The rules of engagement

When choosing companies to invest in it is important to first know what the purpose of the account is. Can I afford to lose most of the money in the account? Or am I relying on it to pay off the mortgage one day?

I will shortly have three investment accounts: my aggressive growth fund, my son's college fund and my mortgage fund.

The growth fund is rainy day money. I do not know yet what I am going to do with it. Maybe start a business or failing any inspiration I could use it to pay off some of the mortgage, reducing the monthly interest payments. If I lost every penny in this account my day-to-day life would not be affected one bit. Therefore I am willing to take risks with this account. By taking risks I don't mean gambling or investing in companies that may go bankrupt, rather investing in companies on high multiples like eBay or Google, or cyclical companies like Frontline. By taking a measured amount of risk this account will probably do much better than my other accounts. It will probably have bad years though, but that is OK.

My son's college fund is obviously money I cannot afford to lose. My son would not be too happy if at the age of eighteen I told him that he cannot go to University yet as the market is not performing well! This money has to go into safe, British, blue chip, dividend-paying companies that can keep increasing their earnings and dividends for at least 10 years. When the end date is getting close some of the money should be transferred to a savings account to protect it from a stock market crash just before the money is needed.

The requirements of the mortgage fund are similar. I do not want to find out, at the age of fifty, that due to one of my holdings going bankrupt it will be another ten years before I can pay off the mortgage. Profitable, dividend paying blue chips are the answer again.

I thought it would be good to have some specific filters rather than vague ones. So here are the rules / limits that companies for the mortgage account must pass:

1. P/E must be less than 30
2. Yield must be at least 1%
3. Market Cap. must be greater than £2 billion.
4. Earnings must be projected to increase over the next five years.
5. No more than 25% of the account can be in foreign companies.

1. Companies on a high P/E are very sensitive to bad news or reduced guidance. eBay was re-rated lower to the tune of 40% when its Q4 2005 results and guidance did not impress the investors. Being on a P/E of over 100 gives the share price a long way to fall. Of course some companies are worth high multiples, but they are for the growth account.

2. I like dividends! Income for no work has to be a good thing! In years where the share price goes nowhere the income from the dividends can keep the account value going upwards. When re-invested the power of compounding can work its magic on your account.

3. It is actually a myth that small cap. companies are dangerous investments. If they are well managed and have a good balance sheet they are not especially risky. However they are not likely to have a diversified product offering, meaning they are more at risk from competition or changes in the market. If I want to buy a small cap it will have to go in the growth account.

4. Cyclical stocks are excluded by this rule. I want steady, increasing earnings and dividends, not profits that jump up and down like the waves of the sea.

5. When buying overseas stocks you are exposed to currency risk. Any foreign companies I buy will almost certainly be American and who knows where the dollar may go over the next 20 years. However there are too many fantastic companies in the States to avoid this market entirely. The great think about having a maximum percentage is that when the American companies do well the profits are automatically captured in order to reduce the exposure to 25%. If I had been holding a company like Cisco in the late Nineties this rule would have ensured that I cashed in some of the profits before the share price crash in 2000.

So there are the rules. In a few days I should be receiving a large amount of cash from my cancelled endowment. The next job is to select four or five companies that fit the criteria.

Favourites at the moment are Royal Bank of Scotland, Glaxo SmithKline, BAA, O2 and Qualcomm.

More soon.

Phil.