SIMON BROWN: The best approach to investing on the JSE

As an investor there are a number of methods to value a business, from the complex discounted cash flow to a simple p:e ratio. All work and all have flaws but ultimately they’re trying to understand the future value of a business.

But even before we get to valuations we need to decide where we’re going to start. The JSE may be a small exchange with about 300 listings, but it’s not really practical to do a deep dive into all stocks.

So the question is bottom up or top down?

Top down means you start with the big picture. Let’s take South Africa: load-shedding has vanished, anf consumer spending should pick up over the next 18 months with lower rates, inflation and withdrawals from the two-pot system. The government of national unity seems to be holding and all of this points to South Africa Inc stocks being a good bet over the next year or two.

Then taking it a step further, which South Africa Inc? Retail would seem an obvious place to start, but which parts of retail? Food, clothing, home improvement? Now we can start digging into the finer data around the spending patterns in the different sectors and from here we’ll start getting a list of stocks that we can individually work on in terms of valuations and prospects.

Bottom up says ignore the big picture and start with individual stocks. Here a simple scan of the investable universe is the first step. I do this on my broker’s platform but you can use websites and other software packages.

I start with a dividend yield above 5%, historical p:e under 10, share price within 10% of NAV and growing revenue and headline earnings per share over the past three years.

This quick search gives you a list of potential stocks that you can start working with and doing the deeper valuation to decide which to buy.

Recently banks would have been popping up all over this search and here there’s another trick I like to use. If we’re getting a lot of stocks from one sector I’ll look to see if there is an exchange traded fund (ETF) that I could just buy instead. If the entire sector is looking relatively cheap, an ETF lets you buy it all. This reduces single-stock risk, though it also removes the odds of you buying the out-and-out winner, but I’m generally comfortable with that.

The problem with bottom up is that you may have a great and cheap business, but if the bigger economic picture for the sector or geography isn’t in its favour, how much can it really grow?

You can also merge the two processes, starting with bottom down and then doing a search within sectors that show promise. I like this as it guides me to great potential (bottom down) and I then have a limited number of stocks to work with.