The Dividend Guy Blog had a recent entry about whether recent gains in the market are a good or bad thing.

If you have some of the same concerns or that the market dip today will continue, I found this from some research from Thomson Financial: best long terms earnings growth by sectors in the S&P 500 since 1980 (highest returns by % to lowest):

1. Health Care
2. Consumer Staples
3. Financials
4. Industrials
5. Consumer Discretionary
6. Materials
7. Energy
8. Technology
9. Telecom
10. Utilities

The sample size is long enough to give you a good track record of industries that will grow year over year no matter what the state of the economy. Interesting to note that energy is #7 and the recent market gains/losses are being fueled by the energy sector (pun intended).

Fortune Magazine published a survey outlining how households with investable assets of between $1 mil-$10 mil invest their money by asset allocation as of 2006. The results are:

45% domestic equities
15% bonds
13% cash
11% international equities
7% investment real estate
5% private equity
2% other
1% hedge fund
1% commodities

A couple of observations:

1. Pretty boring stuff don’t you think? It reinforces the point there is no “magic bullet” solution to financial freedom.

2. only 7% in investment real estate. very interesting. I have some thoughts on this matter in later posts.

3. 13% cash- the rich understand the concpet of liquidity. Having cash around always gives you the feeling of security.

I have alluded to this before but through a series of strange accidents, this blog is about primarily two things:

1. Thickening your wallet; financial musings from an advisor to businesses; and
2. Building a financing company from scratch with the general public as investors

Some of the financial blogs that I read have been musing about outing themselves. As much as I would love to, a team of lawyers will not allow me to do this since any details about the company and the product pre-launch would be considered a solicitation which would get me into a lot of trouble with various securities commissions.

In a nutshell, this is what happened:

1. Advise businesses
2. Advise a business that does really well and become a key clog in their management team
3. Said business has connections to financial community with connections asking me to head up a finance company

This is what I have learned thus far:

1. There seems to be a great demand on main street for easy to understand investment product. Our company finances something exceptional simple (that’s all I am going to say! My lawyer is watching me as I type); we have some potential investors who say to us that they don’t want to buy tech anymore or commodities because its too much of a roller coaster ride. Maybe its time for the stock market to get back to basics?
2. The financial capital of Canada is Toronto but Ontario (the province which Toronto is located in) is also the toughest regulatory market to raise money. Ontario does not have an offering memorandum exemption (what this means is that you cannot sell certain types of investment products without showing an offering memorandum, which is a disclosure of opportunities and risks in the investment) which makes it hard for the middle class to take part in many investment vehicles.  Western Canada has a much more liberal attitude and it is easier to raise money there. I can’t decide whether this is a good or bad thing yet.
3. Every business needs three things (in no particular order): (1) someone who knows the product/service inside/outside; (2) someone who can sell it; and (3) someone who can build it from a business perspective. Next time you look at the management team of any business you want to invest in look for those three things. Most of the time, one person cannot be all three. I am putting together a team now to address all three.

I’ll write more as this develops. Now back to the originally scheduled program…

I hope you noticed a few things about my list of what I look for in stock investing:

1. The non-technical factors outnumber the technical factors- at the end of the day, its all about the KISS principle with me. If a company is doing well on main street (the non-technical analysis), the technical analysis, as a general rule (there’s always exceptions), should follow. For example, when was the last time you shopped at the Gap? I have not bought a lot there for years compared to the 1990’s and neither have a lot of my friends and family (how many khaki’s can a guy have?). Look at Gap’s stock price- its really struggling.
2. My technical factors focus on cash- how much its paying out in dividends, how much free cash it has and how well it makes use of investor’s cash. I readily admit that this is influenced by what I do. Businesses with more cash perform better than businesses with less cash (the painfully obvious observation of the day!). Think of your house-hold: the more free cash you have, the greater your options right? Its the same with publicly traded stock-the market rewards companies that knows how to generate and pay out cash.
3. There is no rocket science involved in my analysis. Anyone can apply these factors. Do not let the investment industry fool you into thinking you cannot do this.

Look for company’s with high return on equity (ROE) ratios

ROE means how well a company is using your investment- in other words, for every dollar you invest, how much can the company make? The higher the number, the better.

I am not going to attempt to break down how ROE is calculated. It is way beyond my high-school math. Most companies or investment research will publish ROE’s so look for it in their public releases or in company research provided by investment banks.

As a rough guide, any non-financial company (so anything other than banks, insurance companies etc.) that can generate ROE over 10% is good. However, if the company has a high ROE and a lot of debt, be careful; like any household, growth based on excessive debt is not a good thing.

If you find a company that is doing both technical analysis #2 and #3 well, what you have is a company that can invest your money well (high ROE) and generates a lot of free cash with your money (increasing net cash provided by operating activities). If there is a lot of free cash, the company is hopefully paying an increasing dividend which, on the balance of probabilities, leads to above market return on investment (see rule #1).

Invest in a company with increasing “net cash provided by operating activities”

Before I explain my logic, here is my 30 second crash course on reading financial statements. There are three types of statements every publicly traded company produces:

1. Balance sheet: balances assets against liabilities (the difference is the total equity in the company)
2. Income statement: basically a profit/loss statement
3. Statement of cash flow: tells you how much cash the company is generating (or losing) year over year

Under the statement of cash flow, there is a line called “net cash provided by operating activities.” In plain English this means how much cash the company is taking in vs. how much it is paying out (a positive number obviously means the company is taking in more cash than its paying out and vice versa if it is a negative number).

Balance sheets can be hard to read because there are line items such as goodwill or intangible assets which are hard to value or subjective (for example, how much is the name Coca-Cola worth?).

Income statements can be hard to read because there can be tax entries (such as depreciation) and one time items (a business is sold, inventory is liquidated) which makes it hard to determine the true profit of a company. As anyone who runs a business knows, a sale can be booked but the revenue never collected or not collected in whole or in a timely manner. However, the sale (subject to any bad debt write-offs) are booked as income.

Cash is cash. It is hard to manipulate the accounting on cash received. If the net cash provided by operating activities is increasing, this means the company has a lot of cash on hand. Cash allows a company to increase dividends, buy back stock, purchase competitors, invest in R&D- all the good stuff a growing company should be doing.

My favourite book on stock marketing investing is Morningstar’s “The Five Rules for Successful Stock Investing” and to quote from it: “the statement of cash flow is the true touchstone for corporate value creation because it shows how much cash a company is generating from year to year- and cash is what counts”

As much as I hate reading financial statements, I make it easy on myself and go right to the net cash provided by operating activities line. It usually sheds a lot of light into how a company is performing.

If in doubt, buy a dividend stock, preferably a growing dividend stock.

Proof is in the pudding; dividend stocks beat the market and growing dividend stocks do even better. The following is courtesy of RBC Capital Markets

S&P 500 Total Return: Last 10 Years (to Feb. 15, 2007)

S&P 500 Non-Dividend Payers: 6.3%
S&P 500 Total Return: 8.0%
S&P 500 Dividend Payers: 8.5%
S&P 500 Dividend Growers: 9.1%

TSX Total Return: Last 10 Years (to Feb. 15, 2007)

TSX Non-Dividend Payers: 2.7%
TSX Total Return: 8.5%
TSX Dividend Payers: 14.2%
TSX Dividend Growers: 15.5%

I found this quote on-line from www.money.com. Fortune Magazine reporter Katie Benner interviwed the managers of Hodges Fund (5 year annualized return of 18.8% according to Moringstar).

In response to a question about investing strategies for a unpredictable 2007 market, the fund manager answers:

“We’re a big proponent of pricing power. What allows a company to maintain or even increase its prices is a lack of competition, high barriers to entry and good demand. PC makers can never have pricing power because there’s too much competition. Instead, we focus on businesses like railroads and steel, where there used to be a ton of competitors and now there are just three or four.”

I note that the examples given, railroads and steel, are in regulated industries (you can’t just put a train on the tracks without getting permission and steel is subject to pricing regulations and quotas). Its nice to have someone confirm my common sense analysis.

Do not invest any money you are not willing to lose

After all that non-technical analysis, you still have to be willing to lose it all if things don’t go well. Buffet’s first rule for stock investing is “don’t lose money” but it pre-supposes the assumption that you will invest in the first place.

If you are going to invest then Buffet’s rule is the golden one but before I make that decision, I ask myself at this point in time am I financially ready to lose money. If I am then I follow Buffet’s rule (hope for the best, expect the worse). If I am not, then I sit on the sidelines.

Don’t invest in anything trendy

As I may have mentioned before, I am in the business of giving advice to other businesses so I see a lot of businesses. The “trendy” businesses I see either do either extremely well or completely flame out in months. There doesn’t seem to be a middle ground. If you are in technology, you basically have 2-3 years at the very most to make it or you are done (someone has better technology, the market has moved to another application or the venture capitalists are chasing the new darlings on the street- as a sidenote, yes I dislike most tech companies as investments, can’t you tell?). For every trendy business that does well, I see 5 that do not.

Not great odds eh?

In comparison, the businesses that do well tend to be in tried and true industries (real estate, import/export, distribution). For the risk takers, there are small cap stocks in each of these industries so just because you invest in these industries doesn’t mean you are in for a boring ride.