Tuesday 18 February 2014

Bargain Hunting

We all like a bargain, don't we? But beware: taken to extremes, it can become a way of life.

For example, in my fridge today is a 6-pint plastic 'bottle' of milk that cost me 10p (yes, ten pence) - paradoxically from one of the most 'expensive' supermarket chains. There's nothing wrong with it, apart from the 'sell-by' date - there is a very small risk that it could go 'off' before we use it.

Come to think of it, most of the contents of my fridge and freezer are reduced-price 'bargains'. And this bargain-hunting mind-set spills over to my investment style.

But what constitutes an investment 'bargain'. Taking the 'milk' analogy above, the attributes might be:
  • low price, compared to what you might expect to pay for something similar
  • some perceived 'risk' (such as the milk going 'off')
  • your own judgement of the seriousness of the risk

You don't need me to tell you the 'value' characteristics - there are lots of measures: price/earnings ratio, price/net assets ratio, price/ebitda ratio.

Risk is in the Eye of the Beholder

Probably the hardest part is assessing the risk. It's fairly easy with a bottle of milk but how to do it with sometimes-complex securities? There's no doubt that measuring 'risk' is trickier - except for that special class of securities that actually pay you to own them: yield is a great indicator of risk.

So how to distinguish between the high-yield 'dogs' and potential 'fallen angels'. The most obvious things to look at are:
  • the likely sustainability of the income (be it dividends or bond returns)
  • fundamental internal risks to the organisation
  • major shocks from the outside that might challenge the management

In terms of income sustainability you might look at dividend cover (and the level of the management's commitment to maintaining the dividend), debt ratio, the debt rating (is it a 'junk bond').

Then you might look at the business model. Does it seem sustainable for the future? Has the market changed? What is the competition doing?

Finally, you should try a bit of crystal-ball-gazing: what is happening now (or is likely to happen) that might change the market? For example: what does severe flooding mean for companies that provide flood defence services? Or for insurance companies?

In a sense, this reading-of-the-tealeaves is the least important part of your analysis, as Mr Market will have done all that for you - and it will be in the price trend. Unless Mr Market gets it wrong, of course - which he does occasionally.

Seek and Ye Shall Find

But there is something more fundamental to being a bargain hunter - and it is rather simplistic: you have to look. That is why it needs to be a way of life, as it is a 'percentages game': the more you look, the more you find.

A practical example: you could go along to my local supermarket fairly frequently and not find any bargains: you might be looking in the wrong place, or - more likely - you might be there at the wrong time. By contrast, I know pretty much the exact time the bargains are marked down and where they are put. Plus the walk up there is part of my overall exercise regime. It's win-win - even if I don't find anything I fancy (which is rare).

This is where being a yield-oriented DIY Income Investor pays off: looking for high yield investments leads you to an exotic mixture of the hopeless, the challenged and the potentially lucrative. Yes, you might 'come a cropper' but then again, you might find a golden nugget. And of course you will be picking up a nice income whilst you are waiting to find out which.

Now, what can I make with 6 pints of milk....?

Update 22/2/14: Fresh loaf of crusty wholemeal bread - 5p

I am not a financial adviser and the information provided does not constitute financial advice. You should always do your own research on top of what you learn here to ensure that it's right for your specific circumstances.

1 comment:

  1. Yogurt!

    Seriously, put the milk in a bowl and lightly whisk in 1 tablespoon of natural yogurt. Cover and leave it over night in the airing cupboard and you should have lots of yogurt in the morning.

    Next Question: What to do with 6 pints of yogurt
    Next Answer: Make fruit flavored frozen yogurt!

    Nice post btw. It all sounds so simple the way you break it down. I find simple is often best when it comes to investing. Asking the obvious questions usually yields the answers required when I am considering an investment!