I’ll never forget a lecture I once went to by Terry Smith, author of the book Accounting for Growth. Mr Smith had been a research analyst at the time, and his book came about as a direct result of the spectacular failure of a number of FTSE 100 companies.
Investors of a certain age will remember Polly Peck and British and Commonwealth, which both went bust despite posting healthy-looking earnings growth.
Terry Smith showed how, while earnings were looking good in their accounts, these companies were getting desperately short of cash. Polly Peck had debts of around £1.3bn when it collapsed in 1991.
If the experts were so easily fooled, how can private investors like us avoid the mistakes?
Avoid the hit
I’m a great believer in strategic ignorance. I have a mental checklist of some headline figures that I rate as important to my strategy, and I don’t even try to examine everything in detail.
If you have a portfolio of, say, 10 to 15 stocks, you really can’t do that anyway. Underlying this, organic that, exceptional the other… bleurghhh! There aren’t enough hours in the day, not if you want to enjoy anything of life.
I do look at earnings (including forecasts), but a key thing for me is keeping an eye on debt. I’ll buy companies carrying debt, sure, but only if I have a fair idea of what’s reasonable and what’s excessive. I also like dividends, but I must be able to see there’s enough cash to pay for them with a reasonable safety margin.
Other than that, I do something that to many might seem unthinkable — I trust the experts to flag up any serious concerns. I know they’ll get it wrong sometimes, but I also know that I’d get it wrong too. And that’s a risk that I factor into my planning.
Use the experts
I’m not just talking about the likes of Warren Buffett or Neil Woodford here, but the vast multitude of commentators whose efforts have been greatly enabled by two momentous developments.
One was the liberalisation of the investing business, which is no longer a preserve of the privileged with their secrecy and their fat fees keeping out ordinary folk like us.
The second is this wonderful medium we call the internet. Looking for dividend experts? Small-cap experts? AIM experts? You might have noticed that, at the bottom of Motley Fool articles, there’s the statement: “Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.“
Why would I rely on just my own brain when there’s that massive pooled multi-brain out there for me to dip into whenever I want?
Get your balance
To sum up, I think the key is to first decide on your strategy — maybe income, maybe growth, maybe small-cap. Decide on those few important measures (yield, cover, debt) that are crucial for it to work. Then read around, and consider what others are saying too. And just accept that you will sometimes get it wrong.
One final key suggestion for me — diversify. When the financial crisis hit, I’m glad I was only holding one bank stock — and reading the opinions of someone I trusted as a banking expert helped me cut my losses early.