Ask Colin

What would be a good strategy to eliminate the undesirable stocks?

I want to invest long term in the share market. I love Buffett strategies, however, I am having difficulty narrowing down the field. Buffett says ROE is the most important issue to look at, although recently a Broker said in Australia ROIC is the first place to look. What would be a good strategy to eliminate the undesirable stocks?

I was thinking along the lines of:

-obtain list of All Ords

-delete investment companies

-delete property trusts

-delete resource stocks

I want to narrow the field down & then look at whether EPS is strong & rising over the last 5-10 years, measure debt etc.

You have asked an enormous question. I will try to address it, but if I do not cover things you need answers to, get back to me. I do not know everything, but I will tell you when I do not know and where you might go for help if I can.

Firstly, if you are interested in being a long term investor, I suggest you get and read Stocks for the Long Run by Jeremy J Siegel (Irwin). I have just written a review of it for Shares magazine (October issue, I think). It is a great book. It is written by an academic, but in this case a particularly sane and self-interested one. He began to try to unravel the investment riddle for himself and has written up his findings. Unlike many books by snake oil salesman it is well researched and facts are documented. It is also not too difficult to read. It is also consistent with Buffett to a point, but certainly on the stress on taking a long term approach.

Let me start by explaining that there are three basic approaches to investment:

1. The asset allocators. These people work on the basis that something like 90% of investment return is derived from the decision to allocate assets. So, the results are determined by how you allocate your total funds to shares and other asset classes. Then, within the shares allocation, how you allocate your funds between national markets. Then, within each national market, how you allocate funds to industry sectors. This is often called a "top-down" approach. Many professional fund managers use this approach. The extreme form is the Index funds.

2. The stock pickers. These people work the other way around and it is often called a "bottom up" approach. The idea is that they seek out the best stocks wherever they are. Buffett falls into this class. So does Templeton. Two of the best in the last 50 years. However, it is not an easy method and many fail at it.

3. The active managers. These people take elements of both the previous approaches. They use a basic asset allocation method, but try to tweak the allocation towards individual stocks they think are best. This is how many professional fund managers try to justify their fees - by "adding value" they call it. Many fail at it, so I guess they are "subtracting value".

The more I read about investment, the more I accept that there are many ways to make money. There is no single best way. It may depend a lot on the person involved.

Among the stock pickers and active managers there are two basic "styles", as they are called:

1. The value approach. These investors buy undervalued shares and hold them until the market re-rates them.

2. The momentum approach. These investors buy growth companies. They are often apparently over valued until one considers the potential growth in earnings.

Again, there are combinations of both approaches. There are also those who concentrate on big capitalisation companies and others who concentrate on smaller capitalisation companies within each of these styles. So, there are many ways to make money in the markets.

Your starting point must be to decide:

1. Your time frame - easy, you have already decided to be a long term investor.

2. Your basic approach. Asset allocator or stock picker or a combination.

3. If you are to have an element of stock picking, whether you want to concentrate on value investing, momentum investing, or try to do both.

Only then can we start to answer the question you have asked.

Value investors will concentrate on measures of relative value like PE ratio, dividend yield, price to net tangible assets.

Growth investors will concentrate on return on equity (however defined) and price to sales or price to cash flow.

You can read many books and different writers will have different favourite methods. The main thing is to select a methodology that has been tested and works in the long term. Then be consistent. John Train made the statement in one of his books that consistency is the real secret - that even a mediocre approach applied consistently will beat those who chop and change between methods.

I hope this helps you see the shape of the landscape. Let me know if I can help by trying to clarify any other issues.