Thursday, May 07, 2009

Investing in indivdual stocks

I have not dealt in individual stocks for nearly ten years due to staff dealing restrictions at my previous employer. My current employer is less restrictive in that I am largely free to deal subject to clearing with a compliance officer first.

My retirement model is based on using income from investments to meet my expenses (i.e. no draw down of capital). This requires that most of my capital be invested in assets which yield a cash flow sufficiently high to meet my living costs. Ideally, there should also be enough assets which have the potential to produce yields that grow over time to keep up with inflation.

Individual stocks have a role to play in the retirement asset allocation in that it is possible to construct a portfolio of stocks which have higher yields than index funds, sovereign bonds, short or medium term corporate bonds or bank deposits. Given that dividends have the potential to rise over time, it seems reasonable to allocate part of my retirement savings to individual stocks.

Of course, there is no such thing as a free lunch (with the possible exception of diversification), and it has to be recognised that individual stocks carry higher risks than investing in bonds, index funds or real estate. For that reason, I have set myself some parameters:

1. no more than 20% of my target number should be invested in individual stocks;

2. I should not invest more than 1% of my target number in any one stock;

3. there is little point in investing less than 0.5% of my target in any one stock;

4. I am investing for longer term yield. It is unlikely that many stocks with yields below 4% will make the final cut and I most stocks should be expected to reach 5% yields within two years of purchase;

5. I should avoid stocks which have high gearing ratios. What amounts to a high gearing ration will depend on the business of the company (compare banks with software companies as an example);

6. if a stock disappoints on yield, it should be disposed of. I do not wish to end up holding unsuccessful investments for long periods;

7. unlike index funds, I will avoid illiquid stocks.

I expect that most of the stocks I end up owning will be mid-caps outside the Hang Seng Index.

I have six stocks which are a legacy of the portfolio I held prior to the previous dealing restriction taking effect. Two of these meet my investment criteria . The remaining four are worth trivial amounts and do not meet my criteria. Three were small holdings that were the result of spin offs from other holdings or life insurance policies and one is a company that came close to insolvency. I will dispose of these four by the end of 2009.

My initial research produced four Hong Kong stocks which meet my criteria. One was on our restricted list. The other three were all PRC toll road operators. Not only do these three companies offer attractive current or prospective dividend yields, but the continued rise in the number of vehicles on China's roads gives reasonable expectations that those yields will rise in the future.

Accordingly, I purchased shares in Jiangsu Expressway (177) at $5.57 and Sichuan Expressway (107) at $2.11. Both are expected to produce yields greater than 5% going forward. I held off purchasing the third stock (Zhejiang Expressway (576) as three stocks in one industry is a bit much at this stage.

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