There are many reasons to invest in shares. Whatever the motive, with thousands of shares listed on the stock exchange, how can an investor choose which ones to buy? Let’s look at a few key considerations.
- Is the company growing its profits? In very simple terms the value of a company can be calculated by adding together all of its future profits. All else being equal, a company that consistently grows its revenue year on year will increase in value more quickly than a company with slower profit growth.
- How big is the company? Big companies may dominate their markets, reducing their potential for future growth. Companies with a smaller market capitalisation (share price multiplied by the number of shares on issue) may be younger and expanding into new markets and industries that support more rapid growth. However, the share price of smaller companies may be more volatile. That can be attractive to investors who use periods of share price weakness to top up their holdings, but less attractive to investors wanting more stability.
- How much debt does the company carry? If a company is paying lots of interest then there’s less cash available to pay dividends and to invest back into the company’s core business. While a company may be able to use debt to grow, in periods of market turmoil highly indebted companies are more likely to see their share price come under pressure than their less indebted counterparts.
- What does the company do with its profits? There are two things that a company can do with its profits. It can re-invest them back into the business, to boost its growth. Or it can pay dividends to its shareholders. Whether it’s best to opt for a high dividend low growth company, or a low dividend high growth one depends on individual requirements. Many investors depend in dividends for their day-to-day income. Others prefer to forgo annually taxable dividends in favour of capital growth that is only taxed – often at a discounted rate – when the profits are realised.
- Does a new share compliment currently held shares? The most basic risk management tool in an investor’s toolbox is diversification. Buying shares in a big bank won’t provide much of a diversification benefit if the portfolio already holds lots of shares in other big banks. Mixing financials with stock across other sectors, for example healthcare, resource, biotech or industrial shares will deliver better diversification.
There isn’t one single magic rule to building a share portfolio. For one thing, much depends on the goals and circumstances of the individual investor, their attitude to risk, and prevailing market and economic conditions. Whatever your situation your financial planner can help you unlock the secrets of share selection.