Manage your portfolio like a smart value investor
Discover the qualities that will make you a smart value investor and improve your portfolio management.
Once you have committed your hard earned money to a company listed on the stock exchange with the expectation of a financial return over time, you are by definition an investor.
What now separates you, as a smart value investor, from the gambling or speculating variety is the quality of thinking that you bring to your portfolio management going forward. Smart value investors will attempt to minimise the risk associated with holding a listed company while maximising returns, whereas gamblers and individuals trading stocks online are happy to trade off higher levels of risk on the off-chance it might deliver higher-than-average returns.
To cultivate a good value investor mentality you need to recognise that as a shareholder, you are a part owner of a listed business that employs staff, borrows money, generates earnings from engaging in one or more core business activities, and where appropriate pays dividends.
Nobel prize-winning economist William Sharpe believes the golden rule of sensible investing is understanding the business, its performance and future growth prospects. This applies whether it’s your own private business or a company listed on the share market.
It’s unrealistic for everyday investors to have the time to independently acquire the knowledge necessary to intelligently differentiate between top stocks and those with doubtful or deteriorating fundamentals that may be potentially wealth-destroying.
That’s why in 2011 online stock research tool Share Analysis launched a no-nonsense, state-of-the-art application to help smart value investors quickly evaluate listed companies across five key criteria.
Five questions smart value investors ask before buying stocks online
When searching for the best stocks to buy, value investors ask these five key questions.
Ask these questions and you’ll quickly eliminate poor quality businesses and focus your attention on only the best stocks to buy.
1. What business is this company in?
Smart value investors will avoid companies operating in sectors offering limited future economic growth or where the business model is unduly exposed to fluctuating economic conditions.
2. Have earnings been rising and are they expected to continue going up?
Avoid companies that have stagnant or declining earnings, and limited ability to generate organic growth or fund future dividendswithout using debt.
3. Are the companies in your portfolio overexposed to debt to fund core business activities?
Smart investors understand the disastrous impact that mismanaged debt can have on a company’s bottom-line earnings. You can’t lay claim to thinking like an informed investor unless you understand the relative performance of the business, its balance sheet and its intrinsic value over recent years.
For example, Share Analysis shows that Flexigroup’s balance sheet has consistently been overexposed to debt.
4. How well have the companies in your portfolio used their equity and how profitable are they?
You also need to be aware of key indicators (or performance ratios) to correctly interpret whether the company has been delivering satisfactory returns. One of the key ratios favoured by Share Analysis is return on equity (ROE). As an indicator of business profitability, return on equity compares how many dollars of equity were required to produce the company’s profit.
A smart investor would much prefer to own shares in a company that produces a profit of $25 million from $100 million worth of equity than one delivering $5 million profit on the same amount of equity. The former has a return on equity of 25 per cent while the latter’s return on equity is only 5 per cent. As a smart investor you should also be attracted to businesses that can produce increasingly profitable return on equity without needing to raise additional capital or take on extra debt.
5. Are the companies in your portfolio adequately covering operating expenses with sufficient cash flow?
Companies with a notable gap between cash flow and debt required to generate it will seriously deteriorate their balance sheet. A net-negative cash flow position is unsustainable, especially where debt is involved, and if not corrected will result in falling share prices as investor confidence diminishes.
Buy, sell or hold?
Once you understand the business, its economics and future growth prospects, as a value investor you must determine whether the company you’re attracted to represents value for the price you’re prepared to pay for its shares.
Paying too much for a top-quality company can destroy wealth as fast as investing in those with excessive debt. Sooner or later, the share price will start to converge with the company’s intrinsic value (or the sum total of the company’s worth based on earnings, dividends, equity and debt).
So as a smart investor who understands this, you’re less likely to buy shares in a company for $20 when the underlying value is only worth half that.
Ideally you want to buy good companies when there’s a discount between the share price and its underlying value, and sell when the share price moves well ahead of its intrinsic value without good reason.
Portfolio review checklist
Reviewing your portfolio will ensure your strategy exposes your portfolio to maximum opportunities in the months and years ahead.
In today’s constantly changing world, regular portfolio management and stock analysis is critical. A set and forget approach simply doesn’t cut it.
First consider macro economic conditions
Before rolling your sleeves up to take a closer look at your portfolio and check if you still hold top stocks, first consider the most profitable investment themes of the previous 12 months and decide if they’re likely to continue. Also think about the future directions of the local and international economy, and where the greatest opportunities for growth lie.
Paying attention to what’s happening around you, and keeping your ear to the ground, will help you spot trending investment themes, narrow down your list of investment opportunities to just the very best stocks and ensure you can manage your portfolio with confidence.
Key qualities of top stocks
Understanding what constitutes a top quality stock helps ensure you have a top quality portfolio. At Share Analysis, we believe great companies display similar distinguishing characteristics. Stocks that stack up well against key criteria are more likely to withstand financial storms, and will be more worthy of a place in your portfolio.
You want to own businesses that:
• have solid balance sheets
• have good cash flow
• are consistently profitable, and
• have the ability to continue expanding.
Portfolio review checklist
It’s time to pull out each company’s latest annual report and run your ruler over the numbers (Share Analysis members just need to login at Share Analysis.com). If a company fails more criteria than it passes, then the future may not be very promising and that business could be a drag on your portfolio’s performance.
Here are the key performance criteria you need to check each company against:
Earnings per share are rising
Rising earnings per share are desirable, however they must not be examined in isolation from the other key business drivers such as return on equity and cash flow.
Earnings per share exceed dividends per share
While high dividend stocks are desirable, chasing dividends at the expense of good economics can be a recipe for disaster. If a company consistently pays more out in dividends than it earns, without increasing earnings per share, sooner or later the dividend will be reduced or suspended.
Normalised profits (NPAT) are rising
A company’s reported profit figure includes its regular earnings, plus one-off items that may not recur in the future, such as the sale of an asset or the windfall from a successful lawsuit. Removing abnormal and non-recurring revenues and expenses provides a more sustainable representation of the company’s ongoing profits. If normalised profits aren’t rising, this will have a negative impact on the business’s return on equity and intrinsic value, and ultimately the share price.
The company isn’t constantly undertaking capital raisings
If a company raises additional equity (capital) and then earns a return on that equity that does not exceed the previous return it was earning, then the return on the entire pool of equity is reduced. The company may be growing its absolute profit level, but if the level of profitability as measured by return on equity on each dollar of equity capital is declining, then the company is best avoided. The practice of raising equity capital in the same year as paying dividends is equally questionable. Why raise capital simply to hand some of it straight back?
Return on equity (ROE) is stable or rising
Return on equity measures the profitability of a company by comparing how many dollars were required to produce the company’s profit. It is the return being generated on your equity.
Attractive businesses are able to increase profits each year without the need to raise additional capital or take on debt. These companies produce increasing profitable returns on their equity without increasing risk. You want to own businesses that can generate a return higher than you could earn from a term deposit or bond, and also allow an extra margin for the additional risk. Top stocks are consistently able to generate impressive and rising returns on their equity in excess of 15 per cent.
Debt is low and/or declining
Debt increases the risk profile of a company. It directly impacts the bottom line and requires ongoing servicing. Highly profitable companies are able to increase profits and return on equity while reducing the amount of debt on their balance sheets. Avoid companies with a net debt / equity ratio greater than 40 per cent.
Cash flow is positive
Every business operates to generate cash. The amount of cash generated in a given period is known as operating cash flow. If a company generates plenty of cash, you can be fairly confident your dividend won’t be suspended. In some cases, companies with strong cash flow are also able to use debt wisely by ensuring they retain enough cash to more than cover their interest bills.
Cash flow generated from operations exceeds net profit and is rising
Cash flow generated from operations represents the cash flows from the company’s day-to-day trading activities. Cash inflows can include sales, receipts from debtors, and any other cash revenues. Outflows include all payments related to expenses (usually including interest), payments to creditors, prepaid expenses, and any payments for expenses incurred in previous periods (such as accrued wages). Top stocks consistently generate cash flow from their operations that is higher than net profits. In business cash is king. The more the better!
Intrinsic value of the company has been rising, and is forecast to continue doing so
A company’s intrinsic value represents the value of the business based upon its fundamentals. Earnings, dividends and equity are some of the inputs into Share Analysis’s intrinsic value formula. Top stocks are able to increase their intrinsic value year after year. Value investing theory is based on the premise that over the longer term share prices tend to converge with value, so if value is continuing to rise, prices should eventually do the same (provided the price hasn’t already run too far ahead).
Future growth is expected
It’s one thing to identify a great quality and high performing company. Looking in the rearview mirror however will not guarantee a thriving portfolio. Businesses are dynamic. Economic conditions change and impact business models. Consumer sentiment also changes. Companies that fail to adapt to changing conditions can be left behind.
When assessing a company’s future prospects, investigate if the business is in a period of growth. Be cautious of companies whose growth is beginning to slow or stagnate.
Other portfolio management questions
• Is the business of the company unique, or will competitors potentially steal some of its market power?
• Will the businesses benefit from government regulation?
• Have the company’s profits risen in all market conditions, or is revenue susceptible to business cycles?
Qualitative portfolio management
When you buy shares in a listed business, you’re relying on the leaders of that business to operate it with your best interests at heart (most of the time it works out). Understanding a company’s fundamentals is vital in ensuring the business model is sustainable. Monitoring the comments made by management, and their subsequent performance, will give you even greater insight into whether your managers are steering your business in the right direction.
Step 1: Collect Annual Reports and do some reading
Get your hands on as many Annual Reports as you can find and print off the Chairman’s and Managing Director’s report from each. Create two piles, one for the Chairman’s reports and the other for the Managing Director’s. Put the most recent reports at the bottom of the pile, and the oldest on top. Read the reports like you’d read a book, from cover to cover.
Step 2: Investigate
Time to do some thinking… What did management say they were going to do in 2012? By 2013, had they achieved what they set out to do?
How have their views of the business changed? And the competitive landscape? Do the reports mention any ongoing issues? Project delays, debt collection issues and a changing market place are a few things to look out for.
Is the Managing Director who wrote the report in 2010 still writing the report today, or is the company churning through senior management? Changing management styles can severely disrupt the underlying business and impact staff retention.
Finally, follow the transactions of the company’s directors. If you find a situation where you feel the business’s prospects have deteriorated and management are selling their shares, that can only reinforce your analysis. If however you believe the business has bright prospects, management’s decision to sell may be of a personal nature and while it should be investigated, may not necessarily be a reason for alarm.
Monitoring business performance in your portfolio
When you buy shares, you are actually buying into a business. Are your managers working for you?
It’s easy to forget sometimes that when you buy shares, you’re actually buying a piece of a business.
With all the noise that comes from the stock market, removing yourself from the day-to-day rhetoric can be a challenge.
Indeed, investing in a business listed on the stock market is no different to acquiring 50 per cent of your local newsagency. Both represent part-ownership of a business.
How well are your managers managing?
When you buy a piece of a business, you’re relying on the leaders of that business to operate it with your interests at heart (most of the time it works out).
Here’s a simple process you can follow to monitor the performance of the managers of your businesses.
Step 1: Get your hands on as many Annual Reports as you can find – 10 years is a good start – and print off the Chairman’s and Managing Director’s report from each.
Step 2: Create two piles, one for the Chairman’s report and one for the Managing Director’s. Put the most recent reports at the bottom of each pile, and the oldest on top.
Step 3: Start reading. Read the reports like you’d read a book, from cover to cover.
Step 4: Time to do some thinking…
What did management say they were going to do in 2005? By 2006, did they achieve what they set out to do?
How have their views of the business changed? And the competitive landscape?
Do the reports mention any ongoing issues? Project delays, debt collection issues and a changing market place are a few things to look out for.
Is the Managing Director who wrote the report in 2005 still writing the report today, or is the company churning through senior management? Changing management styles can severely disrupt the underlying business and impact staff retention.
Step 5: Finally, follow the transactions of the company’s directors.
If you find a situation where you feel the business’ prospects have deteriorated and management are selling, that can only reinforce your analysis.
If however you believe the business has bright prospects, management’s decision to sell may be of a personal nature and while it should be investigated, it may not necessarily be a reason for alarm.
Use Share Analysis to focus on the best businesses and your job as your own private fund manager becomes a whole lot easier.
For more tips on monitoring your managers download Share Analysis’s free whitepaper.
10 investing mistakes to avoid
Learn about the 10 mistakes that even seasoned investors fall into and make sure you avoid costly errors going forward.
Even the best investors succumb to emotion when making decisions. Understanding how emotion can impact your investment decisions will put you in a much better position to make rational decisions.
By devising an investment plan suitable to your own situation – and sticking to it – will also ensure you are appropriately positioned to avoid the most common errors (and emotions) investors experience when buying and selling shares.
To avoid expensive investment traps you must second-guess the investor herd-mentality, which is typically fuelled by fear, greed and uncertainty. Whilst it may seem counterintuitive to defy ‘conventional’ investor wisdom, buying when others are selling, and exiting those stocks when those same investors are crawling over themselves to buy more, is a sensible approach. Legendary value investor Warren Buffett says so too!
To help you avoid costly errors going forward, here’s a refresher on the ten most commonly made investment mistakes even seasoned investors fall into.
1. Treating the share market like a lucky dip
While punters are happy to trade-off higher levels of risk on the off chance it might deliver higher-than-average returns, smart investors reduce the risks associated with holding a listed company while maximising returns.
Part of being a good investor is recognising that you’re buying into a business that employs staff, borrows money, generates earnings from one or more core business activities, and where appropriate pays dividends. So unless you’re a day trader, buy companies based on quality fundamentals not share price momentum, and avoid low quality businesses displaying little opportunity for growth.
Fortescue Metals Group (FMG) share price peaked at almost $13.00 in 2008. That year the company had more than $6 billion debt on its balance sheet and reported a net loss of more than $2.5 billion. Share Analysis estimated its business was worth $0.00. By the end of 2008 FMG’s shares had fallen to less than $1.30. Avoid low quality businesses and stop treating the share market like a lucky dip.
2. Buying tomorrow’s dog stocks
As an astute investor you need to recognise whether the company you’re considering buying represents value for the price you’re prepared to pay for its shares. Remember, Buffet proved convincingly that share prices eventually converge with a company’s intrinsic value (the sum total of the company’s worth based on earnings, dividends, equity and debt).
Ideally you want to buy good companies when there is a large discount between the share price and its underlying value. Paying too much for a top-quality company can destroy wealth as fast as investing in those with excessive debt. Similarly, avoid value-traps. While they appear cheap (based on P/E), these companies have questionable debt levels, fading competitiveness and declining cash flows. If you’re drawn to a company because its shares are under the psychological $1 barrier you could be confusing affordability with value.
In the early noughties Billabong was a market leader. When the company failed to adapt to the changing youth market its sales plummeted – so did the company’s intrinsic value and its share price.
3. Riding the bear market down instead of selling
The closer a company’s share price gets to its intrinsic value, the greater the risk of holding the stock. And the more the share price exceeds a company’s intrinsic value, the greater the argument for locking in your gain. So don’t be too greedy and don’t rely on unwarranted optimism.
In early 2007 Fairfax Media’s share price was almost three times higher than what its business was worth. Locking in a profit would have been the wise decision. By late 2013 FXJ was trading around $0.50 and its intrinsic value, according to Share Analysis, was closer to $0.30.
Equally important, remember this: stocks with low P/E ratios or high dividend yields have typically become that way for good reason. Take these smouldering time-bombs out of your portfolio before they do greater damage, and use the funds to buy superior investment opportunities.
4. Fascination with price over intrinsic value
Contrary to popular opinion, P/E ratio – (current) share price / (historical) earnings per share – reveals nothing of the value of a company. All it reveals is what the market is prepared to pay for the current earnings per share. More meaningful measures when it comes to stock selection are the following performance ratios: Intrinsic Value; return on equity (ROE), which should be greater than 15 per cent; management’s track-record; net-debt to equity, which should be under 40 per cent; and earnings per share (EPS) growth, which offers a snapshot into future prospects and profitability.
5. Lured by unsustainable yield
A key determinant of affordable dividends is the quality of the underlying business, and its ability to consistently grow earnings. So avoid companies offering dividends that cannot be supported through cash generated by the business, and those that only have a high dividend yield based on a falling share price due to declining fundamentals like high debt, falling profits or negative cash flow. View any signals that current dividend levels are no longer affordable as an opportunity to exit the stock.
In 2004, 2006, 2011 and 2012 Ten Network paid dividends that exceeded its reported profit. In 2009 the company reported negative net profit of $89.354 million, and still paid out almost $20 million in dividends. Between 2004 and 2010 TEN’s dividend yield fell from around 7 per cent to 0 per cent. Over time TEN’s dividend policy eventually caught up to the economics of its business. TEN’s share price has headed in the same direction.
6. Overlooking the big-picture
Every company, whether listed on the stock market or privately owned, is impacted by a wide variety of macroeconomic influences. These leading (domestic) indicators provide useful insights into what sectors and stocks stand to benefit (or lose) from the economic activity directly beyond their control.
The key economic indicators you need to keep an eye on include: Interest rates, currency, job vacancies, unemployment rate, building approvals, trade balance, GDP, housing credit, commodity prices, and inflation as measured through CPI. By keeping abreast of the global and local economy, you’ll be better positioned to actively review your investment portfolio in light of those sectors that will either benefit or suffer going forward.
7. Setting and forgetting
Within an environment where the market can move as much as 1 per cent in a week, a ‘set & forget’ approach must give way to a strategy for actively managing shares. Remember that value is constantly moving and keeps pressure-testing your stocks against key fundamentals. Companies with strong brand names, high profiles and a long history of good performance cannot be relied upon to be perennial bellwethers. That’s because past performance is no guarantee of future returns.
8. Not having an investment plan
It can be incredibly empowering to comprehensively review your current financial position, and if you do, you’re more likely to develop an investment strategy that’s custom made for your specific requirements. Before devising an investment plan, it’s important to have an accurate picture of your cash flow, including income, regular outgoings – especially any discretionary spending – and your capacity to save/invest surplus money. “Do not save what is left after spending, but spend what is left after saving”, is a handy piece of advice from Warren Buffett.
The right plan for you will depend on a myriad of factors – none the least being your age, earnings and existing assets – which have a direct bearing on both your investment time-horizon, and risk/reward profile. While cautious investors would also like above average returns, their need for wealth preservation is higher than more aggressive investors who can afford to take greater risks in pursuit of higher gains.
All good investment plans will have one aim in common, wealth accumulation over time. Learning how to invest and understanding why will help crystallise your short and longer-term financial goals, and ensure you diversify your portfolio’s exposure to key asset classes according to your risk appetite. Exactly how much of your portfolio is allocated to each asset class should directly reflect economic conditions and investment prospects, plus your requirement for investment generated (or passive) income. Given that markets are constantly moving beasts, your plan needs revisiting regularly.
9. Quick buck syndrome
We’re entering an era where longevity is the ‘new norm’, and you may spend as much time in retirement as you did working. So remember that while you’ll seek short-term wins, wealth creation through share price appreciation happens over the longer haul.
Average returns for 18 years (1995 to 2012) saw listed Australian shares deliver 10.93 per cent – at that rate your investment would have more than doubled every 7.2 years. But while it’s important to stay ‘in the market’, that doesn’t mean buying stocks and parking them in the bottom drawer indefinitely.
10. Backing value destroying capital raisings
A capital raising may reduce company debt, but the question is: will it increase value on a per share basis over the long term? Typically a capital raising will dilute earnings per share (EPS) in the short term, in the hope that the future earnings impact will be positive, but this outcome is never guaranteed. So if a capital raising results in a material decline in intrinsic value, then sustainable price increases are unlikely. In the long run a company’s share price and its intrinsic value are destined to converge at some future point.
Capital gains tax on shares, explained
Some simple principles can help you avoid common mistakes with capital gains tax and maximise your after tax profits.
Refusing to lock in profits on a stock that’s become seriously overpriced just to avoid paying tax is as irrational as choosing an investment for tax considerations over the underlying merits of the investment itself. A short sighted approach to tax issues can undermine the integrity of your overall investment strategy as a value investor – and consequently your investment returns. We’ve identified the most common tax traps and how to avoid them.
Capital gains tax is triggered by investing success
While you should do your best to legitimately minimise the tax you pay on shares, it’s important to remember that paying tax is an unavoidable reality that is only ever triggered by your success as an investor. So if it’s right to realise a profit by selling shares, then pay the tax owing on it and move on.
This is how the real world works, and your core consideration as a successful investor should be what you’re left with after tax and not how much tax you’ll pay to receive the capital gain.
The refusal to sell down a stock and lock in a gain when you should – for example when it’s trading close to or above its intrinsic value – means you run the risk of retaining companies that are overpriced in your share portfolio. Given that share prices eventually converge with intrinsic value, holding overpriced stocks not only means (potentially) missing out on large unrealised capital gains while they’re available, but also exposes you to future losses, especially if you’re sitting on potential value traps. Remember, companies won’t stay overpriced indefinitely, and certainly not without good reason.
Focus on the difference between price and intrinsic value
You’ll be less inclined to hold onto stocks due to tax considerations if you focus less on the price paid (and any tax due) and more on the difference between current price and estimated intrinsic value – which after all is the core tenet of value investing. And if you really are a value investor then you should be more attracted to paying tax on a profit than paying no tax on a loss.
Remember that the tax argument for selling too late applies equally to selling too soon. If your initial justification for buying a stock still holds water, then there’s little to be gained by selling for a tax deduction. It’s also important to note that good companies can, and often do, find themselves (albeit temporarily) underpriced due to macroeconomic conditions or industry issues beyond their direct control.
So assuming a good stock is underpriced – and as a value investor all the stocks in your portfolio should be when first purchased – then all you’re doing by selling is trading a tax deduction now for the opportunity of future capital gains once the share price corrects. Admittedly, while capital losses can be carried forward without time limits, it does make sense to post the gains and losses in the same year.
This is the time to cull the deadwood stocks that you’ve been reluctant to sell, before they further dilute the value of your overall share portfolio. Most stocks that are significantly underpriced have become that way for good reason, and if the gap between price and intrinsic value is widening, not closing, then you’re better off selling up, accessing the loss and switching the funds into stocks offering superior investment opportunities.
Don’t ‘tax trade’
But don’t be tempted to ‘tax trade’ good stocks just so you can free up cash to pay an upcoming tax bill. It’s a much smarter strategy to accurately calculate your capital gains tax position – using portfolio management software or similar – and ensure there’s sufficient cash put aside to cover it well before it’s due at the end of the financial year.
If you have no choice than to sell shares to realise cash to pay tax and no single stock in your portfolio looks particularly overpriced, then sell down your most over-valued stocks first and maintain your exposure to those looking the most underpriced relative to intrinsic value.
Principles of capital gains tax
Remember, when it comes to capital gains tax, two overarching principles apply, namely
1. Profits are only assessable when realised (subject to your marginal tax rate), and;
2. Losses on the disposal of capital assets are only deductible against capital gains and not against other income.
If your capital losses exceed your capital gains, or you make a capital loss in an income year and you don’t have a capital gain, you can carry the loss forward indefinitely and deduct it against capital gains in future years. Since 19 September 1999, if you purchase shares and subsequently sell or transfer ownership after holding them for more than 12 months you are entitled to a 50 per cent discount. But if you sell shares that you have owned for less than 12 months the full capital gain will be assessable for income tax purposes.
When lodging your tax return you will need the purchase and sale prices of shares you have sold in the previous financial year. Similarly, if you participated in a dividend re-investment plan you will find the purchase price of each parcel of shares on your dividend statement.
It’s true, you are not required to lodge an income tax return if you’re an Australian resident earning less than $6000, but you still need to apply to the ATO (with the appropriate form) to have your franking credits refunded.
How does it work?
Timing is everything when it comes to capital gains tax.
Simone earns $85,000 annually as a beekeeper. She buys 3,000 shares for $2.00, valued at $6,000 with brokerage paid separately on 20 July 2012.
The shares are trading at $4.00 throughout July 2013. If she sells her shares for $4.00 on 19 July 2013, her assessable capital gain will be $6,000, i.e. $3,000 x $4.00 = $12,000 less what she paid for them which was $6,000.
If Simone held the shares for an extra two days and sold them on 21 July 2013 her assessable capital gain would be $3,000 as she’s entitled to the 50 per cent CGT discount. This is because she held the shares for more than 12 months. Assuming she had no other capital losses or deductions, holding her shares for longer than 12 months has earned Simone a nice tax saving of $1,110.
Smart share portfolio allocation: how to get it right
Whilst it may sound fancy, ‘share portfolio management’ simply describes the art of deciding what proportion of your capital is allocated to a single stock or sector.
While you may have given little thought to portfolio allocation (aka portfolio weightings) when you first started buying shares, the risks of getting it wrong only intensifies the more you have invested in the stock market.
The good news is there’s nothing cerebral about getting your share allocation mix right.
One of the core tenants of clever portfolio allocation is ‘good old’ diversification, and the need to avoid putting too many investment eggs in one basket. That’s because not all stocks or sectors will outperform (or underperform) at the same time, so by spreading your capital across different stocks and sectors you’ll build in a natural hedge against that eventuality. When some stocks do well, they’ll offset those that don’t and balance out your overall portfolio performance.
Portfolio allocation and your risk profile
The capital that you allocate to individual stocks should accurately reflect your investor type and the risk profile you have – not the risk profile you fancy having – plus your need to balance growth with income. There’s little to gain from seeking out speculative growth stocks if you’re investment plan specifies you require top stockspaying fully franked dividends.
By focusing on the best stocks to buy, you won’t by default degrade share investing to a game of chance. You’ll also avoid poor quality stocks that could inflict significant damage to your portfolio over time.
Forget set and forget
Given that the share market is a constantly moving feast, managing your share portfolio allocation can no longer be relegated to a ‘set and forget’ strategy.
Whilst there might be an argument for having more of your portfolio exposed to a single sector, like mining when commodity prices are high, the opposite also applies. Similarly, industrial stocks will move in and out of favour depending on where we are in the economic cycle. The portfolio allocation decisions you make should be mindful of these considerations.
Individual stock allocation
While there might be an argument for allocating 25 per cent of your portfolio to a single sector, the amount exposed to any single stock will depend somewhat on the total amount of capital you have invested, plus your credentials as a stock picker.
Even the world’s best stock pickers get it wrong. Having more than six to 10 per cent of your total portfolio value exposed to any single stock probably isn’t a great idea.
Time to sell?
Good share portfolio allocation is as much about what you buy as it is about what you sell and when. When share prices rally beyond the intrinsic value of a business, the argument for locking in the gain, while possibly maintaining a core holding and moving into the market’s next best opportunity, is a good strategy.
What’s the optimal number of stocks to own?
There’s no copybook answer to how many stocks you should have in a portfolio, but how much you have to invest will provide some useful guidelines.
If you’re starting to build a share portfolio with $20,000, you’re better off investing in a handful of top stocks within those sectors that dominate the ASX by market cap
Remember: limit your individual stock exposure to no more than six to 10 per cent of your total portfolio value to avoid a blow up of your portfolio.