Portfolio Management

 

 

Executive Summary:



 

Managing Capital

 

 

If you have a chunk of cash lying around and are looking to invest that money, where do you start? That’s the same question I asked myself when I first began investing. It was quite overwhelming to say the least. Hopefully my article on Be Your Own CFO would have enhanced your knowledge on capital allocation and set you on the right path. Building on that article, I figure this would be an opportune time to take a deeper dive in an area I haven’t dedicated much time studying, portfolio management. Portfolio management is all about finding the right mix of investments that to achieve the best risk/reward opportunity in order to achieve your financial objective.

 

 

I love the smell of portfolio management in the morning meme

 

 

The idea for the article came as I was combing through my stock portfolio as equity valuations here in the U.S. continue to rise. I wanted to identify any weaklings in my portfolio. Similar to a weak gazelle being taken down by a cheetah, when the bear market comes, the weakling stocks that are over-leveraged or have bad economics are the first to go.

 

Fortunately I’m a pretty conservative investor and I have only been investing in solid companies with limited amounts of debt, which has kept me away from any big losers. When I first began investing, I was combining my knowledge from multiple books and a ton of Google searches to form the base of my investment strategy. Over time, I have refined my investing technique and molded it to what suits me (check out the basic framework here). However, since I focused on actual stock picking I never really paid much attention to managing my stocks from a portfolio level. I figured as long as I can pick good stocks the rest should take care of itself. As I analyze my portfolio, I hope to share some my thoughts on portfolio management with you.

 

Portfolio Structure

 

Most financial “professionals” will pitch you the whole 60/40 allocation methodology, which I’m not really a believer in. For example, right now a 30-year treasury bond is yielding ~2.68%, which is synonymous with paying a P/E multiple of 37x for an asset in which the earnings will never grow! So in other words, you probably shouldn’t be allocating money to bonds as they are not very attractive at the moment, especially when compared to stocks. This leads me to holding an all equity portfolio structure at this time.

 

 

The framework I like to use comes from the Boston Consulting Group (BCG). BCG developed a growth-share matrix in 1970 to help companies analyze their business units. I think this is directly applicable to investing as well. I treat my investments as if I was managing an entire company and every stock I own is like an individual business unit. Here’s the basic framework below.

 

 

BCG growth-share matrix

 

 

The takeaway from this chart is that you want to hold onto the cash cows and the stars (which will eventually become cash cows). A lesser portion of your portfolio should be invested in the question marks (top left corner), as these are companies come with a higher risk/reward profile. The hope is that a question mark will turn into a star or cash cow. Lastly are the dogs in your portfolio (lower left corner), which are unstable companies that are deteriorating and need to be cut loose.

 

 

When applying this framework to a portfolio, the cash cows should be the anchor in your portfolio. These are prototypical value stocks that are leaders in mature industries and they typically pay hefty dividends. Stars will be geared towards growth, but they are still stable businesses and should be one of the leaders in their industry.  The question marks should be opportunistic investments that have a lot of upside, but with a little more risk (e.g. turnarounds, special situation, etc.). If these question marks start to deteriorate and eventually turn into dogs then they need to be cut loose.

 

Concentration

 

 

When deciding on how many stocks I should use to structure my portfolio, I like to follow a word of wisdom from the investing legend himself.

 

“If you can identify six wonderful businesses, that is all the diversification you need. And you will make a lot of money. And I can guarantee that going into a seventh one instead of putting more money into your first one is gotta be a terrible mistake. Very few people have gotten rich on their seventh best idea. But a lot of people have gotten rich with their best idea. So I would say for anyone working with normal capital who really knows the businesses they have gone into, six is plenty, and I probably have half of what I like best. I don‘t diversify personally.” – Warren Buffett

 

Having a limited number of investments gives you more time to study each company thoroughly and ensures you only hold onto the best ones. It also reduces risk. In my Rising Risks of ETFs article, I explain that too much diversification is not a good thing. It has been shown in studies that the incremental benefit of adding more stocks to your portfolio for diversification purposes diminishes rapidly after about 10 stocks. See the below chart taken from a study by Lazard Asset Management.

 

Concentrated investment risk standard deviation

 

An interesting point to note from that study is that although mutual funds have had a history of relatively poor performance, it wasn’t due to bad stock picking. Mutual fund managers are actually good at picking stocks, but since mutual funds are victims to their institutional masters, they are forced to over-diversify into hundreds of stocks that ultimately leads to poor performance. Seen in the chart below, when fund managers invest in their best ideas they actually do pretty well.

 

 

Concentrated portfolios outperform diversified portfolios from which they were derived

 

 

This solidifies my belief that you should only invest in your best ideas. Its also intuitive to understand all the stocks that you own, versus trying to keep up with stock #295.

 

 

A few other lessons I’ve learned from managing a concentrated portfolio is that I have been much more careful about what stocks I hold. I don’t invest in companies that have risky capital structures (high amounts of debt). I also don’t invest in companies tied to commodities or companies that are solely dependent on natural resources since their profitability is inconsistent and unreliable.

 

 

My Portfolio

 

 

The exact number of stocks in my portfolio will range depending on the opportunities the market is giving me, but generally I like to keep my portfolio to around 10 stocks. My taxable portfolio currently has 80% allocated to stocks and 20% allocated to cash & money market funds. My stock holdings consist of 9 stocks, but I’m actually looking to cut that down to 8 in the near future.

 

 

Portfolio holdings

 

 

I’m currently looking to unload Gilead, which is kind of a weird mix between a cash cow and a question mark. Its a great company that is a leader in finding cures for infectious diseases, which they successfully did for hepatitis C. Gilead’s other main drug is for HIV treatment and is currently their main cash generator. They’re also starting to make a big push into oncology (that’s cancer research, for those non scientists out there). However, since I have absolutely no science background, its hard to keep up with the company and all of its inner workings. It was a good investing experience, but one thing I’ve learned is that you should only buy stocks that you can understand. Luckily I should net a little profit as I wave goodbye.

 

 

The stocks in my portfolio are generally pretty boring companies. They are very stable businesses that generate strong cash flow. EMR, UNP, DIS, BNS, CVS, and SPG are my cash cows. There isn’t really much to talk about on these companies except that they pay good dividends and they’re leaders in solid industries. Its basically like watching paint dry, but as long as they make me money I can’t complain.

 

 

JLL and INFY are my stars. Both are pretty large companies but they are also growing at high single digit rates. There is a big shift in large corporations to outsource real estate services to save on cost. There are only a handful of real estate companies that have the global footprint to fulfill these mandates. This is where JLL is seeing a large opportunity to capture recurring revenue streams from global corporations, and that’s in addition to their already dominant real estate advisory and brokerage services. INFY is also on a nice growth path taking advantage of demand for IT infrastructure and outsourcing services. Even with the U.S. government clamping down on work visas, this business generates pretty attractive returns with profit margins in the 20% range.

 

 

GILD, as already mentioned, is my question mark/cash cow. They have almost $30 billion in cash on their balance sheet and are a leader in their field. However, since finding a cure for HCV, their sales have been declining (fewer patients needed the cure). HCV made up a huge chunk of the revenues so the company needed to grow via acquisitions since their drug pipeline wasn’t looking to produce anything in the near-term. So this uncertainty brought the stock price down from over $100 down to ~$75 (where I bought) and created an interesting risk/reward opportunity for me. I figured it really wasn’t that risky when you have $30 billion in cash, and their HIV revenue is actually still growing. Gilead recently announced an $11 billion acquisition for Kite Pharmaceutical, which has alleviated investor concerns and has lead to a run-up in Gilead’s stock price. This is where I hope to jump ship and make a decent profit.

 

 

Last but not least is cash and money market funds. Don’t take cash for granite. Its always good to have some purchasing power available when an opportunity arises so that you can actually take advantage of it. The problem with cash is that it depreciates over time due to inflation, which is not ideal. So at least with money market funds you earn a return (although its low) that helps offset inflation until you can deploy that cash. I have about 20% of my portfolio in cash and the cost of holding it versus investing it is like a call option. I loose a little bit due to inflation, but the optionality of being able to deploy that cash only when the best opportunities arrive is well worth it.




Final Thoughts

 

 

So that’s basically how I like to manage my portfolio. I’m always looking for ways to improve, but so far this is what has worked for me. I hope you can apply the BCG growth-share matrix to your portfolio to help increase the returns on your best ideas. Your capital is a finite resource so it shouldn’t be wasted on idea #295. Hopefully some of this information will be helpful to you along your investing journey and I  hope with this knowledge we can all improve our wealth together.

 

 

I'm rich biatch

 

 

If there are other ways you manage your portfolio please let me know!

 

 

 

 

 

 

4 Comments

  • Very interesting article, as was your one on ETFs. However, I am not quite following your logic completely. I would love it if you would do an article soon on the pros and cons between owning individual stocks vs. baskets of stocks (like ETFs and mutal funds).
    I get that the blind buying of ETFs by the uninformed may be inflating the values of the underlying stocks. I agree that over-diversification is useless. On the other hand, studies have shown that for most people picking individual stocks is hard to impossible, given that over time most stocks are losers (the vast majority in fact). I talk about this and provide supporting references at http://www.mindfullyinvesting.com/articles/7-diversification/7-1-stock-diversification/ You provide one quote from Uncle Warren, but not his main advice to individual investors, which is to simply buy an index fund. Are you saying that a few individual investors (like you) can pick individual stocks and do well, but most people should just buy an index fund? Or alternatively, are you recommending that the average Joe attempt to pick stocks like your example here?

    • Hi Karl,

      First off, thanks for reading my article. I’ll make sure to write my next piece outlining pros/cons for stock picking versus investing in ETFs and mutual funds. If you have any more topics you want me to write about, please let me know!

      I just read your article and I thought it was a good read. However, one point I would like to make, which wasn’t covered in the article but particularly important to successful stock picking is valuation. Most investors understand the price of a stock, but most really don’t understand the concept of intrinsic value, yet alone how to calculate it. The real successful stock pickers, and I mean the ones that are consistently good over 15+ years, are the ones that have a long-term value minded approach. This approach is based off of understanding intrinsic value – buying a stock for $0.75 on the dollar and hold for the long-term. Valuation is everything. The concept itself is relatively simple, but the reason why most investors won’t succeed is due to the emotional element of investing. Most people don’t think of stock picking as a 5-10 year commitment in each stock. Check out this investor return chart at the bottom of a different article here: http://www.ninjacapitalist.com/be-your-own-cfo/. In all, the investors that have succeeded and stood the test of time are a dime a dozen, but if you notice in that chart, the vast majority of them are value investors. Not very many short-term trading hedge fund guys can beat the market consistently, which I think most average investors try to emulate.

      I would also like to make a quick note on volatility. This seems to be a metric a lot of investors are focused on when they analyze ETFs. To me volatility just means the market goes up and down, but this has no bearing on risk. This is even more true if you invest with a long-term mindset. I define risk as a permanent impairment of your capital. For example, I don’t invest in companies with excessive debt. Even if their stock price seems stable, which creates low volatility, don’t be fooled that a company loaded with debt means its not risky. Volatility doesn’t capture this element.

      Given the above, I would say that individual stock picking can lead to out-sized returns, but only if you have the proper understanding of how to analyze stocks and have a long-term approach. Afterall, when you invest in an ETF by definition you are guaranteed to not beat the market/specific industry benchmark. With that said, I think for the average Joe ETFs are the way to go. If you don’t have the time or desire to dig through a balance sheet and a 10K, then I would definitely not recommended stock picking. That’s my $0.02. I hope that answers your question.

      Thank you again for reading and if you have any more questions feel free to ask. I’ll also be sure to become a regular on your site, you have some good info on there!

      -Dan

  • Great article and follow up comments.

    I would add one thing.

    Trying to determine intrinsic value can be very subjective depending on the industry the stock is in.

    I think it is easier with companies, like P&G, that have good visibility with their earnings. Their future distributions can be tracked in a narrower range than say Netflix or Tesla. Which is why Warren Buffett likes companies that largely don’t change, like chewing gum companies.

    Although I recently read where chewing gum sales at supermarkets are falling because consumers are busy on our phones instead of impulsively buying gum at the checkout line. Who would’ve thought?

    In addition, two of his biggest winners, Geico and American Expresses’s futures were in doubt at the time he bought them.

    ───

    A heuristic I use when evaluating consumer facing companies is “behavior”. Do a company’s products fundamentally change consumer behavior? Often times, this cannot be picked up in a 10-k or financial statement.

    For example, Netflix fundamentally changed the way many people consume TV shows and movies. Cord cutting or people never getting cable in the first place. If you just looked at their financial statements, you would have a hard time concluding that Netflix is a “good business”. Many still hold to that conclusion, who knows, they may be right in the long run, but if they were short, they have been crushed.

    I feel investing is part quantitative and part qualitative, not sure how the % work out, but part art, part science in some combination.

    I think this quote from Michael Mauboussin sums investing up nicely.

    “Perhaps the single greatest error in the investment business is a failure to distinguish between the knowledge of a company’s fundamentals and the expectations implied by the market price.”

    Enjoy your writing, look forward to future post,

    Caleb

    • Hi Caleb,

      I totally agree that investing is a mix between art and science. With Modern Portfolio Thoery (MPT) all the mathematicians are trying to attach a quantitative value to everything, which I think is flawed. The valuation component is just to get a ballpark estimate of what the company is worth, which is important but it isn’t everything. When I analyze a stock I take a deep look at the numbers, but I would say the majority of my time is spent understanding the qualitative aspects of their business and how they add value to their customers. I then layer this qualitative analysis with a valuation model to determine how much I think the company is worth.

      Thanks for reading!

      -Dan

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