What are the Things to Avoid when Investing in the stock market in 2010
March 12th, 2010 by ALVIN SOONG
What is so difficult about buying a stock when its price has fallen to an attractive level, and then selling it for a profit when its price moves up again? It may not be simple if you are a retiree who relies on income from your investments to get by. With so much market uncertainty, it does not seem prudent to put your nest egg in the stock market. There is a risk that you might lose part of it in a stock market correction.
But keeping the money in the bank is not exactly a great solution either. The paltry returns it earns will hardly cover your living expenses.
For a start, you have to rule out most of the popular trading strategies in recent years.
1. Following a momentum-oriented strategy in the current sluggish market conditions is clearly a bad idea. This strategy involves chasing after the most actively traded stocks - getting in or out of them quickly - in the hope of making a small profit. In a lacklustre market such as this, when stock market volume struggles to cross one billion shares daily, such a ploy can be dangerous. You can come to grief if you need to sell in a hurry as there may be insufficient buyers around to buy the shares you put up for sale.
2. Then there is the strategy advocating investors to buy into high-growth companies whose managements do not believe in paying out any dividends, preferring to reinvest the profit to expand the business instead. But as legendary investment guru Warren Buffett noted in his recent newsletter to shareholders of his firm Berkshire Hathaway, ‘dramatic growth’ does not always add up to high profit margins and returns on capital.
History is replete with examples of investors losing their shirts after making huge bets on the United States auto industry in the 1930s, or TV makers in the 1950s. It is better not to be suckered by sexy stories of high growth.
3. That leaves us with one other strategy - making bets on high-dividend-paying counters.
For years, there has been a mistaken belief among some investors that if a company has a high dividend payout, its management must have run out of ideas on how to make money for them. Otherwise, why return the cash to them?
But one can argue that dividend stocks are less likely to blow up in the face of an investor. This is because once growth has levelled off, a good business will have excess cash to pass on to shareholders.
A commitment to pay out a cash dividend also imposes a certain degree of discipline on managers and ensures they do not take foolhardy risks in expanding the company’s business. True, dividend stocks might not go up as much as ‘growth’ stocks in a stock rally, but in a bear market, they do not fall as much either.
With the future now looking uncertain, dividend stocks are regaining their lustre. What is interesting to note is that good dividend paymasters tend to be the more mature and stable companies - and they have a long-term track record for paying consistent dividends.
In picking dividend stocks, look for firms with solid businesses and a long history of making - or increasing - dividend payouts. I use two simple rules to evaluate them:
The dividend payout ratio should preferably not exceed 50 per cent of a company’s earnings. This is to ensure that the company has the ability to maintain the same payout, even if its business should suffer an unexpected downturn. You can get the dividend payout ratio from a company’s profit and loss accounts.
The debt-servicing ratio - the amount of cash flow used by a company to service the interest payment on its debts - should be low. The rationale is simple: There is no point getting a high dividend from a company that has to borrow heavily to pay it. Such a ploy by the company is unsustainable. You can track a company’s debts from the disclosures that it has to make on its outstanding loans in its annual report.
Because people are living much longer these days, they should consider putting some of their money into dividend plays to give them a steady return when they retire.
Unlike bonds, which have a fixed payout, or buying a property whose huge capital outlay makes it a risky investment, dividend stocks allow those who hold them to enjoy a regular payout and the prospect of their prices appreciating in value.
Summarised from Sunday Times 7th March 2010





