This practice enables managers to ascertain whether the equities he monitors are fairly valued and how much further they can realistically fall or rise.
For example, target prices can be calculated by looking at profit and cash flow forecasts over a two-year period. Stretching any further, according to Mr Davies, would be “detrimental to accuracy”, while focusing on a shorter period risks failing to factor in the time it takes for a troubled company to stabilise its operations and bounce back.
It is also useful to focus on cash profits rather than accounting profits, as the latter can be more subjective and easier to manipulate.
Setting a target price example: Lloyds Bank |
Jupiter’s Steve Davies’ model indicates Lloyds Bank can deliver sustainable earnings of around 8p a share, and it can return around 6p per share in the form of dividends or buybacks. The FTSE All-Share Index has an overall dividend yield of 4.19 per cent, but it may take a while for bank dividends to be valued as highly as this. Mr Davies therefore uses a 5 per cent yield to derive a target price for Lloyds of 120p. That represents potential upside to the current share price. Factoring in high levels of conviction and the fact Lloyds is a highly liquid stock, this is why it is the largest holding in the portfolio currently (as at 30 June 2016). |
Rule 2: Don’t buy flavour of the month
Jason Hollands, managing director at Tilney Bestinvest, thinks being systematic is important when it comes to investing. He says: “I think it’s important to try and curtail your emotions and to run with a set of disciplines to keep these in check.
“It’s all too easy to anchor around an investment that has clearly not worked out and hold on too long because no one likes to admit they made a mistake, or to get swept up in the excitement around investments or asset classes that have enjoyed a recent strong run or are being hyped.
“That often results in self-directed investors developing a very long tail on their portfolios, with too many legacy holdings as they retain yesterday’s ideas and continually add whatever is flavour of the moment.”
To counteract this kind of behavior, Mr Hollands first advises capping the number of funds someone holds in their portfolio 20, regardless of how much money is invested. He claims holding any more could hinder the ability of investors to reassess their convictions, which is something he describes as a “vital discipline”.
By rebalancing a portfolio twice a year, he reckons investors are more likely to take profits before share prices run out of steam, and correctly redeploy these funds into new investments that match an individual’s long-term goals and risk profile.
