Good principles can reduce risks

Following the recent decline in interest rates, and the fact that most economists have released consensus forecasts of impending further declines over the next 12 months, many investors are looking for shares that may benefit from this economic environment. 

One type of share that most investors will think of is the type of share that offers a high dividend yield.

Unfortunately, the decision-making process isn’t quite as simple and investors who tend to act rashly may end up making the wrong decision. 

A company’s dividend yield is a historical figure and it doesn’t bear any guarantees for future yields, which means that the moment a company starts to suffer, this may very well be the first place it decides to cut back.

But how do you protect yourself against the possibility that future data may indicate that a particular company may no longer be able to deliver sustainable growth in future?

Warren Buffett is widely known as one of the most successful equity investors of our time and along with other value investors who follow him closely, he only applies a few basic principles in his selection process.

By applying two or three of these principles, investors will be able to dramatically lower their risks.

Take a long-term approach before you buy, and also thereafter

Don’t tamper with your shares. The value investor invests with a long-term view, in strong contrast to a growth investor. A growth investor looks for shares where prices will rise in emerging sectors and for companies who seem to be ’cheaply’ priced at any price. 

A good example of this is IT share price rises in the late 1990s. Investors were for example willing to buy Dimension Data (Didata) shares at R10, R20, R30 and R70 as from mid-1998 to mid-2000. We all know what happened shortly after, with Didata trading at only R2 per share in 2003. 

Investigate the company and not the market

There are four basic indicators that can help you determine whether companies offer good historical value and they really are quite easy to apply. 

Search for a rise in dividends. The dividend yield is the dividend per share, divided by the share price and it’s usually expressed as a percentage. The higher the dividend yield, the more value the company offers.

Determining value, however, doesn’t stop there. First, when searching for value companies, it is very important to ensure that the company has been in existence long enough for it to be considered valuable.

Second, the company has to show continuous growth – at least five years’ worth, for example – in its dividend distributions.  This makes the quality of the dividend yield more reliable. Only a few companies have managed to do this over the years. 

Search for a low historical price-to-earnings ratio (P/E). The P/E is the company’s share price in relation to its earnings (profit) and shows us how cheap or expensive a particular company’s share is. As the P/E drops, the company can be considered ’cheaper’.

Consider the price to net asset value (NAV) ratio. This ratio shows us how the market price compares to the company’s physical asset value. Similar to the P/E, a lower ratio indicate a “cheaper” stock. 

Research the company’s profile, not its management

When a group of companies appoints a new, more reliable management team to improve its extremely poor reputation and structure, it’s usually the bad reputation that will remain.

By taking a cold and clinical approach and only applying these principles, I have identified five shares that currently stand out above the rest in my opinion. 

They are Pioneer Foods, Remgro, RMBH, Steinhoff and Woolworths. Although Pioneer Foods recently released a trading update in which they stated that their turnover may decline by between 4% and 6% this year, it remains a wonderful company with an excellent profile. 

All five companies have managed to consistently increase their dividend distributions over the past five years and at current price levels, they are trading at an average historical dividend yield of just below 4%. 

Historically, relative to their own historical P/E ratios, they aren’t only trading at extremely low levels, but at an average P/E of 14.8, these five shares are trading much lower than the JSE’s P/E of 20.1 times. 

What’s even more interesting, is the fact that even though these five high-profile companies are trading at very healthy levels, their year-to-date growth has declined by more than 13% (up to 26 October 2017) while the JSE has grown by 17% over the same period. 

This either has to be one of the best buying opportunities in any of these five top companies, or there is something going on that we have not yet been told about.

I feel that the above mentioned investment principles will help investors avoid risks and that these five shares can definitely be considered as part of a well-balanced portfolio.  

Schalk Louw is a portfolio manager at PSG Wealth.

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