Investing Basics: How to Construct an Equity Portfolio

 

Portfolio construction tends to get much less attention than picking stocks. This is a shame because it’s a huge driver of risk and returns.

You can be a great stock picker, but if you don’t allocate monies effectively you’re probably not going to do very well. Poor portfolio construction can also mean exposing yourself to risks you may not even know you’re taking.

‘if you don’t allocate monies effectively you’re probably not going to do very well’

Portfolio construction is, like most things, full of contradictions.

Minimise risk, but maximise returns…. diversify, but don’t over-diversify. It’s a balancing act and no one will ever achieve perfection.

It’s also a very personal thing. There’s no handbook that says you must do it this way or that. It comes down to your own attitude to risk, investment style and so on. It’s about finding what works for you.

Below I set out some of the things I think about when constructing and managing an equity portfolio. As ever, these are my own personal views and nothing should be taken as advice.

 

Number of holdings

 

Personally, I prefer a concentrated portfolio of 20-30 holdings for a few reasons:

Great business are rare. Great businesses that are also well managed are rarer still. I don’t want to ‘diworsify’ my portfolio by adding sub-par companies because I believe this increases rather than reduces risk.

I agree with Phil Fisher – it’s better to own a few great businesses than a great many mediocre ones.

Good ideas are rare (at least for me!). When I have one it needs to make a difference.

‘it’s better to own a few great businesses than a great many mediocre ones’

I like to understand the businesses I own (especially important in a concentrated portfolio). There are only so many companies I can track and develop enough knowledge on.

Most of the best investors I know have or had concentrated portfolios, although there are exceptions (such as Peter Lynch).

When you own fewer positions, it forces you to make tough decisions. Do I really understand this business well enough? Would I be better off holding this company instead?

To me this is a better approach than adding more and more names, akin to a stamp collector – there are no prizes for collecting large albums of stocks.

Many studies show that beyond about 30 holdings, the benefits of adding more positions for diversifying risk are minimal.

 

How much to allocate to each holding

 

Once you’ve decided on the number of holdings comes the question of position sizing.

I focus first and foremost on risk, not return potential, when determining my biggest positions.

I want the bulk of my portfolio allocated to lower risk businesses providing essential goods or services, preferably with a high degree of repeat or recurring revenue; that are well diversified and relatively simple to understand.

My smaller positions tend to be in companies I deem more risky, perhaps becuase they’re very sensitive to the economy or there is a part of their business that I don’t understand as well.

Over time, portfolio weightings will change if an investor does nothing. Some investors may choose to regularly re-balance to keep weightings fixed. This isn’t a strategy I favour.

Constantly tinkering with a portfolio, by chopping back the winners and adding to the losers, leads to higher trading costs with no guarantee of better investment results.

There’s also an implicit opportunity cost in dedicating time to trading (or thinking about trading decisions), that could be more wisely spent understanding businesses better.

‘I like letting my winners run, so if a holding performs well it earns itself a bigger position in the portfolio’

I like letting my winners run, so if a holding performs well it earns itself a bigger position in the portfolio, and vice versa.

This approach may seem irrational, but the fact is most investors are not very good at timing buying and selling decisions.

We’ve all had that situation where we’ve sold a holding, perhaps because we thought the valuation had run too far, only to watch it double in price shortly thereafter.

Normally, if a stock is performing well or badly there are good reasons why. Therefore, I try to keep trading activity to a minimum.

 

Ensuring adequate diversification

 

It’s important to avoid having too much exposure to any one sector. I personally see little point in holding three different luxury goods companies, for example, because they’re all plays on Chinese spending. I generally try to own the best business in a sector and eschew the rest.

However, focusing on sector alone isn’t enough and can often give a false sense of diversification.

‘However, focusing on sector alone isn’t enough and can often give a false sense of diversification’

You also need to consider the degree of overlap in terms of customers, geographies, industries served and so on. Ideally, each holding should offer something different.

If you own a pub group, restaurant and traditional retailer; for example you’re concentrating your bets not only on UK consumer spending, but High Street footfall.

This is a very narrow remit and not one that has worked well in recent years.

Similarly, if you own say Lloyds, Taylor Wimpey and Foxtons you’ve got three different sectors (banks, housebuilding and estate agency) but the same theme. All will suffer from a decline in house prices.

Industrials is a broad category but many have similar end-market exposures. Wood Group, Rotork and IMI, for example, are all effectively plays on oil and gas prices.

The coronavirus crisis will likely lead fund managers to think even harder about how well diversified they are.

Consumer-facing businesses that rely on people stepping outside their homes have been particularly hard hit in the last six weeks.

Clearly, no-one could have predicted this event but sensible portfolio construction will, as a matter of course, blend consumer businesses with those supplying goods or services to other companies.

This crisis will also force investors to think harder about how many of the companies they own provide a truly essential good or service, as opposed to serving more discretionary pursuits.

 

A word of caution

 

Shrewd portfolio construction doesn’t mean having exposure to every sector or theme. You have to choose your bets carefully.

Adding sub-par businesses to a portfolio just because of the assumed diversification benefits is a good way of achieving sub-par outcomes.

I often hear fund managers offer complicated explanations for why certain stocks are held with the overriding principle of diversification.

The argument normally goes along the lines of “If oil prices or interest rates do X, I expect Y to happen which will indirectly benefit business Z”.

Even if they are right, the pursuit of diversification for diversification’s sake normally leads to compromising other aspects of the investment case – such as the quality of the business model. It can also introduce unintended risks into a portfolio.

I don’t think it needs to be complicated. Own a small collection of great businesses.

Make sure each offers something different. It’s fine to have three or four broad themes dominate a portfolio but play those themes via different customer groups, industries, geographies and so on, rather than concentrating too narrowly.

 

Article originally published by The Undercover Fund Manager