnings will come from and the risk of surprise is lower. I will pick on Macquarie Bank as an example. A small boutique investment bank in an isolated part of the world achieving more than 50% market share in global infrastructure financing markets is an amazing success story. It significantly benefited from the availability of cheap debt, low discount rates (in terms of valuing its satellites) and strong capital markets. The world has changed and does it now offer products or services that customers genuinely want or need? Are the bulk of its future earnings truly transparent or is it a black box? The new management team may successfully adapt and Macquarie Bank may continue to be a success but is it a low risk investment or is it one mostly based on faith? Please note that a good business is only a good investment if the share price is also attractive. In my view Woodside Petroleum is an example of a good world class, well managed, Australian company. LNG is a product that customers will obviously want/need for the foreseeable future and it will produce an excellent ROE for Woodside. Good companies can have short term hic-cups and it is possible that the oil/gas price will fall in the short term. However, Woodside has huge gas reserves and it is my belief that on a ten year view the global supply/demand forecasts for LNG mean that the long term prices Woodside will receive for its products will unlikely fall materially from current levels and will likely go up.

RULE NUMBER FOUR. DO NOT BUY A SHARE SOLELY ON THE BASIS OF YIELD. A number of brokers are currently recommending stocks on the basis of yield. A good yield is an added bonus but it should never be the primary reason for buying a stock. The golden rule for buying shares is still to stick to good businesses that are being offered at attractive prices. Brokers eighteen months were recommending us to buy Record Realty at 90 cents with its yield of 11% (one of the then highest yields in the market). Well the share price is now 5 cents and it is no longer paying a dividend. Unless there is a good cash producing company at the heart of an investment there is no guarantee that historic dividends can be maintained. An investment in an ordinary business with a high dividend yield can lead to a capital loss that is greater than the dividend received.

CONCLUSION

History has shown that you can make money following the above rules. There are currently excellent buys in the stock market but there is no guarantee that you will not suffer short term losses. When is the right time to buy? Who knows! I have yet to meet anyone who can accurately predict where the market is going over the short term. Some guess right some of the time but not all of the time. The only certainty is if you buy a good company today at an attractive price you will achieve an excellent return sometime in the next five years. Could you possibly buy better by waiting? Yes, but you may not and any attempt to finesse the purchase date is just guessing. Remember truly excellent companies are not in abundant supply in the Australian market and their prices will turn quickly once confidence returns. Other corporates will look to take over truly excellent companies if their share prices remain low. We all know the best time to buy and sell is to go against the herd. The tidings of gloom are overwhelming at the moment and the commentators are correct to be concerned. The financial system is currently in a mess. However the key question is whether these problems are already built into the prices of good companies. It takes courage to go against the herd and conviction to sit on paper losses when you are a part owner of a good company. Stick to the golden rules of good investing and keep the faith.

Aspect Huntley 28072008