The investment approach that is most appropriate for you will be determined by your needs. You may be planning to build up a long-term share portfolio or start a short-term trading portfolio, making money out of short-term moves in the market. These different drivers require different investment strategies.
According to Erol Zeki of Barnard Jacobs Mellet Private Client Services, the first question an investor needs to ask is: “What is an appropriate asset allocation based on my risk profile?”
If you are saving to pay for school fees next year, don’t go into the market. If you have a slightly longer time horizon of up to two or three years then bonds or property may be a better option. However, if you have a longer term investment plan then creating a share portfolio can provide long-term growth.
Short-term trading is a different animal altogether and carries with it a higher level of risk. Higher risk or shorter term strategies need to form a smaller percentage of your investment pool.
Zeki says many clients have a two-pronged approach. They have a core equity portfolio built up with solid long-term shares using fundamental valuations. Then clients may hold a second, separate broking account where they execute short-term trades. Having two separate portfolios is important, not only because it focuses investors’ minds on different strategies, but because it also has tax implications.
Long-term investment portfolios attract capital gains tax when you sell the shares, however short-term trading portfolios can be viewed as a way to make a monthly income and attracts income tax. It is important that these portfolios are clearly demarcated for tax purposes.
Fundamental analysis
When investing in a long-term port-folio many people look at fundamental analysis where they would consider company valuations and the future growth of the company. Within this context you would need to decide if you are a growth or value investor.
A value investor would be looking to invest in companies that are cheaper than the market and therefore focus on valuation methods such as dividend yields, price-to-earnings ratios as well as understanding the fundamentals driving the company.
A growth investor would be prepared to pay a higher price for shares he or she believes have superior growth potential owing to improving market conditions for the company, product or sector.
However, both look at the fundamentals of the company and its environment and likely future earnings performance. Fundamentals apply to the company’s microenvironment, such as management and the potential of the sector it operates in, as well as the macroenvironment, which is the global world the company operates in and the impact of external factors on the company.
When looking at fundamentals investors have two approaches, bottom up or top down. Bottom up is when an investor begins by looking at the company’s fundamentals, and top down is when an investor first looks at the fundamentals of the economy and the impact on specific sectors.
Ideally, an investor should look at both; it is just the starting point and emphasis that differs. So, for example, a top-down investor takes a view that the rand is going to depreciate, which will be positive for rand hedge stocks. These types of investors then limit the shares they will analyse to rand hedge stocks and start to look at what specific rand hedge sectors will benefit most as well as which company has the most potential to outperform, based on the specific product they provide and the strength of management. If they are value investors they would also look to make sure they were not over-paying for the company.
A bottom-up investor, on the other hand, will look at a specific company that offers great value or potential based on extremely good management, being undervalued or having a defensible competitive advantage. These investors would also look at the potential of the sector. While bottom-up investors would not put too much weight on broader economic trends, they would consider them to analyse potential risks to the company. Bottom-up investors would argue that trying to second guess the rand is virtually impossible.
Short-term trading and technical analysis
A short-term trader would not really find fundamental analysis particularly useful as it is time-consuming and the investor, in this case, is looking at short-term opportunities that are driven by events in the market.
According to Zeki, there are three ways a short-term trader would view the market. First, and the most popular, is through technical analysis or charting, which finds patterns in the market that can help predict future movements in price.
Then there are short-term traders who take advantage of unexpected economic changes. For example, an unexpected interest rate decrease or higher than expected inflation numbers that have a direct effect on the economy and therefore on shares in certain sectors. This is a highly risky approach as the investor is betting against expectations.
Corporate activity is another favourite of short-term investors and hedge funds, for example, a major buyout of a large company such as Absa or major acquisitions that have an effect on a company’s share price.
While fundamental analysis is often used by longer term investors and technical analysis is usually used by traders, the two can be combined to find the right time to buy the right share.
Richard Seddon of Standard Bank Online believes investors should use both techniques — fundamental analysis to pick their shares and technical analysis to time their trade.
While the fundamental analysis will help the investor decide if they are investing in a solid company, technical analysis can help the investor decide when to buy the share or at what price.