| Protect your capital with a portfolio |
 The average person's impression is that the stock market is a very risky place to put their money. People often site examples of companies that have run into difficulties (sometimes even bankruptcy) and talk about the investors having lost all the money that they have invested.
Few professional investors ever experience this type of loss, because they build portfolios of shares. In fact, because they invest in a portfolio most professional investors (including banks, insurance companies and pension funds) are exposed to very little risk when they invest in shares.A portfolio is simply a collection of shares in a number of different companies. Why invest in a portfolio? Investing in a portfolio removes much of the risk in investing in shares. Statistically, the number of companies that have severe difficulties (which could wipe 50% or more off its intrinsic value) in any single year is very small, very much less than 1 company out of a 100 (you may wish to read our article on valuation for a better understanding of intrinsic value.) However, for an investor who invests in just one stock, even though the risk of that stock crashing down in price is low, if it should happen then he could have his capital totally wiped out. And even though the risk of that happening in any single year is low, over an investment lifetime of up to 40 years, the risk becomes much higher and of course it only has to happen once for the investor to lose a sizeable part of his or her capital. However if the investor held a portfolio of just 10 stocks, a loss on one of them might not result in an unrecoverable loss in her capital. As an example, imagine she had 10 stocks and she was expecting each of them to increase by 15% each year. Say one of them experienced an unexpected loss, which resulted in the value of the shares collapsing to zero. If the others performed to expectation then she would end up making a 3.5% profit for the year. Of course, it is much lower than what she was expecting and she won't be happy, but she won't have suffered a loss from which she cannot recover. Portfolio diversification In building a portfolio it is important that it is well diversified. This means that it should not have stocks that are correlated (i.e. that are influenced by each other). The most important diversification is sectoral diversification, i.e. the stocks should be in different industries. So, for instance, if you had all your stocks in alcoholic beverage companies and the government introduced a regulation to restrict the sale of alcohol then all the companies in that sector would be hit, so having a portfolio would not have saved you. How many sectors you include in your portfolio comes down to judgment (though there is a whole body of portfolio theory that tries to make it scientific). Most investors choose between 4 and 10 sectors (anything more than that can become unmanageable). We at Smart Investor tend to diversify over 5 sectors. Choosing stocks for the portfolio Choosing stocks depends on the investors' objectives and appetite for risk. In this article we will only outline the key areas of importance; subsequent articles will go into some detail on choosing stocks. The first question you must answer is, what is the objective of the portfolio? This would normally be to achieve a certain level of return at a certain level of risk. If an investor’s objective was to achieve a 20% return with medium level of risk, then he or she would choose stocks where the expected total return (price appreciation + dividend) was equal to or greater than 20%. They would also choose stocks that have medium level of risk. Investors assess the level of risk a stock has by looking at a number of factors and coming to a judgment. We will not go into detail on each of the factors here (though all the factors are covered in our company valuation reports available in the magazine or on our web site). Factors that we would look at to judge the risk (or quality) of a company are: i) The company’s competitive advantages; the attributes the company has that can defend it from competition. Things like a strong brand and customer loyalty (e.g. Star Beer), patents, high barriers to entry, control of the distribution channel make it less likely that the company’s performance will be adversely affected by competitors. ii) The company’s financial position, which would include its historic financial performance, the amount of cash it generates, the amount of debt it has (its interest cover), and the quality of its dividend (dividend cover). iii) The quality of its management and corporate governance. iv) Its exposure to governmental regulations and environmental factors. v) The quality of its industry. Industry growth, amount of rivalry amongst firms in the industry, supplier and customer bargaining power, etc. Companies that rate highly in all these areas we would generally believe to be of high quality; companies that are high in most areas (including its financial position) but have weaknesses in a few might be medium quality; and companies that are weak in most areas might be termed low quality (and therefore high risk). Of course, investors have high, medium, and low quality companies in their portfolio's. However, professional investors make a conscious choice to buy a certain quality of company and at the same time they only buy the lower quality companies when there is the expectation of making a higher than average return. Most companies you find covered in Smart Investor are companies that we judge to be of high or medium quality. The other question you must answer is how many stocks to put in the portfolio. This will depend on how much risk you want to take on. The more stocks the less risk, however, the more stocks the less likely that you will make a superior return. This is because you will probably only have a limited number of excellent stocks. The more stocks you add to your portfolio the more likely you will be adding weaker companies in order to make the number. For most individual investors a minimum of 10 and a maximum of 20 is appropriate. More than 20 becomes very difficult for a person to properly manage on a part time basis. At Smart Investor, we tend to build portfolios around 10 stocks, because we use very conservative valuation techniques and we watch our stocks very closely. We feel satisfied that the 10 stocks we choose give us a low risk profile. Buying and selling stocks Once an investor has chosen the types of stocks that he or she will put into the portfolio, he then needs to find and buy them. Because there are only a limited number of stocks in the Nigerian Stock Exchange many investors in Nigeria go through the annual reports of many companies to pick the ones that they feel are right; they also take tips and advice from friends and colleagues. In more advanced markets, investors often use stock screens to sift through the thousands of stocks available to find ones that meet their criteria. Once a potential stock has been identified we would advise that you do a thorough analysis of the stock (we will publish an article on how to analyse a stock in Smart Investor) and a valuation (see our article on valuation) and buy the company if its quality is within your criteria and the price is below (or at least equal to) the value. At SI we always advise people to buy at prices below value - valuation is an inexact process and buying below value provides a margin of safety. It often takes several months for an investor to become fully invested in a new portfolio, as it takes time to identify potential buys, do the analysis and sometimes wait until the price is right. But investing the time is generally worth it. Once you have shares in your portfolio you should review them frequently. We would advise at least once a quarter. If in your review you find that the prospects for the company have changed and that it would no longer meet your criteria, don't hesitate to sell it. More money has probably been lost by people falling in love with their stocks and not selling when it should have been obvious that the prospects for the company have changed. It would also be appropriate to consider selling if the price shoots up very much higher than the value. There are no hard rules here, but once one of our stocks is trading at more than 50% its value we look at selling, we frequently find that we are able to buy it back again in the future at a lower price. |
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