Asset allocation: How to invest in the share market

The breadth of choice, let alone the technical considerations, investors face before sinking capital into the share market can make it a daunting exercise. But a few simple guidelines can help secure a safer investment and long-term gains.

When it comes to asset allocation Mark Draper, former stockbroker now financial advisor at GEM Capital, says investors should set aside at least three to five years of capital in fixed income or cash to enable them to weather any potential downturn in the markets.

For anyone thinking of direct investment in the share market – buying shares through a broker rather than investing in a fund – Draper suggests shutting out the ‘noise' about market movements and focusing instead on investing in profitable companies.

"Play the large caps [usually the biggest 100 listed companies], because there's good information flow for those.

"Leave the small caps and the micro caps to the fund managers because often they will have more information before retail investors see it; they're better equipped to operate across that space."

How to tell if a company is profitable?

Avoiding anything with more than 50% debt to equity is a reasonable guideline.

Better still, understanding where companies make their money and picking the stronger performers in their sector, rather than the cheaper options, will help.

That means look for quality rather than price.

"Quality is defined by recurring earnings, so people should look to invest in a company that is growing their earnings, and is a leader in their space," Draper says.

Look at the Price to Earnings (PE) ratio, for example: if you had a company making $100,000 profit, and someone willing to pay you 100 times your earnings (a PE ratio of 100x) then that's someone willing to pay $10 million for $100,000 profit.

"Would you sell or would you buy?" Draper says.

A better indicator might be the Price to Cash Flow ratio, which effectively measures how much cash is coming into the business.

"The problem with the PE ratio is that you can load the company with debt and make it look like a cheap PE ratio, but you can't hide that in the Price to Cash Flow ratio."

Draper also advises investors to check the earnings per share (EPS) and compare it with the dividends per share (DPS).

"You'll get an idea if the company is paying out more in DPS than it is in EPS, which could signal the company is paying dividends through debt rather than equity or profit. That may mean longer term issues," he warns.

Share market subsets

For those willing to explore subsets of the equity market, such as small caps and micro caps (companies with between $200 and $300 million market capitalisation) the returns can be astounding, but it is advisable to use a fund manager.

Carlos Gil, chief executive and chief information officer at MicroEquities, says their flagship micro-cap fund has delivered just over 30% compound annual return over the past five and a half years.

"The traditional view of micro caps is that they're much more price sensitive and have a lot more volatility," Gil says.

But managed well they can outperform the market even in downturns, and part of that lies in picking companies who have been operating profitably for at least two years.

Gil says their fund has a downward capture ratio of 24%, which means when equities drop the fund only falls a quarter of what the market does.

Because they are companies in the early stages of their lifecycle, they tend to be shielded from general economic conditions, meaning typically better growth potential but also growth linked to a company-specific reason.

"With large caps, their growth is for better or worse often intimately related to the prevailing economic cycle… for us, one of the surefire signs we're across a mediocre micro-cap company is when a director at an AGM blames poor performance on slower broader economic growth."

Of MicroEquities' unit holders, 60% are self-managed super funds looking to maximise capital over a five-year-plus timeframe. Like Draper, Gil says that longer-term outlooks will invariably mean better results for investors.

This article looks at investment in a general way; if you need specific advice regarding your situation, you should consult an appropriately qualified and registered professional.