Managing Asset Class Shares

by Alan Hull
Disclaimer
This document was prepared by Alan Hull an authorized representative of Gryphon Learning, holder of Australian Financial Services License No. 246606 and registered training organization provider No. 21327. It is published in good faith based on the facts known at the time of preparation and does not purport to contain all relevant information in respect of the securities to which it relates (Securities). Alan Hull has prepared this document for multiple distribution and without consideration to the investment objectives, financial situation or particular needs (Objectives) of any individual investor. Accordingly, any advice given is not a recommendation that a particular course of action is suitable for any particular person and is not suitable to be acted on as investment advice. Readers must assess whether the advice is appropriate to their Objectives before making an investment decision on the basis of this document. Neither Gryphon Learning Pty Ltd nor Alan Hull warrant or represent the accuracy of the contents of the document. Any persons relying on the information do so at their own risk. Except to the extent that liability under any law cannot be excluded, Gryphon Learning Pty Ltd and Alan Hull disclaim liability for all loss or damage arising as a result of an opinion, advice, recommendation, representation or information expressly or impliedly published in or in relation to this document notwithstanding any error or omission including negligence. None of Gryphon Learning Pty Ltd, its Authorised Representatives, the Gryphon System, Gryphon MultiMedia, and Gryphon Scanner take into account the investment objectives, financial situation and particular needs of any particular person and before making an investment decision on the basis of the Gryphon System, Gryphon MultiMedia and Gryphon Scanner or any of its authorised representatives, a prospective investor needs to consider with or without the assistance of a securities adviser, whether the advice is appropriate in the light of the particular investment needs, objectives and financial circumstances of the prospective investor.

Copyright Alan Hull 2010

This document is copyright. This document, in part or whole, may not be reproduced or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning or otherwise without prior written permission. Further enquiries can be made to Alan Hull, the author, on 061-03-9778 7061. Correspondence can be forwarded to ActVest Pty. Ltd. ABN 44 101 040 939 at 53 Grange Drive, Lysterfield, Victoria, 3156, Australia or via our website at http://www.alanhull.com

Contents........

Introduction to Asset Class Shares

Lifetime Income Assets Markets Searches

3
3 4 7 8

How to manage your Asset Class Shares

Capital Allocation Risk Management Buying asset class shares Research Wait for the market to come to you Reviewing your asset class shares Yearly Review Yield remains attractive What not to do Fundamentally sound and good future prospects Switch from an asset class share to a rising share Capital Allocation

9
11 12 12 13 18 19 19 19 20 21 22 23

Introduction to Asset Class Shares

We can refer to shares that represent companies which we deem to be 'Lifetime, incomeproducing Assets' as 'Asset Class Shares'. To seek out 'Asset Class Shares' we must first establish a set of specific benchmarks to work with. Understand from the outset that there are no right or wrong benchmarks and the selection criteria that we use is very much a matter of personal opinion. Hence whilst there is a degree of mystery surrounding the apparent genius of the likes of Warren Buffet and Ben Graham, they in their turn use or used a discrete set of pre-defined benchmarks to seek out asset class shares and not a crystal ball. Searching for lifetime, income producing assets is a boring and monotonous task, reliant on hard worknot an ability to foretell the future. That said - let's now examine the guidelines for determining our benchmarks. As we are seeking 'Lifetime, income producing assets' we must consider the following 3 areas; Lifetime - Asset Class shares represent Companies that will exist for our lifetime (Ideally we never want to sell our income stocks so they must last a lifetime) Income - Asset Class shares must have an acceptable dividend yieldor better (we are acquiring asset class shares for their income, not their capital growth) Assets - Asset Class shares should be of quality and bought at a reasonable price (hence we want to acquire asset class shares when the Stockmarket is depressed)

But before delving into each of these areas in detail, it is important to reiterate that each of us has a different set of financial circumstances, financial goals and we are all of different ages. Therefore the guidelines proffered here are not set in stone and should be tailored to each individuals needs and situation in life.

Lifetime
In order to make a judgment as to whether a company will last our lifetime, we must firstly quantify our own life expectancy and, secondly, determine the life expectancy of the Publicly Listed Company in question. Of course human life expectancy is well beyond the scope of this discussion and so we will quickly move on to the question of a Companys lifetime expectancy. There are several guidelines that we can combine in order to estimate a Company's life expectancy. The main problem is that we are required to make qualitative judgments about the stability of different commercial operating environments. Ie., we must make an assessment of the longevity and stability of different industry sectors. Warren Buffet's choices in this regard are typified by some of the Companies that he has acquired in the past. He believes that men will always have to shave so he has bought shares in Gillette whereas he completely abstained from the 'Tech' boom on the simple basis that he perceived the operating environment to be subject to rapid changea sensible assessment.
3

Another guideline we can employ is the size of a Company in terms of its market capitalization. The simple logic here is that the bigger a Company is, the less likely it is to disappear off the face of the Earth. Mind you, owners of HIH shares and Enron in the States might disagree with this logic. But whilst size doesn't necessarily ensure survival, it is a statistically valid approach with the vast majority of delistings occurring among smaller capitalization companies. For asset class shares we will apply a cutoff of 100 Million dollars as a minimum as this level fairly accurately defines the top 500 shares listed on the ASX. Of course we still need to assess each company on its own merits as there are always individual circumstances that can't be incorporated into global benchmarks. A typical example of this would be ANZ or Westpac. These banks would become likely takeover targets by the larger banks in the event of the dismantling of the 4-Pillar banking policy by the Federal Government. Therefore the 4-Pillar banking policy could have a direct effect on the life expectancy of these companies. It would be a very similar scenario for Media companies in the event of changes to the restrictions of foreign ownership of media assets. So when it comes to assessing the life expectancy of a Company it will always depend on personal judgment.

Income
Before we look at establishing a minimum benchmark for income, it is important to understand the inverse relationship between a companies share price and its 'Dividend yield' which is the amount of income generated per share, per annum. This is one of the more common tripwires where market participants confuse the science of share trading with the science of investing. In acquiring assets we are purchasing income streams whereas Traders buy and sell the share price for profit (or loss). It is normally wrong for a trader to buy a share with a falling price but, as asset managers, we want to buy an income stream for the lowest possible price. So as the annual dividend of a share remains constant at, let's say, $1 and the share price drops from $25 to $20, the income stream or dividend yield increases from 4% to 5%, making the share more attractive as an income producing asset. 'Buy low - sell high' doesn't apply here because we have no intention (at least at the outset) of ever selling our assets. And, although we are bargain hunting as the Stockmarket declines, we are in search of undervalued companies and the income streams they represent. We are not searching for undervalued shares with the expectation that the market will inevitably come to its senses and push prices back up. This is the logic used by bargain hunting Traders who use the word 'Should' a lot when talking about share price movements. We can visually observe the inverse relationship between share price and dividend yield with the use of charts. Both of the following charts of Blackmores (see next page) represent the same time period where one chart is of the share price whilst the other is its dividend yield.
4

The above dividend yield chart was generated using StockDoctor by Lincoln Indicators, a very handy fundamental analysis program, unique to Australia. (www.stockdoctor.com.au) This chart not only shows Blackmores dividend yield but also includes the average dividend yield for both the relevant sector and index. Blackmores share price, shown in the first chart as an unbroken blue line, is steadily falling over time whilst the dividend yield, shown in the second chart as an unbroken blue line with small blue squares, is steadily rising.
5

As the average dividend yield of the entire Stockmarket has a very strong tendency to track official interest rates, our expectations in terms of income must remain flexible and in keeping with the Reserve Bank of Australia's official cash interest rate. As the average dividend yield is usually just below the official cash interest rate it would be prudent to set our minimum benchmark at the RBA's official rate which can be found at www.rba.gov.au This will ensure that our income stream is always above the official cash rate and we're always ahead of the curve. What's more, this benchmark doesn't take into consideration any franking credits, ie. tax credits, that we may also be entitled to. Be aware that whatever benchmark we choose to employ is only our starting point and should reflect our tolerance towards minimum income. The income streams from these assets will grow in magnitude and proportionality with respect to the prices we originally paid for them. For example, if you paid $6.50 for CBA shares in 1991 then the annual dividend of approximately $2.60 per share (at the time of writing) represents an annual income stream of 40% with respect to your original purchase price whilst it only equates to a dividend yield of 6.5% with respect to the current share price. So if we were to apply the benchmark of 4.75% to the dividend yield chart of Blackmores we can see that it exceeds our expectations in terms of minimum income requirements. (the RBA interest rate was 4.75% during the relevant period)

But, taking the example of Blackmores a step further, the dilemma we now face is 'Do we buy today or, given that the share price is falling (see previous page), do we wait for a possibly higher income yield in the future?'. The answer iswe buy if the current dividend yield is above our threshold and we continue to accumulate shares into the future if the share price continues to fall. Whereas traders will cry foul because we're averaging down our purchase price, a no-no when tradingwe are in fact averaging up the dividend yield or income stream. It is also interesting to note that when we are accumulating shares in a particular company, while the share price continues to fall, we could in fact be losing money. In other words if we add the dividend payments to our capital losses, the result is a negative one. But given our timeframe of 'Lifetime', these losses are just the short term impact of an imperfect market entry. Fund managers will often use similar reasoning as an excuse for losses but it is only a valid excuse if their timeframe is the same as ours and they are accumulating income streams.
6

On a final note on income, it is always wise to ensure that the 'Dividend per share' or DPS is not of an abnormal nature and is in keeping with the normal dividend payment pattern of the company. In other words, check that the company has not paid out an extraordinarily large dividend because it's income has been abnormally inflated due to a unique circumstance such as the selling of a major asset. An example of this is when Mayne Nickless sold its interest in Optus which led to a bonus payment to shareholders of an extra $1 per share.

Assets
This section covers two very important areasthe first being the issue of 'Quality' and the second being 'Value for money'. Of course by quality I am referring to the quality of the company that the shares represent where an assessment can be made using fundamental analysis. To this end I will, once again, enlist the help of StockDoctor by only considering Star Stocks (Companies deemed to be of low risk and good future prospects by StockDoctor) as possible asset class shares. But no matter how good the quality of a company, I always like to pay as little as possible for my assets. So in order to know that I'm getting a bargain, or at least value for money, I must ensure that the P/E and P/A ratios are within acceptable benchmarks. But before we explore the question of acceptable benchmarks we should first clarify what these ratios are. 'P/E Ratio' is an abbreviation for Price/earnings ratio and defines the relationship between a companys market capitalization and its annual net earnings after tax. A low P/E ratio indicates that the earnings of a company are proportionally high with respect to its share price whereas the opposite is true for a high P/E ratio. Whenever the share price of a company changes or a new financial report is issued by the company, the P/E ratio will change. Example A company has a total market capitalization of $10 Million. Its annual net earnings after tax are $1 Million. Therefore it has a P/E ratio of 10 ($10 Million / $1 Million)

'P/A Ratio' is an abbreviation for Price/asset ratio and defines the relationship between a companys market capitalization and its net tangible assets. Example A company has a total market capitalization of $10 Million. Its total net tangible assets (ie. property, plant and equipment, etc) are $2.5 Million Therefore it has a P/A ratio of 4 ($10 Million / $2.5 Million)

A low P/A ratio indicates that the asset backing of a company is proportionally high with respect to its share price whereas the opposite is true for a high P/A ratio. Interestingly, it is possible to find companies with P/A ratios of less than one which means that a $1 share represents more than $1 of value in net tangible assets. This situation occurs when the future prospects of a company are poor and the marketplace is more focused on earnings rather than asset backing.
7

To ensure that this situation doesn't occur we need to look for companies with both a low P/A ratio, indicating substantial asset backing, and a low P/E ratio, indicating good earnings. Our minimum benchmarks will be a price/earnings ratio of 15 or less and a price/asset ratio of 5 or less. These minimum levels for earnings and asset backing will reasonably ensure that we are getting value for money when we go shopping for asset class shares.

Market Searches
The following is a summary of the benchmarks that we have developed for our asset class shares; (This list excludes any discretionary guidelines such as life expectancy) Market capitalization of at least 100 Million dollars Dividend yield greater than the RBA target cash rate Fundamentally sound - companies must currently be StockDoctor Star Stocks The P/E ratio must be less than 15 and the P/A ratio must be less than 5

Using these benchmarks we can, with the help of StockDoctor, create a short list of potential asset class shares. Note that this list is a starting point for further research and doesnt take into account such factors as the abnormal sale of assets such as property and/or plant, etc.

Asset Class Shares from 2002

The following list includes 10 possibilities from a time when global markets were severely depressed in 2002. The number of possibilities is typically very small because our benchmarks are tough and, whats more, we haven't even begun to examine this list with respect to 'Life Expectancy'. The reality is that you should only expect to uncover a handful of ideal opportunities over a period of several years. But when you do, it pays to have the confidence to act swiftlylest you suffer the regret of not buying CBA shares for $6.50 all over again.
___________________________________________________________________________________________________________________________________

Company Name

Code

P/A Ratio

P/E Ratio

Dividend yield%

Alinta Gas ALN 2.52 12.78 5.28 AV Jennings Homes AVJ 1.24 6.90 10.11 Blackmores Laboratories BKL 4.92 13.39 5.43 Bristile BRS 2.28 10.57 5.73 Casinos Austria Int. CAI 2.79 6.67 6.00 Centennial Coal Company CEY 1.39 9.58 5.09 Crane Group CRG 1.51 12.33 5.99 Joe White Maltings WJM 1.45 8.00 5.58 Simsmetal SMS 2.60 14.14 5.18 Stockland Trust Group SGP 1.36 14.38 6.70 ____________________________________________________________________________ (Note that the RBAs target cash rate during 2002 when this list as generated was 4.75%) An 'Asset Class Shares' list appears every week in the ActVest Newsletter. This list is generated using StockDoctor's StockFilter function and the above parameters.
8

How to manage your Asset Class Shares

So now its time to get down to the nitty gritty of how to manage our asset class shares. As part of this explanation I will be reiterating some of the key concepts made in the previous section. And Ill start with the point that we are searching for attractive income streams as opposed to capital gains. This is the flipside of what we do as traders and as the market is falling and prices are dropping, dividend yields start to rise. So Buy and Hold investors like Warren Buffett come out of hidingready and willing to spend some money.

Warren is looking for high income streams from well established businesses like when he bought $5 Billion worth of preferred stock in General Electric with a guaranteed 10% annual distribution. But given that the price of GE continued to fall after Warren made his move (he bought in during the 2008 calendar year), some market commentators have scoffed at what they saw as poor timing.

But, to the contrary, Warren is perfectly happy with his 10%pa income stream (and who wouldnt be) and if the price of GE stock remains low then Warren will probably try to strike another and probably even better deal for some more preferred stock. Afterall hes buying a rising income stream, not a falling share price and we should be following his example by looking for similar opportunities on this side of the Pacific Ocean. So now I would like to draw your attention to second last page of the ActVest Newsletter Data Tables where youll find a list of potential asset class shares. Below is the list from mid-2010 ____________________________________________________________________________

Asset Class Shares

The following table of potential 'Asset Class Shares' was generated using StockDoctor's search function, StockFilter, with the following set of parameters. (www.stockdoctor.com.au) Market capitalization of at least 100 Million dollars Dividend yield greater than the official RBA cash rate target (www.rba.gov.au) Fundamentally soundCompanies must currently be StockDoctor Star Stocks The P/E ratio must be less than 15 and the P/A ratio must be less than 5

Asset Class Shares

Code DJS TGA Company Name David Jones Limited Thorn Group Limited

Reserve Bank of Australia's cash rate = 4.50%

P/A Ratio 3.18 2.35 P/E Ratio 13.53 7.97 Dividend yield% 6.70% 5.27%

___________________________________________________________________________________________________________________________________

PLEASE NOTE

The management of Asset Class shares is explained in detail in the Active Investing course notes from page 34 to 43, inclusive. Further relevant information can also be found on pages 45 and 46 of the Advanced Tactics Manual. The latest versions of these documents can be found at www.actvest.com below the newsletters and data tables. The figures shown in the above table are calculated using ASX data and are post abnormals. For this reason discrepancies may be apparent when comparing these figures to other sources of fundamental data. This table is intended as a starting point for further research and doesn't include any unsearched fields such as franking credits, etc.

IMPORTANT

____________________________________________________________________________
10

Whilst the list from mid-2010 isnt exactly overflowing with possibilities I would now like to remind of how many possibilities there were in late 2002 when we suffered a mini-Bear market and the list was far more extensive.

At this time there was plenty of opportunity and some very attractive yields, not to mention franking credits which arent shown here. So when global markets stumble and fall we can usually expect the list of asset class shares to swell in response. So armed with this list of potential asset class shares, we now need to delve deeper into some of the more practical considerations. These include how much capital you wish to allocate to income stocks versus trading stocks, risk management and how to go about buying asset class shares.

Capital Allocation
This is most definitely a question that I cant provide a general answer to as we are all in very different situations. So we must each decide for ourselves how much of our total capital we want to allocate to asset class shares versus trading shares. Once weve made up our minds then we need to split our money into 2 separate pools and treat them as being mutually exclusive. Asset class shares require very little management and generally only need to be reviewed once a year while trading shares are the ones on the ActVest newsletter rising equity list and the BCR share list that are normally managed on a weekly basis Typically the younger you are then the more inclined you will be to actively manage your shares hence shares that you trade will be more attractive to you at this time As the intention is to hold asset class shares indefinitely then you must assume that you wont have ready access to the capital which you allocate to them (fixed assets) while shares that you trade can be sold quickly and turned to cash (liquid assets) Of course whatever mix you choose can change over time and so I wouldnt dwell on it too much. Also the amount of money you have to play with will have some bearing as well.
11

Risk Management
Whilst capital allocation is open to individual interpretation, the question of risk management isnt and with asset class shares it differs somewhat from that of trading stocks. The key difference being that asset class shares, given their buy and hold nature, cant employ a stop loss. And unfortunately there is always the chance that a stock that can look very attractive on paper, can turn out to be a complete dud. Just ask anyone who bought HIH back in the 1990s. So because we cant apply a stop loss to our income stocks, the only protection we have is diversification. Hence I never allocate more than 10% of my total capital to one individual position and at the annual review of my asset class shares, I will sell down any position that has reached 15% of total capital back to at least 10% of total capital. Also be mindful of your sector exposure which I recommend be limited to 25% of total capital. Thus many long term investors have, and I suspect will again, be caught out with far too much exposure to the banking sector.

Buying Asset Class Shares

The secret here is to always remember that youre buying the income or dividend yield and not the share price. Lets assume youve done your research and the yield is very attractive so you buy. But a little while later the share price drops and the yield goes up. For a share trader this is bad but if youre buying for yield then you simply buy some more. This is called dollar cost averaging and you can do it with one provisoyou still have some money in reserve to spend. So I always recommend that you acquire asset class shares in several parcels over time and preferably when the general outlook is very bleak. An example of this would be if I had $1M and I wanted to build a $400K income portfolio. Then I would allocate $40K per share and I would break this down into 4x $10K parcels that I would then spend monthly or even quarterly. Please remember that theres no need to hurry when it comes to purchasing asset class shares and I personally wont start acquiring income stocks until Im convinced the broad market is in a well established downtrend. Hence, in the case of the All Ords, pictured below, it is consolidating and I wouldnt buy income stocks until it develops into a downtrend as shown

12

The trick here is to pre-empt a major market decline so we have plenty of time to shop around and do our research before committing to what will hopefully be a very long term investment. Mind you, I review my income stocks every year and if they dont measure up then I will contemplate getting rid of them. Unfortunately in this modern era of investing, the business environment is changing very rapidly and a Companys fundamentals and circumstances can deteriorate very rapidly as a result.

Research
So now to the asset class share list again where you will find a list of suggested stocks that should then be researched further. Also note that when these companies drop off the list that it is not a signal to sell them. If they do disappear then it is probably a good idea to stop buying them but the criteria for selling is a different matter entirelyan issue well cover in greater detail a little later on. Anyway, here again is the asset class share list from about mid-2010 ____________________________________________________________________________

Asset Class Shares

The following table of potential 'Asset Class Shares' was generated using StockDoctor's search function, StockFilter, with the following set of parameters. (www.stockdoctor.com.au) Market capitalization of at least 100 Million dollars Dividend yield greater than the official RBA cash rate target (www.rba.gov.au) Fundamentally soundCompanies must currently be StockDoctor Star Stocks The P/E ratio must be less than 15 and the P/A ratio must be less than 5

Asset Class Shares

Code DJS TGA Company Name David Jones Limited Thorn Group Limited

Reserve Bank of Australia's cash rate = 4.50%

P/A Ratio 3.18 2.35 P/E Ratio 13.53 7.97 Dividend yield% 6.70% 5.27%

___________________________________________________________________________________________________________________________________

____________________________________________________________________________ Note that the dividend yield must be greater than the current Reserve Bank of Australia target cash rate which is subject to change on a month by month basis. Hence we always show the latest RBA cash rate with the weekly results and update our search criteria accordingly. As a working example, I thought we would take a closer look at Thorn Group who is the parent company of Radio Rentals. And let me say that based on its business model, I dont think there could be a more defensive stock. Radio Rentals usually thrive during tough times as people will favour renting over outright ownership of many everyday household appliances. Furthermore, 40% of Radio Rentals client base are on some form of welfare and they are hardly likely to be impacted by a downturn in the broader economy. In fact their numbers will probably increase.
13

But enough comments from me as this is the part where I defer to the expert commentary from StockDoctor, a fundamental analysis program that we have been using to create the ActVest newsletter for over 10 years. For more information on StockDoctor please visit the website at www.stockdoctor.com.au and whilst it may help you get a discount, there is no need to mention that you are one of my subscribers as we do not receive commissions for referrals. This is what StockDoctor said about Thorn Group in mid-2010 the facts and figures.

These are the Companys principal activities. Thorn Group Limited (TGA, formerly RR Australia Limited) is an operator in the Australian electrical and household appliances rental market, particularly the SME sector and government. The company offers a wide range of audio visual products, kitchen and laundry appliances and computers along with a new range of furniture and gym equipment on a rental basis or a purchase option. Rent, Try, Buy (RTB): either an 18 or 36 month rental contract, which includes an option to buy a similar product after 36 months for $1. Alternatively, the customer can make an offer to purchase the product being rented at the expiry of the rental term which the company can either accept or reject. Rent, Try, Buy! Plus: is available on a selected range of products and is similar to the 18 month RTB, except the customer pays a premium for additional flexibility which includes the ability for them to return the product any time after 6 months without incurring an early termination fee and the customer can also recommence the rental at any time within the next 12 months.
14

Big Brown Box: As at November 2008, the company launched Big Brown Box, a new online electrical store that aims to provide Australian consumers with a retail experience. Big Brown Box would provide consumers with the opportunity to research and compare products at a time convenient to them and then make a purchase. And finally, here are Michael Fellers (a Lincoln Analysts) comments. We attended a presentation held by the company at the recent Goldman Sachs JBWere Micro Cap Conference 2010. John Hughes, TGAs managing director, is the type of down-to-earth individual you would expect to be managing a company thats been making whitegoods and appliances more affordable for over 70 years. Still, while TGAs core business Radio Rentals has a very old and staid business model, the company continues to innovate and TGAs strong top and bottom-line growth in recent years can be expected to continue in the longer-term. Beyond the companys excellent annual results, longer-term growth can be expected for TGA regardless of wider economic conditions. It is estimated that some 40% of Radio Rentals customers receive welfare benefits so a drop in overall economic conditions will not necessarily affect this demographic and indeed, it can be argued, that a drop in employment, credit or disposable income levels will create more customers for Radio Rentals. Rising property prices leading to an increase in renting, market uncertainty and a trend towards a more mobile workforce also contribute to further growth potential. For this reason a number of Radio Rentals stores are being made over from upscale St Vincent de Paul shops as Hughes expressed it, to retail spaces that will attract an aspirational demographic. Whitegoods, televisions and personal computers generate approximately 20% of sales each for Radio Rentals, with furniture largely making up the rest. Aspirational consumers are more likely to buy electronics from Radio Rentals than other product categories, especially if it means new, latest equipment can be had without being purchased. The end of analogue television broadcasting in 2013 is another key driver. TGAs other experiment in serving this market, however, has disappointed. BigBrownBox.com continues to operate and will become the exclusive retailer for the new Acer build-you-own computer in Australia, but the division still remains a dream unfulfilled. TGAs Business Services division, which provides equipment finance and leases goods to the SME market, on the other hand appears to have better prospects. The failure of SME financiers like CIT and others since the credit crunch is furthermore TGAs advantage. The company's personal lending division, Cash First, also has strong potential and readily meets the governments new consumer credit code. As TGA moves into a more upscale market firms like Flexirent and Thinksmart will begin to bring competitive pressure, but it has its defensive Radio Rentals business to fall back on. The introduction of new one-person branches to service remote and regional areas also opens up the model to areas that were previously underserviced by Radio Rentals. The story behind TGAs latest results is compelling and the company remains well positioned for further expansion.
15

You can see from this sample of information from StockDoctor why Im such a big fan of it. Anyway I personally believe that given its financials and their business model that Thorn Group are a potential asset class share that I would be keeping a close eye on. Now lets move on to the example of David Jones (DJS) where I have a very different opinion; These are the facts and figures for David Jones (DJS) from mid-2010.

Heres the Companys principal activities. David Jones Limited (DJS) is a leading upmarket retailer with stores throughout Australia. The Group operates 35 department stores and 2 warehouse outlets. DJS and American Express in joint venture run a David Jones branded credit card. Department Stores: Retail stores focusing on the premium end of the market in terms of the brands and products. To facilitate store differentiation, DJS is focused on increasing the number of lines that are exclusive to David Jones. Distribution Agreements: The company continually adds well known brands to the portfolio. Recent additions include Tigerlily, Simone, Prle, Sara, Luxaflex, Mambo, Saba, FCUK and Witchery. In July 08 DJS announced that it added 50 new brands to its portfolio on a department store exclusive basis. Strategic Plan: In March 08 DJS released it FY09-FY12 strategic plan, highlighting seven sources it will focus on to drive Profit and cash flow growth. Including opening new stores, launching new David Jones branded AMEX card, improving gross margins and improving capital efficiency.
16

Credit Card Business: In February 08 David Jones announced that it has selected American Express as its partner for a long term strategic alliance that will see the launch of a David Jones branded credit card in Australia. And lastly, here are Angela Ignacios (another Lincoln Analysts) comments . DJS has regained its status as a Consistently Healthy Star Stock following analysis of the company's latest interim results. The company remains in a Satisfactory financial health position. With all key ratios coming in as either Strong or Satisfactory, DJS is exposed to manageable levels of financial risk and therefore satisfies Golden Rule No. 1 - Financial Health. Net operating profit before tax and significant items has risen by 10.4% from $129.968 million in the previous corresponding period to $143.497 million on the back of higher sales and improved margins. The company reported that despite a very competitive environment in 1H10 marked by heavy promotional activity by retailers, gross profit margin hit an all-time high of 40.0% and EBIT margin was up 90 bp to 13.5%. Pre abnormal Earnings per Share (EPS) rose from 17.70 cents to 19.40 cents. This translates into EPS Growth of 9.60%. Return on Assets (ROA) has increased from 23.96% to 24.93%. As ROA and EPS growth are above our target of 8% and have increased, DJS is able to satisfy Golden Rule No. 2 - Management Assessment. The company also satisfies Golden Rule No. 6 with a market capitalisation of $2,583 million. There is sufficient liquidity for both retail and institutional investors with the 22 day average daily dollars traded at $11.214 million. The company last closed at $5.13 at a PE of 16.03 times, which when compared to the sector average of 13.17 times, suggests the company is potentially overvalued at current prices. This is supported by the PEG of 1.67. We will be resuming coverage on DJS and a Lincoln Valuation is forthcoming. DJS declared an interim dividend of 12 cents per ordinary share, fully franked (an all-time high) for the six months ended 23 January 2010 resulting in a dividend yield of 5.65%. The outlook for DJS remains positive with the company's key new store & refurbishment projects on track. The Bourke Street store is scheduled to be completed in 1Q11 with major EBIT benefit to flow through in FY12. Kotara will be completed in Nov 2010 and Claremont is due to open in March 2011. On the expense side, cost of doing business can be reduced further with 58 Cost Efficiency projects on track over FY10-FY12. Management has reaffirmed its 5%-10% Profit After Tax (PAT) growth guidance for 2H10 and FY10, although they remain very cautious about cycling the Government Stimulus in 4Q10. They also reaffirmed its PAT guidance for FY11 of 5%-10% PAT growth. It was noted however that to achieve the top end of this guidance, the retail recovery will have to be in full swing.
17

Now to my opinionand I dont believe that given the nature of its business that David Jones is a defensive stock. Unlike Thorn Group who can be expected to thrive during a downturn in the broader economy, I see David Jones as an upmarket retailer who is not an essential service provider (or what I like to call a toilet paper company). Hence I would put Thorn Group on my income stock watch list but I would be far less interested in David Jones. Certainly as at mid-2010, David Jones is domestically focused and its high dividend yield and 100% franking credit are both a plus. However I believe its price:earnings ratio is on the high side and will probably get even higher as revenues fall away in a slowing economy, which is what you would be anticipating. But this is just my opinion and as you can see, choosing asset class shares is not an exact science. Nor is anticipating the direction of the broad economy. Furthermore you may decide to do a lot more research than what Ive shown you here but at least you now have a good idea of what were looking for in an asset class share. Of course the weekly list that we provide in the ActVest newsletter data tables is a safe and sensible starting point that will ensure that youre in the right ballpark.

Wait for the market to come to you

So I like Thorn Group and I would keep a close eye on this share but I wouldnt necessarily race out and buy it straight away. As I have already said, when buying asset class shares there is absolutely no need to be in a hurry as we should have plenty of time to sit back and wait for the market to come to us. Remember that we are buying a rising income stream which means that we want the share price to be falling and in mid-2010 that certainly wasnt the case for TGA

18

Whilst TGAs price chart would suggest that its beginning to struggle (a possible double top?), it certainly hasnt begun to trend down. So its too early to be buying TGA but we can always be shopping around and compiling a list of possibilities. Of course, if Thorn Group does fail to trend down as we hope it will, then we will simply move on to the next possibility.

Reviewing your asset class shares

Now to the final piece of the jigsaw puzzle which is when to review your asset class shares and what you should be looking for. There are several things you need to consider but uppermost in your mind should be whether or not each of your income producing assets are producing an adequate amount of incomeand will keep doing so. But there are other considerations as well and it will probably be best if we tackle them all, one at a time Yearly Review This first point is fairly obvious and easy.I recommend that you review your asset class share portfolio on an annual basis. But I would also recommend that while youre at it, you also review your capital/asset allocation to ensure that you are not too heavily weighted in any particular asset class. This is an exercise that all investors should also perform on an annual basis and one that, I believe, becomes far more critical if we are in or approaching retirement. This is because an imbalance in our asset allocation can expose us to the totally unnecessary risk of a catastrophic event occurring within a single asset class, such as shares for instance. So lets assume you have your money spread across the following asset classes;

A sensible set of guidelines for the average baby-boomer would be; Have enough cash to live on for at least 2 years in case of a general downturn Shares shouldnt exceed property assets (very pertinent during a market boom) Retain your business interests if possible, also in case of a general downturn Make sure your assets are legally protected, especially if you are in business Establish/manage financial structures to minimise tax and reduce legal exposure

Where possible I believe its a good idea to retain one's business interests into retirement as this is a good hedge for times when both Property and Stockmarket assets dip at the same time. Yield remains attractive As already stated, this is central to the review of our asset class share portfolioare our assets producing adequate income and are they likely to keep doing so? But please ensure that you make this assessment based on your initial purchase price, incremented using the cost of living via a suitable benchmark such as the annual CPI figureand not the current share price.
19

And being such an important part of the annual review process, it is probably best if I demonstrate how this is done with a working example. So lets take the fairly straight forward case of CBA shares which well assume you hypothetically purchased back around 1991/92 at the bargain basement price of just $6.50. The question being; what is your $6.50 worth today? Now (at the time of writing) approximately 20 years on, your original $6.50 is now worth a lot more largely due to the impact of inflation. In other words $6.50 back in 1991/92 had a lot more purchasing power than it has today. However we can calculate the equivalent value of $6.50 from 1991/92 by indexing it using a hypothetical (but indicative) annual CPI of 4%... 1991 1992 1993 1994 2010 $6.50 $6.50 x 1.04 = $6.76 $6.76 x 1.04 = $7.03 $7.03 x 1.04 = $7.31 $13.17 x 1.04 = $13.69

So there you have it; $6.50 in 1991 is equivalent in purchasing power to $13.69 today. So now we can compare CBAs current dividend payment to the current value of your original purchase price of $6.50 where CBAs annual dividend in 2010 is $2.90 $2.90 / $13.69 = 21% annual return on your original investment And reversing out the 100% franking credit = 21% / 0.7 = 30%pa Based on these numbers I would suggest that CBA shares purchased in 1991/92 are now a very nicely matured income producing asset. But there are a couple of other key points you also want to consider when assessing a shares income Is there an investment I can move my money into that has a better yield? Is the annual return on my investment increasing or decreasing each year? Was there any abnormals included in the annual distribution to shareholders? (for instance, did the company sell off any major assets creating one-off profit?) Is the value of the share dropping over time and therefore offsetting the income? If these questions dont raise any concerns and the yield is attractive then I would suggest that the share is generating an acceptable income stream, for now. And so once again I reiterate the need to perform this review at least once a year and not put your asset class shares in the bottom draw. With the business cycle getting shorter and shorter I think those days are definitely over. What not to do Do not fall for the trap of using the current dividend yield because it is based on the current share price which is not actually relevant to this assessment. Take the example of AV Jennings which was a very attractive asset class share back in 2002. Please see the report on AV Jennings (generated using StockDoctor) at the top of the next page.
20

Whilst it is an extreme example, the case of AV Jennings illustrates the point well. Looking at the first column for AV Jennings (Sep 02) you will see that, based on the share price at the time, the dividend yield was 13.41% with 100% franking creditsvery attractive in anyones view. But one & a half years later on (March 04) and the dividend yield has dropped off dramatically to just 4.80% which would suggest that the actual dividend has more than halved. But in fact the dividend payments to investors remained virtually unchanged whilst the share price rose from about 80 cents to over $2, making the yield drop dramatically. So the dividend yield can be very deceiving and you should always look at the dividend payment itself and, as stated earlier, compare it to your initial purchase price indexed using the cost of living (ie. the annual CPI). Of course with the doubling of AV Jennings share price its fundamentals became somewhat overstretched but that is actually an issue that I believe should be handled separately. Fundamentally sound and good future prospects And so if we go back to the above report on AV Jennings, you can see that as the share price rose dramatically, the fundamentals tapered off nearly as fast. I draw your attention to the row marked financial health which went from Strong in Sep 02 to Marginal by Sep 05. At this time the P/E ratio was 36 and the earnings per share was well into negative territory. Hence, whilst fundamental analysis isnt an exact science and so I am not prepared to give set benchmarks for when to sell, the alarms bells were certainly ringing loudly for AV Jennings. And as you can see, a companys financial ratios can and will change, and must be monitored.
21

Another related consideration is the assessment of a companys future prospects. Imagine owning a company that made buggy whips when cars were first introduced into everyday life. Whilst a buggy whip company could have had very good fundamentals and an attractive dividend, its days were certainly numbered and I suspect its share price would have been slowly falling as a result (a point I mentioned earlierfalling share price offsetting dividend income). Thus Im somewhat skeptical about Telstra and its aging copper wire network. And you can see what Im talking about in the following chart where Telstra is in a very long term downtrend. This is not really a situation I want even with my asset class shares and therefore we should be mindful of the long term price trend even though we own the share for income purposes.

Switch from an asset class share to a rising share Returning to the example of AV Jennings, there is another option for those who purchased AVJ back in late 2002 and that was to switch it from being an income producing asset to a trading proposition. This would have meant applying a stop loss strategy and managing the share price as opposed to the income stream it provided via its dividend payments. The decision at the time would have been triggered by the sharp rise in its share price and the potential capital growth.

22

I personally would have been tempted to take this approach because a share price that doubles in the space of just one year will inevitably lead to overstretched fundamentals. Furthermore you would have been forced to sell down anyway to maintain a safe level of capital allocation. Capital Allocation This follows on from our earlier discussion on asset class shares and risk management. As our only means of protection against catastrophic risk is diversification (given we dont use stop losses to manage income stocks) then we must continually rebalance our portfolio. I personally like to ensure that each income stock remains close to about 10% of the total portfolio value. Thus when I initially purchase asset class shares I only spend a maximum of 10% of total capital and when I do my annual review I will sell down any position that has exceeded 15% of total capital. And three guesses what I sell it back to10% of my current total capital or the total portfolio value, whatever you like to call it. But there is also the question of sector allocation which I previously said I like to maintain at a maximum of no more than about 25% per sector. Hence if my sector exposure exceeds 30% of total capital then I will sell it back to 20% of total capital. Please note of course that these benchmarks are not set in stone but are a sensible set of guidelines that are open to a degree of individual interpretation. Thus an investor with a very large amount of capital may be inclined to use even more conservative benchmarks. Without knowing your individual situation, I believe we have come as far as we possibly can with this discussion and its key aspects. However on a final note I will say that there is a time to trade markets and a time to accumulate asset class shares. And to ultimately succeed as an active investor, you must apply the right approach at the right timeand in the right way.

23