Investing in ASX shares can create really good returns. By looking at certain areas, we can identify stocks that may be able to outperform the wider market. I'm going to share a few tips that could help us deliver performance like a pro.
Of course, investors can decide to just invest in a leading exchange-traded fund (ETF) that provides strong diversification, such as Vanguard Australian Shares Index ETF (ASX: VAS).
But, I believe we can outperform the market by picking the right stocks.
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Identify ASX shares with an economic moat
If a business has competitive advantages, or an economic moat, that can give it the power to make (and protect) good revenue and profit.
Think about the strength of businesses like Microsoft or Disney, it'd be extremely challenging for a competitor to challenge their main offerings. Microsoft's services are embedded into many people's lives, while Disney has an extremely strong position in the entertainment space.
If a business has a powerful economic moat, it can enable it to achieve stronger returns. For example, cloud accounting business Xero Limited (ASX: XRO) is very popular for business owners with all of its time-saving tools and how it presents financial information. The loyalty of its subscriber base has meant it can pass on price increases with little negative impact.
A moat can come in the form of many different ways, such as brand power, intellectual property, network effects, cost advantages and so on. A business like Wesfarmers Ltd (ASX: WES), which owns Kmart and Bunnings, has shown how a great business that grows can do very well for shareholders over the long term.
If there's no good moat, competition may be a problem soon enough.
Choose stocks with attractive financial metrics
There are a number of different ways to judge businesses, with different metrics being important for different industries.
For example, important metrics for real estate investment trusts (REITs) could be the (debt) gearing, the occupancy rate, the weighted average lease expiry (WALE), the organic rental growth rate and the net asset value (NAV).
But, software stock investors may want to look at the retention rate, the annualised recurring revenue (ARR), the average revenue per user (ARPU) and the customer acquisition cost (CAC) – how much it costs to win a new customer.
One of the best financial metrics I like to see with a lot of ASX shares is an increasing return on equity (ROE). The ROE tells investors how much profit a business makes for the amount of shareholder money retained in the business. If the ROE is increasing, it means the company is becoming increasingly profitable for shareholders, which could mean improving shareholder returns in the form of a higher share price.
For asset-based businesses, it's good to compare the share price compared to the NAV. If it's at a sizeable discount, this could signal an undervalued opportunity.
It's also a good idea to keep in mind the earnings multiple, or the price/earnings (P/E) ratio. If the P/E ratio is relatively low for the expected medium-term profit growth rate, it could be an attractive opportunity.
Invest in cyclical ASX shares at the right time
Some businesses like Xero and Pro Medicus Ltd (ASX: PME) seem to grow in size every year. But, there are plenty of others that go through ups and downs, such as discretionary ASX retail shares and ASX mining shares.
I believe we can make good money with cyclical names, but we need to buy at the right part of the economic cycle. For example, the iron ore price is close to US$140 now, which is a very strong position for miners. Less than a year ago the iron ore price had dipped below US$100 per tonne, meaning it has risen by roughly 40% in about eight months.
I don't think this is a good time to invest in ASX iron ore shares.
Last year, and in 2022, there was a lot of concern about the retail ASX share sector on worries about how household spending was going to be impacted because of inflation. Those are the sorts of situations where a shorter-term decline can be a great time to invest. In October and November, I decided to pounce on retailers like Temple & Webster Group Ltd (ASX: TPW), Accent Group Ltd (ASX: AX1) and Lovisa Holdings Ltd (ASX: LOV).
Some investors want to consider 'selling high' if they have managed to 'buy low' with cyclical stocks, though holding for a longer time could unlock strong dividend income.
