THE JUMP to investing in individual equities (shares) is a big one and not one you should consider making without ample preparation. There is no shame in never going any further than investing in the index itself through an index-tracking unit trust fund. At almost 14 per cent return over the long term, you are setting yourself up for your life ahead. You will beat most of the professionals, and assure yourself a secure future.
For those who wish to continue and buy shares: don't panic. You are going to buck the trend of our soundbite culture and think in years, tens of years. You are going to invest in the easily understandable and recognisable brands that you use in your daily life and with which you have been familiar for years.
Consider: the second richest self-made man in the United States and therefore the world is an unassuming Nebraskan called Warren Buffett. He's worth somewhere between $15bn and $20bn dollars. How has he done this? Purely and simply by investing in simple, understandable businesses with favourable long-term prospects and which are already efficient at what they do. Using this somewhat mundane strategy - by investing in companies like Coca- Cola, American Express, Disney and Guinness - he has returned 24.1 per cent annually since 1964 to investors in his Berkshire Hathaway investment company.
As a first venture into the world of Foolish investing, we suggest you don't just buy what you know but you buy what everyone knows. Brands are the really important point. We are looking for brands that are instantly recognisable.
Anatomy of a great share
To show how you should work out whether to buy a share or not, let's look at a share beloved of Foolish investors: Unilever. It is everywhere in our daily lives (although you may not realise it yet). The steps below clarify why Unilever meets the Foolish definition of being a Great Share and how we can apply these criteria more generally.
1. Have they built a consumer brand?
Unilever is a series of monster worldwide brands. Really? The shelves at your local supermarket are heaving with Unilever brands. Lux soap, Brooke Bond and PG tea, Birds Eye peas, Oxo, Domestos and Jif. That's a small sample of the Unilever world.
2. Are they the best in the business?
Which business? Unilever is listed in the Financial Times as "Food Producers" and that is part of the story, but the major growth area of its business is detergents and personal care products. There are no other British companies coming close to this range and success.
In other sectors, identify the top two or three companies, decide which is the best of the lot, do a bit of research into their financial situation (we'll see how later on) and buy and hold the strongest among them for decades. Or you can buy the two or three main competitors if they are good enough.
3. Do people buy their stuff regularly?
Once you have smeared, eaten or washed with a Unilever product you have to go back and buy more of them.
4. Are they making a lot of money for their efforts?
In general, you want to find companies making more than 7p in every pound (after taxes) and you'll generally want those companies to be driving a consistent rise in that rate of profitability. This isn't where Unilever shines. Over the last few years they have been making around 5p in the pound after tax. Low margins (that's the name for this amount of profit) are common in bulk consumer businesses. Unilever's margins have remained steady, while its business has been growing. Coca-Cola has managed to increase its after-tax margins from 10 per cent to nearly 22 per cent in the last decade, which might make you think Unilever is a slouch. But Coca-Cola has one dominating brand that allows it to streamline production and marketing around the world. (And yes, it is a great share!)
Unilever's diverse business is never going to have high margins but it is expanding aggressively into the huge untapped markets of the developing world.
5. Are they up to their eyebrows in debt?
There is good debt and there is bad debt. One of the simplest ways to look at how much a company is in hock is by looking at how many times the income it is making will pay the interest on the loans it is carrying. This is called the "interest cover" and for Unilever it runs at almost 15. If you want to express it as a formula it looks like this: interest cover = interest payable divided by pre-tax profit and interest payable. Interest cover of 15 means they can pay the interest on their debt 15 times over, which is plenty. Interest cover of five to 10 is a comfortable norm.
6. Have they been a success up to now?
Success breeds success. While past success does not correlate infallibly with future success, it is an important indicator. Any company that comes into consideration as an Obviously Great Investment will have been a success for many years and that success will have carved it a dominant industry position.
How do you find out how shares have done over the last five years? The easiest way is to look on the internet. At the Datastream site (www.marketeye.co.uk) you will be able to download, free of charge, price histories on all UK shares for the past five years. Calculating the compound rate of annual growth in share price over the last five years is actually quite easy if you have a scientific calculator. Take the current share price and divide it by the price five years ago, then take the fifth root of that, take away one and multiply by 100. Then you have the percentage. Here's an example:
Share price 4 July 1993 : 25p
Share price 4 July 1998: 75p
Fire up the calculator and key in 75p divided by 25p = 3. Press "shift" or "inv"' button then the xy button then 5 (for five years) and finally the equals button. The answer is 1.2457. Take away one and multiply by 100 and you have the annual percentage return for Cactus Plc: 24.57 per cent. (If you are calculating over six years you take the sixth root - and so on.)
Show me some more companies
Of the 2,000 publicly traded companies in the UK, you will be hard-pressed to find more than a few that meet the six criteria above. Other Foolish shares are Marks & Spencer, Vodaphone, Glaxo Wellcome, SmithKline Beecham, and Zeneca.
Have a look at the UK Motley Fool website (www.fool.co.uk) for information and discussion about UK shares.
Extracted from the `Motley Fool UK Investment Guide' by David Berger with David and Tom Gardner, published by Boxtree at pounds 12.99. Copyright David Berger, David and Tom Gardner 1998. To order a copy with free postage, call 0181-324 5522. Find out more on the internet at www.fool.co.uk
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