Assessing Investment Opportunities

No matter what the investment opportunity is (whether it is placing funds on deposit with a bank, investing in the shares of blue chip companies or investing in managed funds, corporate or government bonds or alternative investments) one should in each case consider the “expected return-for-risk”.

That is, one should consider the return that one would be reasonably expected to earn on the investment, the prospect of suffering a loss of capital and if one did suffer a loss of capital how dramatic that loss would be. To state the obvious, those that generate a higher expected return-for-risk would be preferred over those generating a lower expected return-for-risk.

Some commentary is set out under ‘R&M Investors’ on the expected return-for-risk in relation to various alternative investments. This includes investing in the shares of a blue chip company, the shares of a ‘dividend stock’, placing funds on deposit with a bank and investing in managed funds.   It also sets out some commentary on investing in peer-to-peer loans, mortgage loan funds, investing in a book of loans provided to borrowers of prime credit standing and in a subordinated tranche of such a book. Hopefully by reading this commentary you get further insight in to the return-for-risk in respect of an investment in each of these asset classes and how they compare with each other.

The vast majority of people would find the task of assessing the pros and cons of investing in debt or equity instruments issued by companies, listed or unlisted, to be challenging. It can also involve a considerable amount of time and effort in each case.

One first needs to establish what information is needed and then gather that information. Having done so one needs to analyse the information, determine its expected return-for-risk, rank the investment opportunity against other investment opportunities and then make an investment decision.

Unfortunately one is very unlikely to find the necessary information in an annual report, product disclosure statement or in the company’s financial statements.

[The article ‘Investing in early stage companies’ set out under the blog section of the Rogers Morris website gives some insight into some of the information one would need when assessing the merits of investing in companies. Although the article related to investing in early stage companies, a similar approach would be taken when assessing the merits of investing in listed companies, even large listed companies.]

It should be up to the directors of the company concerned to provide the necessary information, which includes three financial forecasts (pessimistic, optimistic and realistic scenario) and the main assumptions (which need to be reasonable and justifiable) on which they are based.  Unfortunately, that information is seldom (if ever) disclosed in any prospectus or other product disclosure statement. It is also not disclosed in the company’s financial statements. One is however not prohibited from asking for it. As private companies generally find it difficult to secure additional non-bank (debt, equity and hybrid) capital their directors are generally willing to answer questions and provide additional information. The directors should also address the ‘expected return-for-risk’ of an investment in their company and to provide comparative information to persuade one that their company offers the best-expected return-for-risk. One will however not get the information from listed companies. If they disclose the forecasts and so on to you they will need to also disclose it to ‘the market’ and that will open the proverbial can of worms.

It is important to recognize that different companies, even in the same industry, have different risk profiles and that the risk (and the expected returns) of one instrument differs from that of another. The article ‘Investing in blue-chip shares’ provides some insight into the level of risk associated with an investment in ’blue-chip’ shares. That is, an investment in the ordinary shares of Australia’s largest ASX listed companies. Similar conclusions can be drawn from an analysis of the world’s largest listed companies.

Before investing in blue-chip or other listed securities one needs to understand how those securities are priced, what risk one is taking on and what one would be expecting to earn on those investments.

The price of a share is basically the present value of the market’s view of the expected future performance of the company discounted to the present at the rate of return required by the market. So by investing one is taking a punt on the market’s view of the expected future performance of the company. If one is of the view that the market is too pessimistic, one would expect to earn a higher return than the ‘market return’, which is the return on investment implicit in the share price. If one is of the view that the market is on-the-money, one would expect to earn the ‘market return’.

The ‘market return’ is basically the sum of the “risk free rate” (which in our case is the Australian Government bond rate) plus 4% to 6% pa. The 2-year Australian Bond yield at the time of writing is about 1.6% pa, which would put the ‘market return’ at 5.6% to 7.6% pa. So if one buys blue chip shares and the company’s performance matches that expected by the market, one would earn 5.6% to 7.6% pa.

In order to generate a higher return, one needs to be smarter than the very bright, well-educated and experienced financial analysts who are employed by the top investment banks and fund managers, have access to vast amounts of relevant data and just as importantly have access to the right people. A tough gig for us mere mortals!

In concluding I would like to stress that investing is not akin to gambling and there is no short cut – one should either do rigorous analysis in the case of each investment opportunity or defer to an expert.

By Mark M.J. Morris