Mastering Portfolio Building
“If you look at the S&P and ask yourself why it outperforms most people, it’s not because the S&P has a superior stock selection methodology.
They select 500 stocks out of 10,000 public companies. They’re not selecting these on the basis of trying to beat other money managers. They’re trying to get companies that represent the overall U.S. economy.
They want companies that are leaders in an industry, niche, or sector, that have been around for some time, have adequate trading liquidity, and have financial characteristics such that they’ll be in business ten years from now. That’s about it.
Why does that beat 95 percent of money managers? It’s not the stock selection, it’s the money management strategy of the S&P. It’s long-term, has low turnover, is tax-efficient, and doesn’t change company or industry weightings. It just lets them evolve. You’ll hear money managers say all the time, ‘I’m overweight this, underweight that, I’ve got too much technology, or whatever.’ The S&P doesn’t come out and say, ‘Microsoft is the biggest company, so let’s cut it back.’ They let their winners run. Technology and financial services together were 5.5 percent of the S%P 35 years ago. Now they’re more than 40 percent. Why? That’s the way it’s evolved.
Most money managers have fairly strict limits on what they’re going to do and how much they’re going to have in the portfolio. Look at people like Buffett. He doesn’t say he’s overweight in Coca-Cola, so he’s going to sell some. He just buys and holds it. If the time comes when he decides he’s going to sell it, he will sell. –William (Bill) Miller, Legg Mason
What are Keys to Building Great Portfolios?
#1. One Stock Does Not Make A Portfolio. If you work for a company that offers stock as part of compensation, great! But don’t consider this single holding as your entire portfolio. Even if you are lucky enough to be employed by Microsoft, the best performing stock over the last 15 years, you should consider a bit of diversification to reduce volatility and risk. You could argue that every dollar you invested in Microsoft in 1987 grew to nearly $43 by 1997. But for every example of spectacular performance there are a dozen examples of average or below average stocks. Imagine if you were holding IBM stock from 1987 to 1997 instead of Microsoft! There is no need to bet your future on a single stock, even your favorite.
#2. Ten Stocks is Enough. If you are like most investors, this is a part time effort. You still have a job as your primary income for supporting your family. You don’t have time to track 100 stocks on a daily basis like a fund manager with a team of analysts. (Actually, there is a bit of scepticism about fund management teams being able to track as many stocks as they tend to own!) Academic studies also show that owning more than 10 stocks adds little more value in terms of diversification and begins to dilute the effects of one big winner among your 10 stock selections, known as “diworsification.”
#3. You Start where You are the Expert. The first stock you own should be a leading company in an industry you understand well. If you are a software designer, you should be able to apply that knowledge to select a leading brand in software like Oracle, or an emerging Asian niche player like Cytech. If you own a small family construction company, you should be able to spot the best positioned companies in your industry who’s services are in demand and are making solid profit under savvy management. If you love to shop, you should know what franchise stores are hot this Christmas or Chinese New Year.
#4. Your Portfolio Needs a Defined Strategy. As you look to add more stocks to your portfolio to compliment you “expert” pick, first design a organized strategy you will follow to determine allowing or declining admittance. Every stock wants to be in your portfolio, but not all who come calling will be qualified. You need a theme and stringent screening criteria. Perhaps you demand growth. Your screens may include revenue growth of 30% and profit before tax growth of 30% per year. If you favor value, you may demand a P/E ratio below 20 with growth rates above 20. If you want income you may screen for high dividend yields and low payout ratios versus earnings (high, but safe dividend yields). Don’t wait until you already own your 10 stocks before considering your overall portfolio goals and strategy.
#5. Assume you only get 20 Chances. Investing is about long-term returns. You should carefully assess your choices before purchasing and sell very reluctantly as you evaluate a business’ progress quarter to quarter and year to year. If you tell yourself you can only make 20 stock purchases your entire lifetime, you’ll be very selective. You will be less likely to jump on a hot tip or friendly rumor without thorough investigation.
Only you know what is right for your unique goals and risk tolerance. Take a small position in your favorite stocks as soon as you identify them, then continue to monitor.
As they rocket higher you can enjoy it and brag to your friends. As they tumble out of favor from time to time you can invest your savings to buy more shares as your friends are panic selling at bargain basement prices.
It’s a lifelong journey that can never perfected.
