With thousands of companies listed on the UK and US stock markets alone, it can be hard to know where to start investing. How to find the right sorts of shares with no background in the market?
I would start investing the same way I would go on. Specifically, there are three characteristics I would look for when trying to find shares to buy.
1. Strong future business prospects
As Warren Buffett explains, buying a share is like buying a small stake in a business. So when investing, I look at the overall business and ask whether I think it has what it takes to do well in future.
Taking the long-term approach to investing, the future for me is not just coming years, but decades.
So I consider the possible size of a company’s target market, what competitive advantages it has, and how well its business model allows it to convert such advantages to profits.
2. Attractive valuation
Imagine you could buy, for £1,000, a business that earned £500 per year. After two years, you would already have paid for it (excluding any interest costs) and own it outright.
On paper, that business is selling for a price-to-earnings (P/E) ratio of two. That is low and sounds very cheap.
But then imagine I told you that business was £100,000 in debt. Suddenly, although the P/E ratio is the same, the value may looks much worse.
A great business can be a bad investment if one overpays for it.
When people start investing they sometimes focus too much on one valuation metric, like the P/E ratio. I would aim for a rounded approach to valuation – including always looking at a firm’s balance sheet.
Bigger may not be better, but it may be better monitored
Companies of all sizes and shapes can fail.
However, I prefer to invest in medium or large-sized companies than tiddlers. They have often had longer to prove their business model. A large listed company is also more likely to have institutional shareholders with big enough stakes to motivate them to keep management in check.
A tiny company often does not offer me that extra layer of reassurance, especially if its shareholders’ register is dominated by management.
Putting the theory into practice
From the moment I started investing, I would aim to diversify my portfolio across multiple companies.
Let me illustrate the above three principles by reference to a single share in my portfolio: ITV (LSE: ITV).
The audience for traditional television is in decline and I see that as a risk to sales and profits for the company. I also think it helps explain why ITV sells on a price-to-earnings ratio of 15, with a 6.6% yield to boot.
But traditional television remains a sizeable, though declining, business. ITV has been rapidly growing its digital footprint in recent years.
On top of that, a studios and production business means that the proliferation of viewing options seen in recent years has been monetised as a revenue stream for ITV rather than just being a risk.
I own ITV shares and would happily buy them if I was to start investing for the first time again.
This post was originally published on Motley Fool
