Thursday, September 18, 2008

Market Tremors Series - Rationale


This is #3 in the Market Tremors series.

I previously stated that few retail investors ask and answer the right questions before portfolio construction, with the result that they panic during both bear and bull markets. This panic, whether due to significant market decline or portfolio lag, is the cause of most market underperformance.

I suggest that all investors need to ask and answer these five questions, in order to outperform the market:

1. Process;
2. Rationale;
3. Emotions;
4. Holdings;
5. Market Exposure

Today, we are looking at Rationale, through the lens of my own recent portfolio reconstitution. Here’s how I define Rationale:

What was my thought process for assembling this particular portfolio, and how well will this rationale hold up if market conditions are reversed?

In terms of my own portfolio, my first item to mention is holdings concentration amongst my equities. I hold a concentrated portfolio, with relatively few positions. It’s my belief that concentrating your holdings concentrates your mind, and you become willing to take larger positions, as your margin of safety grows. Many studies have shown that equity managers who run concentrated portfolios do better than those who have more traditional numbers of holdings. My rationale is that if I’m looking to outperform the market, if I’ve found something cheap enough with the growth I like, then I’m willing to concentrate my holdings.

In fact, five stocks account for 50% of my equities. The other 50% of equities is held by five ETFs, with significant thematic overlap on two of those positions.

While just ten positions (5 stocks, 5 ETFs) sounds like relatively few, research has shown that diversification benefits begin dropping dramatically after just five holdings. That’s not to say that risk doesn’t continue to decline relative to market averages, just that the risk decline quickly tapers down.

I demand numerous margins of safety with my stock purchases. First, a “moat” (barriers to competition). Second, a stock price at purchase that reflects a healthy discount to fair value. Third, a decent dividend yield (with recent dividend growth) – this indicates the possibility that the market is currently mispricing the stock. Fourth, decent earnings growth over a period of time (although I’ll accept “stalled” earnings growth for a short period, in order to buy a good stock at an attractive price).

A major rationale with my portfolio construction is that I’m seeking at least a moderate level of diversification – none of the selections look like the others. For instance, I have one industrial conglomerate, one bank (a UK bank), a teleco, a spirits (liquor) maker and distributor, as well as a hard asset owner/manager. There is very little or no thematic overlap. This contrasts with the way I used to construct my portfolio, with extremely heavy weightings in just two or three areas.

In terms of the ETFs, I have concentrated my holdings thematically. Some investors use ETFs as a “portfolio gyroscope” providing leanings and risk profiles towards market averages (i.e. SPY or VT as examples). On the other hand, I use mine to provide a ten year growth tilt. If juicy dividends and low PE ratios are available, then so much the better, these but not totally necessary, as I want a moderate to high growth profile.

Accordingly, I think about where the world will be in ten years, what the demand cycle might look like, and try to buy specialty ETFs that capitalize on those long term opportunities. Just like you couldn’t give away oil and mining stocks in 1998, and yet investors have been crazy for them in the last five years, I’m trying to envision the longer-term.

Overall, I have a clear preference to value positions, yet even then I seek growth profiles within those positions. In my portfolio, value accounts for about 65% of the portfolio, with a clear growth tilt to the balance. However, even on the individual stock purchases (which are generally the value orientations), three of them have clear exposure to emerging markets, so despite their conservative valuations, they are also growth profile selections. I have further underpinned, I believe, the safety of this portfolio with a predominant dividend selection process – affecting some 65% of the portfolio.

In summary, I believe that the intrinsic value of the portfolio is much more stable than the market average, given all the attributes I have attempted to capture.

However, I also recognize that market gyrations on the ETFs may be above market averages, but that, in my opinion, these wouldn’t represent permanent impairments of capital. Overall, given the relative valuation measures on both the stocks and ETFs, it also appears there’s considerable opportunity for price growth, should recent market conditions begin reversing in the few years. If not, I get to collect a fat dividend cheque on much of my portfolio, while I await that turnaround.

Finally, it’s my long-stated belief that the US will continue its currency decline over the longer haul (next five to ten years), and I have therefore limited my purchases to reflect that belief. That’s not to say that I don’t have exposure, just that it’s considerably less than the 44% world-stock-market-capitalization held by US companies.

So, summarizing my own rationale, bullet-style, might look like this:

- Titled to diversification – eight different sectors, many different markets.
- Titled to value on most of the portfolio – many relatively low PE selections
- Titled to growth on significant portions of the portfolio
- Titled to dividend downside protection
- Titled away from revenues that are primarily received in US currency
- Overall rationale is “If I left this portfolio untouched for 10 years, would it still be successful?”

In the final analysis, the only thing you can control on your portfolio is your risk profile – the market determines the returns. In my case, I feel that no matter the markets short-term orientation, I have built a portfolio inclined towards relative long-term safety and yet with growth opportunity.

The next installment in this series will be “Emotions”, which will be published on Monday.


The Confused Capitalist

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