Laith Khalaf, head of investment analysis at AJ Bell looks at why Black Friday bargain hunting doesn’t translate neatly into choosing stock market investments.
“Black Friday is a perfect example of how price cuts can precipitate a buying frenzy, but the discipline of bargain hunting on the high street or the internet doesn’t translate neatly across to choosing cheap investments on the stock market. The whole idea of investing is that your chosen shares, funds or trusts grow over time, and the assessment of value is more nuanced and difficult. By contrast, a flash new telly can be expected to depreciate in price from the moment you take it out of the shop, but then, you’re not relying on it to provide you with a retirement income. Unlike many of the items bought on Black Friday, an investment isn’t just for Christmas, and normally the money changing hands is a significant sum, so it’s worth taking the time to make considered decisions, rather than rushing into a purchase, or indeed a sale.”
Trap 1 - catching a falling knife
“Investors shouldn’t make the mistake of thinking that a big fall in the share price of a company is a buying opportunity. It might be; in the short term markets do tend to over-react to news, both positively and negatively. But a falling price may also be a signal that the prospects for a company have significantly changed for the worse, meaning it will deliver lower profits and dividends for investors. Any long term share price decline has to begin somewhere, which is why investors should be very wary of catching falling knives. Investors should bear in mind that the cautionary definition of a share which has fallen 90%, is one which has fallen 80%, and then halved in value.”
Trap 2 – overegging the PE ratio
“The Price Earnings (PE) ratio is a very useful measure of the value the market currently attaches to a company’s earnings stream. However, it shouldn’t be used in isolation to inform investment decisions, and it needs to be understood in its proper context. The most widely available PE ratio is the trailing twelve months measure, which compares the current price to earnings over the last year. The strength of this version of the ratio is that it uses actually realised data, rather than estimates, but its downside is that it’s backwards-looking. This means it can be misleading in industries where profits vary widely from one year to the next, or during or after financial booms or busts.
“For instance, take the mining company Rio Tinto, which currently trades on a lowly trailing 12 month PE ratio of just over 5 times earnings (source: Refinitiv). This means that in just five years’ time, Rio would have earned back your investment in profits if its earnings stay flat for that period. It turns out that’s a big if, because the iron ore price spiked at the back end of 2020 and the first half of 2021, boosting Rio’s profits. More recently, the price of iron ore has fallen back, halving from its summer peak, and Rio’s shares have also declined, as the market has priced in the effect lower iron ore prices will have on Rio’s profits going forward. The trailing twelve month PE ratio is based on this lower current price, but combined with the heightened profits of the last twelve months. It’s therefore giving a deceptively cheap signal.
“While an extremely convenient measure of value, investors need to treat PE ratios with some care therefore, and assess whether market conditions may be distorting this measure. Forward PE ratios help with this to some extent, as they are based on projected earnings over the next twelve months, though these are harder to come by, and are clearly dependent on the accuracy of the forecast. Investors also need to consider PE ratios in the context of the industry a company sits in, and hence the earnings growth it’s capable of delivering. An established supermarket isn’t going to be able to deliver the same growth in profits as a monopolistic technology company, and this should be reflected in the latter having a higher PE ratio. Investors can get an idea of whether a particular company’s PE ratio is elevated or depressed by comparing it to its peers, and to its own history over time. Of course, expectations for earnings growth and the value placed on it will vary across investors, and that’s what creates a market, and investment opportunities.”
Trap 3 - buying trusts just because of a large discount
“Investment trusts can trade at a premium or discount to their Net Asset Value, which means you might think you’re picking up a good deal if you find a trust trading at a considerable discount. However, you aren’t able to directly access the net asset value of a trust unless it winds up, a rare occurrence nowadays, and in the meantime trusts can trade on a persistent discount. If you buy a trust at a 3% discount and sell at a 5% discount, you haven’t exactly snagged yourself a bargain. It’s therefore important to consider the discount in the context of its longer term level. The AIC provides historic discount/premium charts in the performance section of its trust comparison tool. These give investors a better idea of how deep the discount really is compared to its long run average, rather than just looking at the current value. More mathematically minded investors can also refer to Z-scores, which give an indication of how far below its normal level a discount currently sits.”
Trap 4 - borrowing to invest
“Buy Now Pay Later has clearly taken root in the retail market, and follows on from store cards and credit cards as a convenient way to make purchases. When it comes to investing in the stock market however, borrowing to fund your purchase is extremely risky, because falls in the value of your investment can leave you nursing debts which you can’t repay. This isn’t a particularly prevalent problem in traditional finance, not surprisingly lenders aren’t generally too keen to offer loans to individuals looking to buy volatile assets with the money. But there is one area of the market where it is worryingly common- cryptocurrency trading. The FCA found that 14% of crypto buyers used some form of borrowing to fund their purchase, loading up credit cards and overdrafts in the hope of getting rich quick. The risk, particularly with something as hugely volatile as cryptocurrency, is that you lose some or all of your money, and rack up large interest bills on your outstanding debt, which then spirals out of control.”
Trap 5 - rushing to make a decision
“The Black Friday phenomenon seeks to encourage shoppers to make a quick purchase decision in order to meet a sales deadline. Investors should always resist making such hurried decisions, even at the end of the tax year when there are deadlines for SIPP and ISA contributions. Investors can buy time in these scenarios by contributing to their accounts and holding the money as cash until they are ready to invest it. In the long run, making considered, informed decisions is much more likely to be a successful investment strategy than engaging in impulsive FOMO buying.
