If I was to start investing today, what shares would I buy? With so many choices, the UK stock market can seem overwhelming.
Here are three principles I’d bear in mind to start investing, each illustrated by a UK share I’d consider buying.
Free cash flow
One of the things I look at when considering a company is how much money it makes. A common metric for this is ‘earnings’. Although I find earnings useful, the figure can include non-cash items. So I also look at a company’s ‘free cash flow’. That is the money which comes in the door once outgoings are paid.
Free cash flow helps me understand whether a company is really profitable on a sustained basis. It also tells me how much money the company generates that it could use to pay dividends.
One UK share I’d consider buying is drinks maker Diageo. Owning premium brands such as Johnnie Walker and Guinness, it is able to charge a high price for its products. That enabled Diageo to generate £1.6bn of free cash flow last year. This free cash flow generator has raised its dividend annually for over three decades. With a rise in abstinence, though, there is a risk of lower revenues and profits in future.
Companies in a growth stage often burn cash before becoming profitable. My focus on free cash flow would exclude such companies from my consideration. I’d be willing to start investing without buying loss-making companies in their growth phases.
Net cash position
When Ben Graham published “The Intelligent Investor”, he found many companies traded for less than the liquidation value of their assets. That is fairly unusual for UK stocks today, except for investment trusts. But it does still happen. A discount to asset value alone wouldn’t be enough to make me buy a share. But it can make an attractive company more appealing.
The builder Galliford Try is an example. At the end of last year, it had net cash of £211m. Yet the company’s market capitalisation – the price of all its shares combined – is £155m. In theory, a bidder could spend £155m to buy the company and make £56m in cash profit. The buyer would also own a company which generated £4.1m in pre-tax profit last year.
One risk with Galliford Try is that if projects turn out to be costlier than it expects – for example because of physical distancing requirements on building sites – it could incur losses.
I’d start investing in winners
When people start investing, a common idea is to choose a company whose shares have collapsed because of a problem such as a fall in demand. They can look like bargains.
I understand why such turnaround situations seem attractive. But they can also be very risky. Past performance isn’t a guide to future returns, but if I was to start investing, I’d look for a company that has well-established markets, pricing power, and likely sustained demand.
For example, I own shares in the consumer goods company Unilever. It may offer lower possible returns than some turnaround candidates. And it is sensitive to consumer demand, so any economic downturn risks squeezing profit margins if shoppers cut spending. But I think its track record suggests it is likely to be around for a long time to come.