Constructing a portfolio
Few investors apply much consistency or logic to the creation of their personal investment portfolios. Your average investor will usually hold a range of stocks, with substantially differing values, delivering wildly varying yields, with no obvious theme or structure. Often there is a mix of a few small-value privatisation or mutualisation holdings, a number bought on the basis of ‘well worth a punt’ tips from city columns, ‘gossip’ recommendations which have done the rounds at the 19th hole of the golf club, perhaps a share bought through sitting next to a director on the return holiday flight, maybe the favourite retailer frequently visited by your wife or partner, plus a number of personal hunches. In truth, a bit of a dog’s breakfast!
This type of portfolio is unlikely to make your fortune – performance will probably be little better than average. Put very simply, to give an extreme example, if a portfolio has only, say, three holdings, one worth £50,000 and two each worth less than £1,000, the performance of the two small holdings will be virtually irrelevant compared with that of the £50,000 holding. It is crucial to ensure that holdings you have great confidence in are of sufficient value to make a real difference to your overall result.
Some investment commentators believe that there is a clear division between ‘income’, i.e. shares which deliver good and regular dividend payouts, and ‘growth’ stocks, i.e. here the dividend yield is low, perhaps minuscule, with the PLC focusing on retention of profits – ploughing them back for future growth which investors believe will be significant.
I have always believed that as an investor you should look for shares providing both, and that there is an obvious relationship between the two. In Chapter 4, when talking about valuations, I said that I looked for a reasonably attractive dividend yield, ideally 5%+, and a single-figure price earnings ratio. However, I have to concede that shares like this, often in long-established PLCs, are a disappearing breed, and in the future investors may have to accept lower initial dividend yields than they could have obtained in the past.
How big should your portfolio be?
Among investors there is disagreement about the number of shares you should have in a portfolio, with endless arguments using too many clichés between spreading the risk and having too many eggs in one basket. In my current portfolios, putting together my ISA and non-ISA holdings, I hold around 35 different stocks. There is no particular magic about ‘35’, although curiously many private investors seem to find this a comfortable number of holdings to have: keeping track of significantly more holdings can be quite demanding.
My stocks vary significantly in value, probably by a factor of up to 10. This is for two reasons:
- In some cases shares I own are in the early stages of build-up and I need to know more about them before adding further. This is something I’ll do when I have gained greater confidence in those holdings.
- As with a number of my larger holdings, they have grown substantially over the years. With many small cap stocks where there is often a limited market in their shares I have to make up to a dozen or more purchases before building to the size of holding I desire.
I do not bother with overseas holdings, nor am I concerned about asset or sector allocation – I am focused on particular stocks. Let me explain my reasons.
If you’re a manager of large institutional funds you’ll usually aim for X% in the USA, Y% in South East Asia, Z% in Europe, etc., and similarly a certain percentage in banks and financial stocks, another in media, and yet another in healthcare, etc., and this is the right approach. But I believe that the private investor should forget about all this for their more modestly sized portfolios. I like UK-headquartered and quoted businesses which operate internationally anyway as they seek world markets for their products or services. If I look at my four current largest holdings – Delcam, Nichols, PZ Cussons and Treatt – they all generate significant profits abroad. However, I do have one or two holdings, such as Smiths News in news-papers/periodicals distribution and Wynnstay in agricultural services, which are overwhelmingly UK centred.
Attitude to risk
Before embarking on an equity journey and building up your portfolio, it is important to decide how much capital you wish to allocate. All equity or ordinary share investment carries a degree of risk and you should work out how much you are prepared to risk. I believe that everyone should keep a reserve of liquidity outside their portfolio to meet family emergencies. While a portfolio can be part liquidated relatively quickly, there have been times, such as the secondary banking crisis of the early 1970s or the 2008 subprime/banking crash, when markets have plunged and stocks have become almost unsaleable. In addition, for someone predominantly invested in small cap shares, you have to be conscious of a tighter or more restricted market, thus patience may be required when attempting to realise cash.
I’d also advise that there is no need to invest all your equity allocation in one splurge. Take time over it, build up the portfolio at a pace that you feel happy with as and when you go ‘nap’ on (select) a particular share.
The degree of risk an investor is prepared to take clearly varies from individual to individual. Put very simply, the scale of risk can be anything from very high risk biotech or exploration stocks (great if they come off, but invariably near-total losses if they fail and therefore not for me) to relatively safe, established companies like Dignity in funerals, Diageo in spirits, Tesco in retailing and Unilever in household products. Of course, the latter can move up or down in price depending on their profitability and the general performance of the stock market, but losses here are likely to be much more limited and certainly an investor will not lose everything.
One of my cardinal principles has been to focus on avoiding losses rather than chasing profits. In golf it is the shot in the river or wood that destroys the round; similarly with investing – it is the portfolio losses that drag down an overall performance.
Investment fashion – the rational and the irrational
Share price movements, in my experience, tend to be more rational than irrational, but sometimes an excess of rational buying can propel prices upwards to an unsustainable and unrealistic level. If we look back at three very different sectors – pharmaceuticals, supermarkets and mobile telephony – you will see what I mean.
In the past all were regarded as great growth sectors, for obvious reasons, and rated accordingly. Yields on leading shares in these areas were low as share prices rose on the expectation of sustained growth – Vodafone at one stage was yielding only around 1%. Investors who bought in early did well, but those who arrived late would unquestionably have lost money as these sectors went ‘ex-growth’. Pharmaceuticals saw governments becoming increasingly unwilling to pay high prices for drugs, generic competition increased and research and development (R&D) successes became fewer. Our towns became supermarket saturated and heavily competitive, with communities growing increasingly resilient to yet more supermarket developments which they saw as destroying the high street. Similarly, the mobile phone marketplace became progressively more difficult as competition from new providers offering cheaper tariffs increased and a greater percentage of the population owned a mobile phone.
Thus former growth stocks moved downwards on to much lower ratings, dividend yields correspondingly rose, and the investment community increasingly viewed them as income rather than growth stocks. I steered well clear when prices were high, but happily bought into Vodafone in 2009 at 122p when it was yielding around 6%, taking a tax-free ‘turn’ in my ISA at 163p in 2011. They have since moved further ahead, primarily on the realisation of their holding in Verizon of the USA. My conservative approach keeps me well clear of buying stocks on minuscule yields and PERs of 20+.
From time to time a niche investment sector will suddenly excite investors and they will pile in almost herd-like. In November 1997 I bought 5,000 shares in Nord Anglia – a North Western company operating children’s nurseries and private education establishments – at 187.5p. It was then announced that the company had been awarded certain government training contracts. Whoosh! Favourable media comment and buying in a relatively tight market saw Nord Anglia shares rise dramatically – I departed four months later at an unbelievable 437p. They hardly ever saw this price again. Sadly, poor management and a disastrous acquisition brought a collapse in the share price and ultimately the company was bought out.
It was the world of the internet which demonstrated the irrationality and gullibility of investors and the dangers of following the herd. For a time any company which developed a website or any flotation which suggested internet/web involvement was chased by investors to crazy levels. I kept well away, apart from a brief flirtation in February 2000 when my broker was handling the flotation of something rather touchingly called Just 2 Clicks. I agreed to take some for a punt at 150p. I got 6,666 shares, speedily turning them over a week later at 250p. Just 2 Clicks had no real business – it was all hope and prayer and definitely not my bag. I ended my January 2000 FT ‘My Portfolio’ article with these words: ‘I will never be a “day-trader”. When there is a blow-out in many of the absurdly over-priced internet stocks, the tears will not be mine.’
Many speculators made substantial monies on the way up, but much blood was spilled on the way down. The lesson to be learned is: tread very warily when following ‘fashion’ and avoid getting swept up by euphoria.
When to exit or when to stay
Whether you are a professional or a private investor, when to sell is one of the most difficult decisions to take, and in truth it is an area which is very difficult to give guidance on. It is relatively easy if you are losing on a particular stock. My advice is to apply a 20% stop-loss, i.e. sell shares if they fall 20% below the original purchase price. By all means allow a company one mistake, but then draw the line. Not only will selling and taking the loss on the chin be arguably the correct course financially, it will also, and if not more importantly, clear the decks and restore confidence. There is nothing more debilitating than studying your portfolio and being reminded daily of investing mistakes. You need to accept the loss as soon as possible and move on. Every investor makes mistakes but usually investors only want to talk about their successes, so don’t be fooled. I devote the next chapter to my mistakes and sadly there have been too many!
If you have profitable holdings, my general approach is to let profits run. Don’t sell if you are invested in a company delivering profits and dividend growth year on year. Most of my mistakes have been in selling too soon, although uncomfortably there have been bad selections as well. In the investing world there is wildly different advice: some advisers say sell half a successful holding so the balance stands you in nil cost. Then there is an old Rothschild saying: ‘I made my money by selling too soon’, i.e. not being too greedy. But generally I would let profits run.
However, most growing companies will experience a pause in profits growth. Be patient, stay aboard, don’t lose faith. Only if a holding becomes too ‘toppy’ – too over-priced – should you sell. Or, of course, if you believe that the company’s future is either really uncertain or has worsened dramatically.
Above all, put time into the equation. The biggest mistake private investors make is to constantly chop and change. It might make your broker happy but you won’t make your million that way.
As the legendary Warren Buffett famously said: ‘Lethargy bordering on sloth remains the cornerstone of our investment style.’ Definitely an attitude to be encouraged.