If one is going to have a share portfolio of shares how does one go about selecting the individual stocks? There are many approaches ranging from investing in the top 20 or 50 so called blue chips to replicating the relevant share index to technical analysis (basing selections upon the interpretation of charts of historical share prices) to throwing darts at a dartboard across which has been pinned the share listings from the newspaper. Or perhaps in this digital age the share listings page should be spread across a computer keyboard and one bangs away on this blindly to see which ASX codes come up. And many many others approaches of course.

While there is more than one successful approach this blog will discuss a successful share strategy that is useful for long term portfolio investors who seek sound returns (from both increasing capital values and dividends over time) from their investment capital while mitigating as much as is realistically possible long term (as opposed to shorter term market movements) permanent loss of capital.

This strategy can be categorised as a value share strategy. Value investing comes from the investment approach of Benjamin Graham and Warren Buffet.  Two current exponents in Australia of value investing are My Clime and Roger Montgomery. And of course, with all modesty and no bias at all haha, Lifestyle Financial Services.

Two of the important elements of this strategy are to only invest in companies that represent high quality businesses and to purchase these companies at a price that represents reasonable longer term value based upon the company’s forecast future profitability.

So how does one identify high quality businesses? It is basically a matter of working out which characteristics or criteria are common in well performed businesses so that one knows what to look for. Characteristics of companies that have historically represented high quality businesses include having, a robust business model, an identifiable, sustainable competitive advantage, a high quality rating for financial fundamentals, a high return on equity, a track record of delivering increasing value, profits and dividends for shareholders, low debt and reasonable interest cover, future prospects that appear bright (i.e. increasing value, profits and dividends), and the ability to self fund growth and create value (usually from investing incremental capital to generate high rates of return).

It is also important to not pay too much for a company that does have these characteristics. Based upon forecast profitability and an appropriate discount rate it is possible to estimate a future reasonable value that is independent of the share price. In value investing this is usually called a future intrinsic value. While I don’t like the term intrinsic value because it implies a level of preciseness that isn’t really there (after all we are looking at the future here) this estimate of future reasonable value or intrinsic value is nevertheless a useful indicator of value as long as its appreciated that it’s a ballpark rather than exact value and that it is based upon current estimates of future profitability. The question does need to be asked as to how likely these estimates of future profitability will be. What these future values do tell you is that if the company does get close to achieving forecast profitability, whether the current price represents reasonable value or, even better, a discount or margin of safety to reasonable value.

Investing in shares is basically a probability exercise and businesses that have (and appear likely to continue to have) these characteristics are more likely to be well performed investments than those businesses that do not have most of these characteristics (although not every time). And particularly so if bought at prices that represent a discount to estimated future value. It should be your aim to have a portfolio that is filled with high quality businesses that represent reasonable value. It should be noted that there is no automatic correlation between a business being of high quality or being reasonable value and being in the ASX Top 20 or 50 or being a household name. Examples of companies that are either household names or in the ASX50 and are not regarded as high quality businesses based on their financial fundamentals include Qantas, Toll, Transurban and Newcrest.

If you are unable to find enough companies that represent good businesses at a reasonable price you should hold your funds in cash waiting for opportunities to arise rather than risk paying more than a reasonable value or investing in a lower quality business merely to be fully invested. If you do this sooner or later the probabilities are going to impact portfolio performance in a negative way.

Wow it all sounds so easy. In practice, however, it takes a good understanding of the business of a company in order to determine whether a company has or does not have the above characteristics. Beyond this probably the most difficult part to implementing any share strategy is to retain discipline. This can be difficult at times and more so in times like the present where there has been a strong sharemarket rally over the last 18 months or so and many companies (including many of the favourite yield stocks) are now selling at prices well in excess of what is a reasonable estimated future value based upon current profitability forecasts. Paradoxically these are the times when investor confidence is usually at its highest. For example consider how many investors are happy to now buy the banks and Telstra because the dividend yield is higher than a term deposit. Yet in early 2009 when the Australian share market had just fallen 50% in value and the share prices of the banks, Telstra et al were much lower and the dividend yields were much higher very few investors were interested in buying.

So the final part of this share strategy is to remain disciplined. To improve your ability to be disciplined and remain disciplined the Black Sabbath approach to share investing can be used. If one is tempted to invest outside of these guidelines that have stood the test of time tell yourself that if you do relax your discipline you will have to listen to Black Sabbath for ten to fifteen minutes. Maybe Electric Funeral or Fairies Wear Boots possibly. That should usually do the trick. If you are still tempted then you will have to listen to Black Sabbath for maybe one hour and ten to fifteen minutes. Faced with threats like that most investors won’t do it again.

Ask yourself do you have a tightly defined strategy for your portfolio? Do the companies in your portfolio appear to represent high quality businesses? Are your companies currently trading at prices that represent reasonable value or are they trading at prices well above estimated future reasonable value and thus at risk from significant falls in price when conditions change? Are you disciplined in your approach to investing in shares? If the answer is no to any of these questions (or you don’t know) a review of your strategy and/or portfolio may be appropriate.

This blog is general in its nature and cannot take into account any investor’s individual circumstances. Investors should seek professional advice before making any decisions with regard to investing in shares.