What not to buy

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I find the question posed by, “What not to buy” one of the more important to ask when building a portfolio – especially for those investors with less experience. It is so easy to get distracted when trying to cover too much ground. Big mistakes can be made by missing some detail in one, or more, of one’s investment selections. It is not important if you miss a few stocks that happen to do well. But it is very important to try and exclude potential duds.

Once enough stocks are excluded from view, a viable watch-list can be formed. The investor can then read and analyse in-depth only on those stocks in the list. The list can be updated in say six months or a year when then the whole portfolio should be reviewed. But blinkers are needed to keep focus. Remember, after the event, it is clear which stocks did well. Before the event we would have needed to assess the risk in investing in those stocks and the risks may have been too great for the expected return!

Making a list

The three simplest filters are size, sector and recommendation. The price volatility of large capitalisation stocks tends to be lower than those for smaller cap stocks. Therefore, I find it very easy to exclude any stock outside the top 100. I used this rule when building portfolios for people with several million dollars invested. Wealthier people are often more focused on wealth preservation and so they are quite happy to steer clear of smaller stocks and the associated risks.

The optimal number of stocks in a portfolio reflects, in part, the amount to be invested. I find 25 stocks enough for even a multi-million dollar portfolio. A hundred thousand dollar portfolio might only justify 10 to12 stocks to reduce the impact of brokerage costs (it is not just the cost of buying the portfolio but the rebalancing that should go on from time to time).

As there are 11 important sectors in the ASX 100, allocating one stock to each of the smallest two sectors of IT (0.8% weight) and Utilities (1.7% weight) would attract only $800 and $1,700, if the investor followed the index leaving $97,500 to be allocated across only eight to10 stocks. To get some diversification within a few big sectors, some sectors have to be avoided in small portfolios. Excluding the two smallest sectors is one obvious rule for an index-hugging style – but more of that in a few weeks time when I again write about yield and other ‘styles’.

I rely heavily on Thomson-Reuters consensus recommendations (‘recs’) in my own portfolio construction. On a scale of ‘1’ for a buy to ‘5’ for a sell, the consensus average for a stock is seldom close to 1, as some brokers are usually a little less enthusiastic and there is a strong bias against even a ‘4’ (for an underperform) let alone a sell at ‘5’. As a result, I would never build a new portfolio unless the consensus could at least manage a 3 (or hold). In my next column I will discuss recs in more detail. This ‘3’ rule excluded 23 stocks from the ASX 100 on Monday’s close.

Additional rules

I find three other construction exclusion rules to be useful. First, some stocks in the top 100 would not currently be ranked in the biggest 100 stocks in the ASX 200 because the S&P/ASX index team takes a longer-term view of price movements and it only rebalances the index (i.e. chooses the 100 or 200 component stocks) every three months – as it did last Friday. Seven stocks are excluded by this rule by – almost belonging to the lower half of the ASX 200. When a stock leaves an index, there is some pressure for certain fund managers to sell, as the stock may no longer satisfy its mandate.

Given that we have just gone through reporting season, I also excluded stocks with a significant downgrade over the period since the beginning of February. I used a slip of 0.25 in the rec to trigger an exclusion. That removed six stocks from the ASX 100.

And my third additional rule is to exclude stocks that, in my personal view, have too much volatility or downside risk. I include insurers (QBE and IAG) in this list because unpredictable natural disasters can have a big impact on share prices between possible very good periods of capital gains. I exclude airlines (only QAN, as Virgin has already left the index). Leighton (LEI) seems to go through too many periods of good and bad spells, often because they handle very big lumpy contracts. I also omit Arium (ARI) for reasons similar to LEI. That rule takes out six stocks.

Some stocks get excluded by more than one rule. After allowing for such overlap, I can still easily omit 34 stocks from the ASX 100. Since 66 stocks is far too big a number for my watch-list, I need another final rule. I rank each stock by market cap within each sector. With a 25 stock portfolio, I am unlikely to need more than five stocks in any sector. Therefore I chose the five stocks with the best recs. That leaves me 39 stocks in my watch-list. I can manage that number.

Of course, investors need to use rules that suit their own needs but perhaps this column might help some form a view on how their own watch-list might take shape. I present this list in the table along with their recs. I should stress though that this is not my buy list – or indeed anybody else’s. It is a list from which to try and find a good portfolio – and that is the topic for my next column.

It is worth noting that the consumer staples sector did not have any stocks that passed my stated filters. Even financials did not have five suitable stocks!

Source: Woodhall Investment Research; Thomson-Reuters Datastream; data as at market close, 24 March 2014

Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.

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