Constructing a share portfolio

Picking winning shares on the equity markets is not an exact science. Investors should always bear mind that time in the market is more important than timing the market.

Investors who try to time their entry into the market, rather than spending time choosing quality shares whose value will increase over time, often end up with deteriorating investment portfolios. Speculators, who often try to time the market, are usually only interested in short-term gains. Speculators use sophisticated trading tools to make their decisions and need to have a profound understanding of the dynamics that affect markets and individual shares in order to be successful.

The most common method that is used to determine the value offered by a specific share is to consider the share’s relative valuation. This entails comparing the price/earnings (PE) ratio of a share with the PE ratio of similar shares, or with the average PE ratio of the corresponding market index. If, for example, a share has a PE ratio of 20, and most of its peers are trading with a PE ratio of 10, then the share would be deemed to be expensive.

A greater understanding of the specific company may reveal why its shares are trading at a different PE ratio than the norm. This requires a significant degree of investment analysis – looking at a variety of profitability, liquidity, solvency and other ratios, both in isolation and relative to the company’s peers. If, after such a comprehensive examination, the share still appears to offer good value, it would be a probable candidate for acquisition.

A variety of investment products are available to those investors who have neither the time nor the expertise to perform extensive investment analysis. The foremost of these are exchange traded funds (ETFs) and unit trusts, also referred to as mutual funds or collective investment schemes. These instruments allow an investor to acquire a portfolio of shares, rather than selecting individual shares. ETFs are known as ‘passive investments,’ meaning that the underlying portfolio of shares in the fund tracks a market index. That index can be very broad, such as the JSE All-share Index, or it can be fairly narrow, with a highly selective share portfolio. By definition, an ETF cannot out-perform its underlying index. Unit trusts, on the other hand, tend to be actively managed, meaning that a portfolio manager can change the composition of the portfolio on a regular basis, the intention being to attempt to out-perform a certain benchmark, which is often an index such as the JSE All-share Index.

Unit trusts and ETFs are more suitable as vehicles for smaller portfolios. This is because there are certain costs involved in constructing and maintaining a discrete portfolio, consisting of individually picked shares, which may be prohibitive if the value of the portfolio is below a certain amount. ETFs are especially cost effective, while unit trusts are somewhat more expensive, but offer the investor the opportunity to acquire a wide diversity of shares in his/her investment portfolio.

Financial advisers have a very important place in many investors’ worlds. A financial adviser should have an intimate knowledge of a client’s financial circumstances, and should thus be able to advise clients on which investment strategy is best for them, be it individually constructed portfolios, ETFs, unit trusts, or other investments.

The information contained in this article is of a general nature and intended for information purposes only. It is neither to be construed as financial advice nor to be regarded as a definitive analysis of any financial, legal or other issue. Individuals must not rely on this information to make a financial or investment decision. Before making any decision, we recommend you consult your financial planner/adviser to take into account your particular investment objectives, financial situation and individual needs.