Things to consider when buying shares

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Here is an extract from a discussion on whether or not to buy some Rio Tinto (RIO) shares at current prices and whether this would be good value in 3 or 5 years time.

 Many people look to buy and sell shares on a given day, and many do so without any real consideration of much more than a simple ‘hunch’. A hunch is arguably as good as most recommendations from friends or people-in-the-know but if you seek to ponder such issues at a deeper level than a hunch then this article considers some of the points that would usually be worked through when looking to buy shares.

Remember, the use of RIO specifically is just an accident of this particular discussion. We are making no recommendation on RIO and you must not act on this to buy/hold/sell shares in RIO based on the content of this article.

 Is there a short answer to your question? No.

 Maybe if i tackle it another way… The first issue is whether 3 or 5 years is a specific date. In other words, do you need to sell the shares at that time?

 If you do then you are introducing a greater level of uncertainty – and this is the case no matter which company share we are dealing with.

 On the other hand, if you are retaining the shares at the end of 3 or 5 years and this is simply the funding period for the purchase of the shares then it is a completely different matter altogether.

 The reason there is a difference is ‘business cycles’. That is, i assume that we cannot predict just where on a business cycle a company sits at any given point of time. For example, has the commodity boom (which has been trashed last year then massively revived this year) actually peaked or are we sitting at the base of a long term growth period? We all know that the exploration, funding, development and start-up of a resource is a time consuming process that interacts with credit cycles, production cycles, broad economic activity cycles, global trading patterns etc, etc, etc – so the ability to point to a single resource and predict its position in 3 to 5 years is very limited. This is a key reason for the diversification of many mining companies, as they seek to spread their timing risk across a number of resource minerals/mines/countries/currencies etc.

i know that this is Investment Basics 101 but it does go to the heart of your question. No matter how good your research on RIO, the relativity of shareprice to resource is never a constant and this introduces the element of risk. However, if you are intending to retain the shares over a number of company/ business cycles then there is a greater chance that any fundamental analysis of the relative benefits of a company will play out in the share price.

 One way (and maybe not a good way) is to look back over the last 3 to 5 years for the specific company – RIO.

 

A look at the volatility of Rios share price

A look at the volatility of Rio's share price

 

 You can see the 3 year return is close to nil (apart from dividends of course). The 5 year return shows reasonable appreciation in price from somewhere around $30 to mid $50’s. If we go back to the low point in 2008 then you can see that even the 5 year return shows as nil at that point. Again, the obvious point is that the future usually bears little relationship to the past. However, it would be ridiculous to state the the underlying basics of the past and their reflection on the pricing of a security would not at least give some indication of how a particular company share price moves in relation to those basics. In other words, if the underlying commodity prices for RIO’s mine output hold up then you would expect the company’s plans for increased production would result in a growth in underlying value. Nothing is ever simple in such analysis, and it could be argued that even if those prices do hold up and production is increased then there is no guarantee that the shareprice will improve as the total ‘resource’ (ie, reserves of unmined minerals that the company holds in its leased areas) may be declining – leading to a perception that the company is on a downhill slope.

 There is quite a bit of bally-hoo in financial markets about the resources vs industrials mix and outlook. For decades the industrials outperformed resources. The rise of resource companies from the turn of the century surprised many. As an observer of those times, it seemed to me that the initial reaction was incredulity and a perception that it would be a mini-boom in an otherwise unappealing sector. It was only later that the “BRIC” (Brazil, Russia, India and China) story seemed to evolve as an underlying reason for the resurgence of resource companies. There is still a great deal of uncertainty about just how much longer this particular lift in prices has to run. i have seen comparisons made at fund manager meetings between the industrialisation of China and the equivalent period in other countries, with this being used as a reason for expecting the impact of the BRIC countries to continue for a long time yet.

 We could look at the fundamentals of the specific company. AspectHuntley Research rates RIO as a ‘buy’ as of 20th August 2009, suggesting that on current assumptions you would look to reduce your RIO exposure at somewhere around $111 and consider selling at somewhere near $136. This would suggest that RIO at the current price represents a discount to the valuation placed on it by some researchers. The comparative example with BHP (being two of the biggest miners it is reasonable that they always be compared), the research suggests RIO is trading at 12x its prospective earnings versus BHP’s 16.8x for the 2010 year. In other words, RIO is running at a bigger discount to the calculated current value of its assets and cashflow.

 Again sticking to company specific issues, it may take some time before ‘market’ confidence in RIO’s management is restored – that confidence having taken a knock with the perception of poor timing for the Alcan purchase, the rejection of the BHP takeover and the angst that the move towards selling key assets to Chinese interests provoked. This may seem a rather nebulous point but if we look back in time we can see that BHP suffered similar difficulties from its failed copper purchases and other perceived management decision making failures and that it was a long time before BHP’s price fully reflected the values of the underlying operations. Simply put, investors and analysts can worry that companies will make silly decisions and wipe out large amounts of company money in the process. Therefore, the companies trade at a discount to the standard valuation and do so for an extended period.

 So the fact that a company is at a discount to the inferred valuation is no guarantee that the price is a bargain. It could be that you buy that bargain, hold it for years and sell it at a loss/small gain only to find that it eventually recovers strongly.

 This is one of the reasons that some are calling the end of the “buy and hold” strategy for investment. Proponents of this argument suggest that buying and holding for the long term is a ‘mugs’ game’ and that the better option is to attempt to buy low and sell high (it sounds so simple, doesn’t it?). However, in my experience it is not so simple to work out what is a low price and what is a high price. Thousands of fund managers around the world try this every single day and many of those fail. This is one of the reasons that we adopt the ‘passive’ index approach to basic investment. By spreading your money very wide across a market and reducing your holding costs as far as you reasonably can there is a greater chance that you will obtain the broad market return – which is usually a premium over the cash rate (for all sorts of reasons).

 So an opinion on whether RIO shares are a worthwhile purchase over 3 to 5 years is far more difficult than it would seem.

 Another way to approach it is to look at the portfolio point of view. If you buy these shares, will RIO make up a big slice of your overall sharemarket exposure? Your overall portfolio for all investments? If it will then you would be increasing your selection risk and the chances of selecting wrong. If the purchase will keep your RIO exposure reasonable (whatever reasonable may be in that context) then that would make this less of an issue.

 Portfolio exposure is important because no matter what the company, it is possible for individual companies to show huge variations in price and the more you have in one area then the more exposed you are to those variations. If the money is spare then that may be ok. If it is central to your money aims then perhaps a broader diversification with less potential gain but also less potential loss would be worth considering?

 Also from your personal finances point of view, if you want a strong income from the investment then perhaps RIO is not such a good choice, as the current dividend is around 1.4% as a return over a year (ignoring franking credits). Companies such as RIO and BHP traditionally pay a lower dividend as they reinvest into capital intensive operations and attempt to retain ‘fat’ to help them through commodity cycles, as well as aiming to keep the actual dividend paid as stable as possible.

 

Hope that helps!

  

As usual, remember the disclaimers – this article is NOT advice and should not be considered advice. It is simply an example of some of the issues that need to be looked at when considering buying a single company share. You must not act as though it is advice because it will not take into account your personal situation. That can only be done through your seeking and paying for specific personal advice that does look at your full current financial position, aims and objectives. 

 

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  1 comment for “Things to consider when buying shares

  1. May 21, 2010 at 12:55 pm

    Thank you for your informative post. I think back the first Ipod purchase I ever did. It is similar to investments in some ways. You don’t know if the next year’s model will be better but I purchased it any way.Just like the stock market, difficult to say where things will be headed, so you need to take some chance. Looking forward to additional posts. Thanks

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