Choosing which shares to invest in can be a tricky task, and particularly during periods of economic uncertainty when you may feel anxious about the impact events could have on your investments.
But successful investing, whatever is going on in the wider world, is about more than just picking a few shares which you hope will perform well. It’s also about holding your nerve, focusing on the long-term, and diversifying across a wide range of sectors, asset classes and geographical areas to spread your risk.
Remember that whichever shares you choose, their values can fall as quickly as they rise, so you must be comfortable accepting the risk that you may not get back any of what you put in. But over the long-term of, ideally, at least five years, returns from shares have tended in the past to beat those you can earn from cash. That said, it’s important to appreciate that, with investments, their past performance is not a reliable indicator of their future performance.
Here, we consider how you might spot a probable long-term winner for your portfolio.
A strong foundation
While identifying star performers isn't easy, look for companies with a combination of traits that may make them compelling investments.
Warren Buffett, arguably the world’s best-known investor, has talked about seeking out firms with an “economic moat”. By this, he means companies which not only have a very strong brand, but have a competitive edge in their marketplace. Such businesses are typically protected from disruptive forces, such as being made obsolete by technological changes.
Other characteristics to look for are relatively predictable earnings that haven't tended to suffer too much in market downturns. In addition, look for companies with the ability to achieve high returns on investment without having to rely on excessive borrowing.
Cash generation is also vital as the amount of money a firm earns determines whether it can readily invest in new opportunities or reward shareholders with attractive dividends.
Consider the detail
One way of assessing whether a firm is worth investing in is to look at its price-to-earnings (PE) ratio. This can be found by dividing the share’s price by the earnings per share over the past year. The theory is that the higher the PE ratio, the better the investment looks. But a low PE may not mean a share is a bad investment but rather it’s undervalued by the market. To get a clear idea, compare PEs of firms in the same sector.
If you’re seeking an income from your investments, ensure that you avoid falling into any dividend traps. Just because a firm is carrying a high payout, it doesn’t mean it is a good investment. It can often be the case that a rise in the yield comes in the wake of a falling share price, and the firm may in fact struggle to grow its dividend – it may even have to cut it.
You can use a share’s so-called ‘dividend cover’ to indicate how likely it is that a company will maintain, if not grow their payouts. You can find out a firm’s dividend cover by dividing its earnings per share (EPS) by its dividend per share (DPS). For example, if a group’s EPS is 100p and the DPS is 50%, then the cover total is two. The general rule of thumb is that a dividend cover of two or more represents a decent level of cover, although some groups, such as utility firms, well known for their reliable earnings can carry lower cover but are still viewed as steady payers.
Review your investments
As time moves on, the make-up of your portfolio will inevitably change, as some shares will have flourished, while others may have floundered. Keep an eye on your investments and ensure you rebalance when necessary by banking some profits and/or reinvesting in other shares to keep an allocation you are comfortable with.
However, choosing steady winners is not always easy, so you may decide instead to invest in a pooled fund, such as a unit trust, open-ended investment company (OEIC), or investment trust, that spreads risk across a wide variety of shares. This way, you pass the responsibility of choosing where to invest to a professional fund manager who will do all the legwork and selection on your behalf.
You can choose from a wide range of funds across different sectors and regions, but if you need help narrowing down your options, the Barclays Funds List is a list of funds that have built solid reputations and established sound investment processes, selected by Barclays’ investment specialists.
Remember that Smart Investor does not offer financial advice, so it’s down to you to decide how to invest your money. If you need help, seek professional financial advice. Always bear in mind that all investments can fall in value; you may get back less than you invest.