Dividends are good

The next section of chapter 29 examines the practice of retaining profits to build up the business.  The issue here is that if you owned the business you could take 100% of the profit because the profit is what is left over after everyone else has been paid.  However, most companies will retain part of the profit on the basis that it will enable management to build up the business and maintain the dividend rate in future.

I briefly discussed dividends when establishing my stock screening criteria (See "Selecting Stocks - Take Two" from January 2009).  Based on the premise that the value of the unpaid amount is added to the company value (because a share is a portion of the company), I said I preferred companies that don’t pay dividends because individuals receive a 50% deduction on tax due on capital gains (ie the change in the share price) and it is paid only when you sell (if you are not classified as a day trader by the ATO and hold the shares for over a year) but pay full tax on income (ie the dividend) and pay it annually.  (At least that is my understanding, tax law is always changing and I could simply have it wrong).  Also, there are no brokerage charges associated with reinvesting your dividends if they are just retained by the company (although this is not an issue if the company offers a dividend reinvestment plan).

Graham and Dodd question the practice of retaining earnings (ie withholding dividends) on the basis that:

1. if two companies are similar in all respects except the size of the dividend paid, the one with the higher dividend will have the higher share price.
2. withholding profits lowers the return.
3. it rarely succeeds in maintaining the dividend rate in terms of $ per share.
4. any increase in share price generated by withholding dividends will not necessarily compensate the shareholders for the dividends withheld – particularly if you take into account the interest that would have otherwise been earned on the funds.  I had a go at trying to test this using the data I’ve complied for the NAB, but given the volatility of the share market, seven years is too short a period.
5. they believe a study would show that the earning power of a corporation does not expand in proportion with the dividends withheld, although they are assuming the company is retaining the majority of the earnings, say 70% to 90%.
6. individuals in charge of companies have a vested interest in withholding dividends – they will want to retain the cash in the company where they have control over it and they will want to increase the size of the company for self aggrandizement and to generate a higher salary.  They may also withhold dividends to depress the share price so they can purchase more shares or to minimise their tax bill.

In relation to point 3, I have replicated an exercise Graham and Dodd performed on United States Steel, in my case using figures for National Australia Bank over the period 2003 to 2008:

Sum of earnings per share for the period:    $14.455

Dividends paid to shareholders                   $10.380

Dividends withheld:                                  $  4.075

In 2009, after earnings fell to $1.975 per share from $2.373 per share the year before, NAB reduced its dividend to $1.46 per share from $1.94 per share the year before.  With over $4 per share “saved up” in the previous six years (and more if I went back further), there seems little justification for reducing the dividend. I scanned through the annual report to find any discussion on how NAB determines the amount of the dividend and found nothing.

Graham and Dodd’s conclusions are:

• Any dividend not paid out loses value for the investor.
• The major proportion of earnings should be distributed and any earnings withheld should be justified by management.
• You should look for both an adequate return and an adequate dividend when investing.

And the winner is ... dividends!

In Chapter 29 of Security Analysis, Graham and Dodd make the comment “Until recent years the dividend return was the overshadowing factor in common-stock investment”. (These words come from the 1940 edition of the book.)

To illustrate this they present two tables, one for American Sugar Refining Company (ASR) and one for Atchison Topeka and Santa Fe Railway Company (ATSR). Each table shows for a number of years, the price range of the stock, the earnings per share and the dividends per share.

ASR had quite volatile earnings, for example going from $18.92 per share in 1911 to $5.31 per share in 1912, but maintained a constant dividend of $7 per share over the period of the table (1907 – 1913). According to Graham and Dodd, the volatility of its share price was low, suggesting that it was the dividends driving the price rather than earnings.

The table for ATSR covers the years 1916 to 1925. The dividend paid was $6 per share each year except for the last when it rose to $7 per share. Earnings per share, while exhibiting some volatility, had a general upward trend. The price range again was relatively steady and level, but jumped in the final year when dividends were raised. So again, dividends seem to be driving the price.

I decided to undertake a similar exercise on a current ASX listed company. I chose National Australia Bank Limited (NAB) because I thought a long established bank would have steady dividends but volatile earnings and because, due to accidents of history, I own some (a very little some) NAB shares.

Instead of replicating the tables, I created two graphs: one plotting earnings per share against closing price on the day the full year results were announced and one plotting dividends per share for the year against closing price on the day the full year results were announced.

Here’s the graph of earnings against closing price for the years 2003 to 2007 inclusive. Closing prices were taken from Yahoo’s finance site, which only goes back to 2003. The R-square figure of 0.163 is a measure of how well the movement of earnings per share affects the closing price. A R-squared of 1 would mean that a change in the earnings per share would result in the exact same change in the closing price. A R-squared of 0 would mean that a change in the earnings per share would result in absolutely no change in the closing price. A R-squared of 0.163 is very low suggesting earnings per share has little influence on price.





What I see when I look at the graph is a squiggle – it folds back on itself. In this case I think the R-squared is meaningless and earnings do not directly affect the share price.

In contrast, when I look at the graph of closing price against dividends per share for the same period, things are a bit clearer. Each rise in dividends paid has lead to a rise in the share price. The R-squared of 0.664 suggests a reasonable correlation. So although there are not many data points here and no doubt a statistician would draw no conclusions from this, it would appear dividends directly affect share prices and earnings do not.




The impact of dividends could also be seen in the market reaction to Qantas’s decision to cut its interim dividend for the FY2010 half year despite the profit result being in line with company guidance. Its share price fell 8% in one day.

You may be wondering why I only took the graphs out to 2007. It’s because 2008 is when the global financial crisis hit and things went awry. When I extend the graphs out to 2009, it all goes horribly wrong.





Now both graphs are squiggles. So from this I conclude when it all goes wrong, it all goes wrong and hopefully when it happens again, I will have already switched my portfolio into cash.

Selecting Stocks – Take Two

State of Play: under Motley Fool basic rules there are no companies worth investing in listed on the ASX, so I’ve dug out another book, Tim Hewat’s The Intelligent Investor’s Guide to Share Buying to see what I can glean from it.

In Chapter 8, Solid Signposts for Success, Mr Hewat sets out six guidelines for selecting shares:

1. Diversify by investing in 12 shares. Interestingly the same figure I settled on – clearly great minds think alike.

2. Tend towards Big Caps first and then, if there is no value there, second-line shares. Unfortunately, the book doesn’t define what a second line share is, so I’m not sure how low to go with market capitalization.

3. Give top priority to PE ratios of 10 or below. Mr Hewat has a whole chapter on the Price-Earnings Ratio (current share price divided by earnings per share). He describes a study done by David Dreman (an investment manager) and Professor Michael Berry of the University of Virginia. They made a list of the top 60% of shares by market value listed on the New York Stock Exchange, ranked them by PE ratio and split them into quintiles (ie, shares with the top 20% of PE ratios in one group, next 20% in the next group, etc). They revised the groups each year for 25 years using the same methodology. (I’m guessing this means that at the end of each year they “sold” shares no longer in one group and then “bought” the shares that where now ranked within the group). Over the 25 years, the shares in the lowest quintile returned 17.3% pa, whereas the average for the whole group was 12.3% pa. (There is no comment on whether they took into account taxes and transaction costs).

Another fellow called Qualls did a similar thing with 100 randomly selected industrial companies listed on the (then) Sydney Stock Exchange and also found the lowest group outperformed the rest.

The chapter gives a few more examples, all with the same results. Mr Hewat settled on an absolute benchmark of 10 (note, his book was published in 1994 in the midst of a market boom). This approach saves the time taken to rank all the shares, however, a look over the tables from the weekend edition of the Australian Finance Review shows a fair proportion of them have PE ratios below 10. Also, given we now have the internet and MS Excel, the process of ranking shares by PE ratio and splitting them into quintiles should take all of five minutes, so I think I’ll use that method.

4. Price to Assets Ratio (PAR) should be 1.0 or lower. This is explained along the line of, for example, if the PAR is 0.9, it means you can buy $1 worth of the company or 90c. From this I’m assuming that the ratio is calculated by dividing the market capitalization of the company by the net assets reported on the balance sheet. My concern here is that it assumes the assets in the balance sheet are valued correctly. If I was looking at these figures today (26 January 2009) for a property company, and they were based on 30 June 2008 annual reports, I’d want to discount the properties by, say 10%. But I suppose, as with all of these things, the devil’s in the detail.

5. Satisfy yourself that Dividend Yield meets the demand for an adequate return. I have serious issues with this guideline. Aside from the fact that Mr Hewat provides no real way of determining what an “adequate return” is, the last thing I need is for companies to give me back money in the form of dividends, so I have to pay tax on it and then have to find a place to reinvest it and (unless they have a dividend reinvestment program) pay a fee to a broker to do so. Unfortunately, I think its quite fashionable for Australian companies to pay dividends. I use to the term fashionable quite deliberately, because there is no real reason to pay dividends except that investors in Australia seem to like them so you are an Australian company you are unlikely to attract investors if you don’t pay dividends. We will see when the time comes whether I can find any non-dividend paying shares for profit making companies.

6. Dividends paid without interruption for at least five years. This I see as a lazy way of checking whether the underlying performance of the company has been OK. I would prefer to look at whether the company has actually made a profit for the past five years, because, if a company is making a loss and funding dividend payments through increased borrowings, then it’s a company from which you should run a mile.

Having reviewed all that, I’m going to set a new set of criteria based on a mixture of the Motley Fool rules and the above. So, my new criteria are:

1. Daily Dollar Volume: From $100,000 to $25m;
2. PE Ratio within the lowest 20% of PE ratios for all shares;
3. Price-Assets Ratio of less than or equal to 1.0;
4. Net Profit a positive number and greater than last year;
5. Revenue of $500m or less and greater than last year;
6. Cashflow from operations: a positive number; and
7. Preferably all earnings reinvested (no dividends paid).

So lets see how we go.

1. Daily Dollar Volume: From $100,000 to $25m and
2. Price-Assets Ratio of less than or equal to 1.0

I ran these two tests together, starting with the full list of all securities on the ASX having deleted all the options and other non-share securities. First I ranked the shares by PE ratio and deleted all the shares with a PE ratio of zero or less (ie all companies that had made a loss). I then calculated the daily dollar volume for each share (closing price multiplied by volume traded) and deleted those shares with a DDV below $100,000 and above $25m. There were 201 shares remaining, which I ranked them by PE ratio and kept the bottom 40.

3. Price-Assets Ratio of less than or equal to 1.0

The AFR tables have the Net Tangible Assets (NTA) for each share, which is “the total assets of a company less total liabilities and not including intangible items such as goodwill.” (Refer http://afr.com/home/tables_1.aspx#indus_lnk).

There were nine shares with negative or no NTA so I deleted all of those. Of the 31 shares remaining a further nine had a PA ratio (last sale price divided by NTA) greater than 1.0, so I’m left with 22 potential shares to comprise my portfolio.

4. Net Profit a positive number and greater than last year

I already knocked out the unprofitable companies in the first test, so its just a matter of checking whether the 22 remaining made a greater profit this year than last year. Eight had negative earnings growth, so we are down to fourteen shares.

5. Revenue of $500m or less and greater than last year

Four companies had negative sales growth, so ten remain. Of those, only five had annual revenue less than $500m:

• Macquarie Office Trust
• Mount Gibson Iron
• Nomad Building Solutions
• Macquarie Country Wide and
• Charter Hall Group (one of the final contenders under the Motley Fool criteria)

6. Cashflow from operations: a positive number

The five companies all have positive cashflow from operations.

7. Preferably all earnings reinvested (no dividends paid)

I knew this would be a bridge too far. Only Mount Gibson Iron does not pay dividends, so I will keep the five.

Does this mean I get onto CommSec tomorrow and start splashing my cash around? No. It means I have to start reading annual reports, so I’m going back to “The Motley Fool Investment Guide” to read Chapter 14 “Making Sense of Income Statements” (next post, that is).

The Criteria in Action

State of Play: I have a long list of 583 shares listed on the Australian Stock Exchange (refer first post) from which I want to pick 12. I have a list of seven criteria (refer previous post) to bring down my long list to a short list. Here goes.

Criterion 1 - Daily Dollar Volume: From $100,000 to $25m.

I downloaded the Industrial Market daily report and the Mining and Oil Market daily report for 9 Jan 2009 from the AFR website (http://afr.com/home/tables.aspx). For the 583 shares I found the volume and closing price (using the sumif() function in Excel, not by hand) and multiplied them together to get the Daily Dollar Volume (DDV) for each share. I then sorted the list by the DDV and deleted all the shares will a DDV below $100,000 and above $25 million.

Have a guess how many shares were left. Go on. Remember I started with 583 shares.



62.



Yep 62. Only 62 shares were left. That’s 12% of the original list. I thought, there must be some mistake, so I went to the full market list and did the same thing. Of the full list of 2,310 securities that you can invest in on the ASX, fully 49% did not trade at all on 9 Jan 2009. That 1,138 securities that if I owned I could not have sold on 9 Jan 2009. (I use the word securities because the list includes options and other types of instruments, not just shares.)

A further 817 had a DDV below $100,000. Only 18 shares had a DDV of greater than $25m (I told you that figure would be high for the Australian market). So, from the full list of available securities only 294 (13% of the market) meet this criterion. This matches my results on the long list and as the aim of the game here is to get down to a short list, I’ll move on with the 68.


Criterion 2. My Relative Strength Proxy: 90 or Higher

As discussed in my last post. I don’t know where to find the relative strength of shares so I’m going to rank them by last sale price divided by the 52-week low (both as at 9 Jan 2009).

So starting with the full list of securities from the Industrial Market daily report and the Mining and Oil Market daily report, I deleted all the options and other strange securities. That left 1908 shares. I then sorted by the “return” (closing price divided by the 52-week low). The results are worth a look at.

The highest return was 6900% for a company called Q Ltd. Their 52-week low was 0.5 cents and their closing price was 35 cents. I figured this was worth a further look, even though they did not trade on 9 Jan 2008 so they won’t be on my shortlist. Looking the company up on the ASX website (www.asx.com.au) revealed a serious downward trend in their shareprice from June 2008, when they were trading at above $2.00. This highlights just how flawed my little proxy is, but we shall press on.

188 shares or 10% of the market had a 0% “return”. This means they are at their 52-week low. It might be interesting to track this figure to see if it gives any clues about when the market is turning.

I then checked whether any of the 68 made it into the top 10% of “returns”. No. Top 20%? One – Australian Education Trust. Right. I now pronounce this whole criterion a waste of time so I’m sticking with the 68 shares from Criterion 1 and moving onto Criterion 3.

Criterion 3. Earnings and Sales Growth: 25% or Greater

For those of you paying attention, you would have noticed that I listed this last time as Criterion 5. However, you can pull these figures off Yahoo’s finance website (au.finance.yahoo.com) under Key Statistics, so I’m going with this one next.

I didn’t believe any stocks would meet this test and I was eye-ing my bookshelf to see what book I should move onto as I searched the yahoo site. However, a whole eight shares from my list of 68 had both earnings and sales growth above 25%, they are:

NAME Sales Growth Earnings Growth
AWB LIMITED 48.20% 262.90%
WOTIF.COM HOLDINGS LIMITED 41.80% 29.40%
JB HI-FI LIMITED 41.10% 59.40%
ABB GRAIN LIMITED 41.00% 532.00%
FLIGHT CENTRE LIMITED 40.20% 51.70%
INVOCARE LIMITED 36.80% 24.30%
CHARTER HALL GROUP 27.20% 35.20%
THE REJECT SHOP LIMITED 25.30% 35.10%

[Sorry about the formating, I'm afraid my blogging skills don't extend to tables.]

AWB immediately rings alarm bells. They are the crowd involved in the Iraqi oil-for-food scandal (check out Wikipedia for the full story) and litigation is on-going, they have lost the right to be the sole controller of Australian wheat exports, there is uncertainty over its share structure, its under threat of class actions and its having to pay (remaining) staff extra because they all want to leave (wouldn’t you!).

Criterion 4. Cashflow from operations: a positive number

Again, I’m not sticking to my original order, but again this is something you can look up on the Yahoo Finance website. All the shares get through on this one except AWB.

NAME Cashflow from operations
WOTIF.COM HOLDINGS LIMITED 46.28
JB HI-FI LIMITED 42.44
ABB GRAIN LIMITED 4.3
FLIGHT CENTRE LIMITED 391.93
INVOCARE LIMITED 38.6
CHARTER HALL GROUP 45.28
THE REJECT SHOP LIMITED 19.02


Criterion 5. Net Profit Margin: At Least 7%.

Strangely, this isn’t in the key statistics listed on the yahoo site, so I downloaded the latest annual reports for each company of their websites.

NAME Net Profit Margin
WOTIF.COM HOLDINGS LIMITED 3.6%
JB HI-FI LIMITED 3.6%
ABB GRAIN LIMITED 2.1%
FLIGHT CENTRE LIMITED 10.2%
INVOCARE LIMITED 12.1%
CHARTER HALL GROUP 70.0%
THE REJECT SHOP LIMITED 4.7%

As the table shows, only three companies meet the test and yes, the net profit margin for Charter Hall really is 70%. I think this has to do with it basically being a fund manager, but we can look into this further if it makes it all the way through.

Criterion 6. The company’s sales are $500m or less.

NAME Sales
FLIGHT CENTRE LIMITED $1,407m
INVOCARE LIMITED $228m
CHARTER HALL GROUP $91m

Who knew Flight Centre was such a big company? People who bother to look at these thing I suppose. However, they are too big according to the Motley Fools, so we are down to just two.

Criterion 7. Insider Holdings: 10% or more

I’m glad I was only down to two companies for this one, because it took a lot of flicking through pages on the annual report to work this one out (and even then I’m not entirely sure its correct.

For Invocare (funeral directors, by the way, odd what you find on the ASX) it appears that the directors of the company own a grand total of 1.5% of the shares. So Invocare doesn’t make the cut.

Charter Hall contained a nice list of its top twenty share holders, which consisted of 18 institutions (superannuation funds and such) and two people. The two people were directors holding 1.54% and 1.49% of the shares respectively. Its possible that if the information was there for all the directors it would amount to 10%, but I don’t think it would, besides, one share does not a portfolio make. So Charter Hall is out as well.

So what have we achieved from all this? Well we could throw in the towel and conclude that there are no companies worth investing in on the ASX or, as I said earlier, we could find another book. Coming to an end (perhaps) of one of the worst downturns on the market in history, I can’t believe that there are no companies worth investing in, so its time to turn to “The Intelligent Investor’s Guide to Share Buying” by Tim Hewat and see what he has to say about things.

Momentary Diversion: Of Eggs and Baskets

After publishing my first post yesterday I realised there was a contradiction in my post. I explained that given I am paying off a mortgage on an apartment and I work in property finance that I was overweight in property and therefore excluding it as an asset class. However, I included property and banking companies in my (very) long list because “Your Industry” was recommended for inclusion in “The Motley Fool Investment Guide”.

On a related note, I also said my aim was to construct a portfolio of shares from 12 companies, but I didn’t explain how I came up with the number 12.

How are these two things related you ask? They both come under the heading of “diversification”.

Diversification is a fundamental concept in investing which doesn’t require a lot of explanation. If you put all your money in one investment and it tanks, you’ve done your dough. But if you put half in one investment and half in another, it’s less likely that both will tank at the same time, therefore investing in two investments is less risky that investing in only one.

Having said it doesn’t require a lot of explanation, there has been a lot of work done on trying to quantify the benefits. The book “Modern Portfolio Theory and Investment Analysis, 5th Edition” by Elton and Gruber includes a table measuring the effects of diversification (page 61). What they did is look at monthly price increases, ie ‘returns’ of stocks on the New York Stock Exchange. For each stock they calculated:
1. the average monthly return, ie how much in percentage terms the stock went up on average each month; and
2. the variance of the returns, ie a measure of how much the return varies from the average.

[If you don’t like maths you can ignore this paragraph and just accept that there is a way to put a figure against how much the return may differ from what you expect it to be. For the next paragraph where you see the word “variance” think “riskiness”.] If a stock goes up 1% per month on average we know that its highly unlikely it will go up exactly 1% every month. One month it might go up 0.5%, the next 2%, etc. To calculate the variance, for each month you calculate the difference between the actual return and the average return and square it (multiply the figure by itself). The reason to square the figure is to make the negatives positive, eg actual return of 0.5% less average return of 1% gives a difference of -0.5%. If you have a difference of -0.5% in one month and +0.5% in the next month, the average of the differences over two months is zero, which implies that the return each month always equals the average. By using the square of the difference each month, it removes this problem. The variance is then just the average of all the squares of the differences. (For those who like statistics, the standard deviation is the square root of the variance).

So having calculated these figures for every stock listed on the New York Stock exchange they then calculate the average variance of all the stocks. The figure was 46.619. They then calculated the average variance from investing in two stocks. It was 26.839. So, on average, by investing in two stocks instead of one, you almost half (58%) your risk. Doubling the number of stocks again to four, results in an average variance of 16.948. Note, the risk has decreased, but not by as much - the variance of holding four stocks is 63% of the variance of holding two stocks. They continued to calculate the variance of increasingly larger portfolios and (mathematically) calculated the best you can do is reduce the variance to 7.058 for a portfolio with an infinite number of securities.

So when deciding on the number of securities to hold in a portfolio, the more the better in terms of risk, but the less the better in terms of work required in maintaining the portfolio. I decided on 12 because it seemed a good trade off. A portfolio of 12 shares had an average variance of 10.354. At this point every time you add two extra shares to the portfolio you reduce the variance by less than 5%. (It remains to be seen whether I actually have the time to concentrate on this many companies.)

It should be remembered, however, that I’m assuming here that (1) shares listed on the ASX will behave in a similar way to shares listed on the New York Stock Exchange and that (2) the way share prices behaved in the past will be the way they behave in future (3) that the 12 shares I select will be sufficiently different from one another to achieve this level of risk reduction.

So that explains the 12 shares, but what to do with the banking and property shares on my long list. The above would suggest that I should cull them now, however Warren Buffet (you know it wouldn’t be long until his name came up), has other views. He believes “that a policy of portfolio concentration may well decrease risk if it raises, as it should, both the intensity with which an investor thinks about a business and the comfort level he must feel with its economic characteristics before buying into it. In stating this opinion, we define risk, using dictionary terms, as ‘the possibility of loss or injury’.” (refer “The Essays of Warren Buffett: Lessons for Investors and Managers”, compiled by Lawrence A. Cunningham, Section II.C. Debunking Standard Dogma). Basically, he is saying that the more you know about an investment the less likely you are to invest in something that will lose you money. So by concentrating on gaining greater knowledge of fewer investments you are decreasing your risk.

Extrapolating this logic, you are likely to have a greater knowledge of companies in your own industry because you live and breathe it every day. You are never going to gain, through research alone, the level of knowledge of another industry that you have of your own. On the other hand, imagine you work for ANZ, which recently announced job cuts. The closing price was $14.87 on 24 December 2008. The closing price a year earlier was $27.46, that’s a fall of 46% in one year. Imagine if you have just lost your job and your investment portfolio had fallen 46% in a year. You wouldn’t be happy. Hopefully, if you were in this situation, your knowledge of the industry and ANZ would have led you to sell the ANZ shares (and possibly look for a new job too) long before this happened. If you had sold your shares, you would then need a place to put the money, so we still get back to needing to diversify.

(Note, the Yahoo Finance site is great for looking up historical prices, look for the link under the “Research” heading on the left hand side of the page: http://au.finance.yahoo.com/investing)

Warren Buffet goes on to say “if you are a know-something investor, able to understand business economics and to find five to ten sensibly-priced companies that possess important long-term competitive advantages, conventional diversification makes no sense to you. It is apt simply to hurt your results and increase your risk.”

Twelve isn’t too much more than ten, so I will stick with it for now. I will also leave the property and banking shares in the list for now because I do want to learn more about these industries and because I am interested in seeing how they rate against everything else. Time will tell if they make final cut - back to the process in the next post.

Getting started

I've decided to start this blog to hopefully bring some discipline to my investing. Over the past twenty years I've had half-hearted attempts to invest in shares, which at best has only resulted in me not losing money (I should have just stuck the money in the bank). I've also collected a whole lot of books on investing and haven't made it past the first few chapters.

The only good investment decision I've made is to take all my investment funds out of a managed fund in August 08. I call that a good investment decision because I actually made it on the basis of research. Just after I took the money out, the market started to rally. I thought "Oh, no, I've stuffed up again" but after a few days in turned around and continued heading south. When I checked the unit prices a couple of months later the price had fallen another 10% and then in November, it was one of the first funds to stop withdrawals. I don't know on what legal basis funds can just say "no, you can't have your money back", but I was glad I didn't have to sit by and watch my investment get smaller and smaller and not be able to do anything about it.

So, to set the context, I will be looking only at share investment and only at shares listed on the Australian Stock Exchange (ASX). The aim is to set up a portfolio on paper and hopefully, at some point, build up enough knowledge and confidence to throw some real cash at it.

The real issue with investment is deciding what to invest in. There are countless things to invest in from the Melbourne Cup to BHP. If we ignore the Melbourne Cup (and gambling in general) investment breaks down into three categories: cash (bank accounts and term deposits), property (everything from own home ownership to renting out office buildings and shopping centres) and shares (part ownship of a business).

I'm concentrating on shares here because:
(1) typically cash gives the lowest return and is fully taxed further reducing your return. I say typically gives the lowest return because over the past year (2008) I think it would have been the only category giving a positive return.
(2) I own an apartment (with mortgage) - which puts me overweight in property (add to this I work as a property financier which over exposes me even further, but I will get around to the principles of diversification some other time).

I read somewhere years ago that the ASX constitutes only 2% of the world's share markets. In this context, you shouldn't restrict your share trading to the ASX, but investing in foreign share markets introduces currency risk and generally makes life far more complicated. So I'm sticking to the ASX only for now at least.

That's about as far as my own knowledge has taken me. To continue, I'm going to work my way through all the books I've bought. The first is "The Motley Fool Investment Guide" by David and Tom Gardner (check out www.fool.com).

I won't be giving a summary of the book, just the points I've found useful, which is why I'm starting at Chapter 9 - How to Find Companies to Invest In. It recommends you look at:

- Your industry: I work in a bank lending money to property developers and investors, so I'm including both banking and property

- Your interests: I'm not sure that "American Dad" is going to provide many investment opportunity for me, but it did make me think of JB Hi Fi, which made me think of shopping / Retailing (and even though I'm a chick, I hardly ever shop - no really!). I also go to bootcamp, so I'll include Health.

- Your insight: ie look around and see whats thriving - I'm not sure anything is thriving at the moment, so I might let that one go

- Your investigation: The book recommends reading "Investor's Business Daily" every day. I will start reading the Financial Review everyday, but for now have no more categories to add.

To this list the book recommends adding blue-chip stocks (established leaders with largest market capitalisation, ie number of shares times share price) and small-cap stocks (which it defines as companies with a market capitalisation between $250 million to $1 billion). Given our stock market is somewhat smaller than the US market, I think these figures may be a little high in the Australian context.

Given all the above, I went to the ASX website (www.asx.com.au) and downloaded a list of all the listed shares. The list includes the name, ticker and GIS Industry Code. From the total list of shares I kept:

• the banks (eg Commonwealth Bank of Australia)
  
• consumer discretionary (eg Seven Network)
• consumer durables and apparel (eg Billabong)
• consumer services (eg Domino's Pizza)
• food and staples retailing (eg Woolworths)
• food beverage and tobacco (eg Coca-Cola Amatil)
• health care (eg Sigma Pharmaceuticals)
• health care equipment and services (eg Fisher & Paykel Healthcare)
• real estate (eg Bunnings Warehouse Property Trust)
• retailing (eg David Jones)

I then downloaded the list of companies included in the ASX 50 as representative of blue-chip shares and the ASX Small Ordinaries as representative of the small cap shares.

This gave me a list of 583 shares. I'm aiming for a portfolio of about 12 shares, so there is still a bit of work to do.

My next post will look at Chapter 13 - Selecting the Best Growth Stocks.