The Guide to Investing in Stocks and Shares

Investing Pitfalls

Dan Tebbutt - A Shareworld Contributor

Published - 31st May 2010

When a bull market is teamed with a booming economy, investing in shares seems easy. The rising tide lifts all shares, easy credit means that few companies run out of cash, and reliable profits mean that any capital shortfall is quickly made up. New investors rush into the market, seeing the profits that their friends and neighbours are making, and looking to join the fun.

Unfortunately, the good times never last forever. The last 3 years have thrown up numerous examples of what can go wrong with an investment - things we should remember the next time the economy booms and the stock market seems to be heading for the stars.

The long-term view is not enough

To be a successful investor (rather than a speculator), you should generally focus on the long-term prospects of your investments - after all what does it matter what next year’s earnings will be if you’re planning to hold for the next decade?

Unfortunately some short-term events have a way of interfering with that approach. At the start of 2008 an investor with the long-term view in mind could happily have asserted that:

• In 10 years time RBS, Lloyds and all the other big UK banks would still dominate the market.
• Banking in the UK would still be very profitable.
• Therefore the long-term value of RBS and Lloyds will likely be significantly higher than at present.

As we now know, being right about those long-term factors hasn’t stopped investors seeing their shareholdings being horribly diluted in the meantime. Events overtook the banks, and those long-term forecasts could only be fulfilled with the injection of substantial amounts of capital.

Sometimes price is important

As Warren Buffett says: "Price is what you pay; value is what you get". You shouldn’t be scared of investing in companies with a low share price - but sometimes that low share price can have unfortunate consequences.

• Delisting. This seems a favourite tactic of small AIM companies whose share price isn’t performing - particularly when most of a company’s shares are in the hands of one person. There are all sorts of costs associated with being a listed company - and what’s the point if the share price never goes anywhere? I was lucky to get out of Zirax before it delisted, and I was within an ace of buying shares in Touchstone and Total Systems, which have both done the same.
• Being acquired. If a company’s share price languishes in the depths for some time, it can become an acquisition target. That is usually good for a bounce in the share price (say 40% or so) since the acquirer will have to offer something higher than the market price to get shareholder approval. But if you bought a share expecting to triple or quadruple your money, the offer price may not be to your liking. FDM Group was bought out by its own management team at a pretty low price, which doesn‘t really seem like fair play.
• Acquiring someone else. Company directors can pursue some crazy-looking takeovers at the most inopportune moments. Recently we’ve had Kraft / Cadbury, Man Group / GLG partners, and the prospective mega-deal of Prudential / AIA. If the acquiring company issues shares to pay for the acquisition then they can be swapping their own undervalued shares for a stake in a very overpriced target.

Consider all the risks

I think the key lesson that I’ve taken from the last couple of years is that you should look at a much wider range of risk factors than just “will this company do well over the next 10 years”. Do the directors have a history of pursuing risky deals? Does one shareholder dominate the register? Does the company have enough capital and liquidity to see it through the short-term and realise its long-term potential?

Although I haven’t really enjoyed the experience, holding shares in RBS, Taylor Wimpey and Zirax have certainly given me an appreciation for some of the things that can go wrong - let’s hope I only have to learn those lessons once.