Indeed, many investing theories that seem simple are more nuanced and complicated than you might think. Follow these common misconceptions without understanding the caveats and you could hurt your overall returns.
Strong economies equal strong stock markets
There is a good reason why people think that robust economic growth automatically translates into higher returns, said Paul Atkinson, head of North American equities with UK-based Aberdeen Asset Management Inc. When people feel secure in their jobs and their financial situations, they are more willing to spend and invest. That, in turn, can help boost company sales, profits and stocks, right?
It’s not that simple. Numerous studies have found that rising markets have nothing to do with economic growth. A London Business School study examined 19 countries between 1900 and 2011 and found that, on average, gross domestic product (a measure of the value of domestically produced goods and services) actually falls when markets rise, and vice versa. “It’s an inverse relationship,” Atkinson said.
For more recent examples, look to Europe and Asia. In 2012, France’s CAC40 Index rose by 14%, yet its GDP growth was flat. That same year Hong Kong’s Hang Seng Index was up 22%, yet China’s economic growth slowed from 9.8% in 2011 to 7.8% in 2012. In 2010, when Brazil’s economy was seeing 7.5% growth, its stock market finished the year down 1%.
So what’s happening? Bob Gorman, chief portfolio strategist at Toronto-based TD Waterhouse, said that stock markets are a “discounting mechanism.” They rise and fall in anticipation of future events and not as a response to current events.
Instead, it can be smarter to take a “what goes down, must go up” approach to stock investing, said Gorman.
Investors have a better chance of being rewarded if they buy when fears about a lagging economy are depressing stock prices. Those who wait until the economy is hot again will likely miss most of the market gains.
“The conclusion is that sluggish economies are better to invest in than high-growth ones,” Atkinson said.
A low price-to-earnings ratio means a company is cheap
When people search for undervalued companies, they often hone in on an operation’s price-to-earnings ratio. That measure, called PE, represents the price people are willing to spend on a business for each dollar of earnings it generates.
If people expect strong future growth, they’ll pay more. If it looks like earnings will only expand slowly, or not all, investors will pay less. It’s a metric touted by investors and fund managers all over the world.
While PE is a good starting point, it is dangerous to base a buy on that ratio alone, Gorman said.
In some cases, a one-time event may have caused the PE to fall in the short term, making the stock appear cheap, said Safa Muhtaseb, a portfolio manager with New York’s ClearBridge Investments. For example, if a company has a surprising one-time boost in quarterly earnings while the stock price doesn’t budge, the PE ratio will decline.
It’s important to look at all three types of PE ratios — trailing, current and forward, said Gorman. Trailing PE uses past earnings, current takes into account this year’s earnings and forward uses what analysts think the company will earn in the future.
Gorman relies most heavily on the forward PE measure.
“It’s a lot more important to know what things will look like in the future,” he said.
In addition to PE, look at other valuation metrics, such as price-to-book (the price people are willing to pay for the value of the company’s assets) and enterprise value to earnings before interest, taxes, depreciation and amortization (EBITDA). The latter metric measures a company’s return on investment.
If these numbers are also low, then it is a good indication that the stock is undervalued, said Gorman.
The higher the yield the better
Since 2009, investors have been piling into dividend paying stocks, many of which have yields of 5% or higher. They were attracted to these companies because it was hard to make money in bonds thanks to low yields, and overall portfolio returns were low, too.
Unfortunately, those who only looked at yield suffered if those dividends were suddenly cut by the company.
The right way to invest for income is to buy shares of companies that increase their dividends year after year, said Atkinson. It is a “red flag” if dividend cents per share is not increasing, he said.
Average yields are the 2% and 5% range, so anything above that should to be scrutinized. If a company’s yield is too high, that could be a sign that the payout will soon be slashed. As well, yields rise when stock prices fall, so a high payout could indicate that investors are worried about future growth at the company, said Muhtaseb.
The most attractive yields are within that 2% to 5% range, said Atkinson. You eventually want the dividend to exceed that 5%, but only if the payout is sustainable, he said.
Buy and hold is the best
Many investors will fondly remember the 1990s, when nearly everything they bought rose in value amid a stock market bubble. As we’ve learned from the tech crash and the subsequent recession, markets go up, they go down and then they go back up again.
If you just buy and hold your stocks, you won’t be able to profit from changing economic conditions or sector-specific situations, said Gorman. Don’t confuse buy-and-hold with investing for the long term, he said.
Gorman likes to hold his clients’ stocks for between three and five years, but he’s always looking at his portfolio to see if he should sell.
“Don’t put it away in your safety deposit box,” he said. “Ask yourself, do the reasons that compelled me to buy this investment today still apply?”
Say you bought something that was cheap, but the stock price and valuations rose dramatically in a year. Buy-and-hold inventors would hang on, but a savvy investor should be thinking about selling some shares instead, he said.
Global events could also create attractive buying opportunities. If you take a hands-off approach to investing, then you would have missed out on a chance to buy shares of cheap European stocks that popped up during that region’s recession, said Muhtaseb.
Don’t get too excited, though. You don’t want to be a frequent trader either. “It’s never all-in or all-out,” he said. “Gradualism is best.”