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Why stock selection and timing is so important

Cuffelinks recently published a fascinating article by Ashley Owen of Philo Capital, in which he demonstrates that investing in some blue chip shares has produced little in the way of real returns (after inflation) since 1968.

In fact, companies such as ANZ (ASX: ANZ), Lend Lease (ASX: LLC), National Australia Bank (ASX: NAB), Rio Tinto (ASX: RIO) and Santos (ASX: STO) are still below their late 1960s highs – after 45 years!

Peter

(Notes: Capital adjustments are taken into account. The chart does not include re-investment of dividends. Commonwealth Bank and Telstra are not included as they were both government-owned in 1968.)

On the bright side, BHP (ASX: BHP); QBE (ASX: QBE) and Westpac (ASX: WBC) are ahead in real terms – but by less than 3% per annum.

What should investors take from all this? Well first, a buy and hold strategy is only appropriate if stocks were bought at good prices in the first place, and special care should be taken when buying large, widely held stocks in an optimistic market. Buoyant markets (such as now) have a historic tendency to overrate the growth prospects of favoured blue chips — and price them accordingly.

Second, Mr Market is genuinely manic and there are surprisingly regular opportunities to get set in heavyweight stocks at discounted prices. For example, ANZ could easily have been bought for under $14 during the GFC period and under $20 two years ago. Heavyweight stocks (especially banks) are likely survivors in any market rout and when this happens you can start buying them with confidence (although it may not feel that way).

Another effective strategy is to seek out those smaller companies whose business growth rate is likely to exceed overall market growth. For example, you may anticipate that a particular company has the capability to grow real earnings per share by an average 7% per annum over the next five years (not necessarily in each year) and the market to grow by a real 2.8% per annum (25-year average) over the same period. If it worked out, your company would outpace the market by a considerable margin over five years and you would have an effective price cushion. Two current favourites of mine in this category are IMF (ASX: IMF) and Servcorp (ASX: SRV).

Foolish takeaway

In the end, a share portfolio is really just a business investing in other businesses. Business value is reasonably measurable long term whereas market gyrations are ruled by short-term sentiment (whether right or wrong). Although easier said than done, you should be no more influenced by market clutter than the latest Hollywood movie when making investment decisions. Investing is about the future, and the clutter is usually yesterday’s news.

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Motley Fool contributor Peter Andersen owns shares in IMF and Servcorp.

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