What Shares Should I Buy?

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Buying your first few shares in the market is often accompanied by anxiety and fear. Although you have likely gained some knowledge about how the stock market works and the process to buy and sell shares, there are numerous unknowns that raise your risk.

To get you involved in the investment process with reduced risk, here are some publicly traded companies in the Australian Securities Exchange (ASX) to get you going.

We will group these into three broad categories: Dividend companies, long-term growth picks, and speculation.

Category 1: Dividend Companies

When a business earns profit they can either retain it for further growth opportunities or they can distribute some or all of it to shareholders in the form of a dividend. Typically, young and aggressively growing companies will save their earnings for growth while the larger cash-rich companies will start giving back regular income disbursements to shareholders. This screen will look at larger dividend-paying companies to build up the income part of your new portfolio.

What should we look for with these dividend companies? We will look for three criteria:

• They should be a decent size. Small companies are typically more volatile which leads to higher risk. We will consider large stocks as your first shares to own with having $20 billion market cap or higher (market cap is arrived at by multiplying the amount of shares by the price of the shares).
• There should be some sales growth. While most investors focus on profit, the sustainability of net income is dependent on increasing revenue or sales. The filtered shares should have averaged at least 5% sales growth per year over the past 5 years.
• The dividend yield is compared to the annual dividend payout to the share price in the form of a percentage. Only stocks paying more than 4% yield will be considered.

As of 11/6/2011

Category 2: Long-term Growth

Another approach is to pick stocks that you feel have long term potential for stability and appreciation. This filtering process will look for historical revenue and earnings growth rate to be slightly higher than in the dividend scan. The long term anticipated growth rate will have a set minimum. As well, we will lower the market cap minimum to include a wider range of companies.

• 5 year revenue growth rate at least 10% per year
• 5 year earnings growth rate at least 10% per year
• Long-term growth rate at least 9% looking forward
• Market capitalization of at least 4 billion dollars
• Stocks that already made the dividend list will be excluded from this list

As of 11/6/2011

Category 3: High Speculation and Deep Value

Then you might be inclined to add a speculative pick or two for some higher risk to reward exposure. There are many different methods to pick such stocks. Here is one idea (11/6/2011):

• High dividend yields and low payout ratios have been linked to stocks that outperform over the long-term. If we narrow our search to yields over 5% and payout ratios under 50%, two stocks come forward on our radar: OZL and TFC.

Or, we can look for small value companies which have been linked to excess gains in some famous studies. We will ask that share prices trade near the net asset value, that the worth of all shares be under 1 billion dollars, and that the price to earnings ratio be less than 15. Keep in mind that stocks trading near these low valuations are likely here for a reason. That’s why they should only make up a smaller sliver of our higher speculation.

• ATP – Atlas South Sea Pearl Limited. This company would be considered a value pick. The hope is that it will come into favor with investors again or that the growth will at some point make prices pop. Here are a few numbers to mull over. Income growth is popping. However, when you look at how much the company earns in annual profit compared to its share price, it is trading 3 times lower than its peers. The stock price is only marginally above the amount of revenue per share(annual)– which gives this the feeling of deep value. As well, it is trading 20% below the net asset value. If the company liquidated its assets at fair market value (went bankrupt), in theory the share price would rise. This is a deep discount and is no doubt factoring in risk. It has low debt and enough assets and money to pay the bills (liquidity).
• DVN – Devine Limited. This company is considered a speculative pick because it has some good features and some bad. First the bad using the annual reports: the profits have went down hard. In 2006 the earnings per share was roughly 7 times higher. This is partly due to the share pool tripling in size and profit dropping by more than half. The good news? Total company revenue is about the same as 5 years ago. The stock is only trading at one-third its annual revenue per share. It is also trading at half of the net asset value. The price is quite low when looking at the annual earnings. While this company is trading at very low valuations, it’s a highly speculative pick since they share pool keeps being diluted and the bottom line profits need to come up before the price will greatly appreciate.

Wrap Up

Your first few shares that you purchase should include some long-term holdings. Try to pick stable companies with growth that are highly visible. Take your time to learn about the different trading strategies and concepts to find one that suits you best. Think of investing as putting together a winning sports team and you are adding in some of the slower but defensive players first.