What not to buy – Part 1: size matters

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I’ve started this four-part series with what not to buy in order to reduce the time and choice you need to spend researching stocks. Over the next few weeks, I’ll cover a few different ways of slicing and dicing the nearly 500-stock universe that is the All Ordinaries. Let’s start with size.

There’s a strong relationship between a company’s market capitalisation and the volatility of its stock price. Companies with a large market capitalisation, or ‘big-cap’ stocks, are typically less volatile than those with small market capitalisation, or ‘small-cap’ stocks. When dealing with volatility in small-cap stocks, it’s difficult to distinguish between a downward dip that will self-correct and a terminal fall in price. If you keep deserting small-cap stocks on the way down, your portfolio will seriously underperform. If a big-cap stock starts to fall, you might have the conviction (and the research) to hang on and wait – or even buy more.

Low liquidity also increases volatility with small-cap stocks, with moderate trades sometimes causing large price swings. For example, Emeco (ASX:EHL), a stock I hold, was trading against the trend last Thursday. Although it’s a top 200 stock, a sell of 13,226 shares went through at lunchtime and moved the price down by 3¢. All other trades were for $1.18. While a 3% swing might not seem much, the average capital gain of stocks in a year is about 7%, so a 3% blip can eat into performance.

There’s a lot to be said for investors limiting their SMSFs to the ASX 100. I used to construct ‘High Conviction’ portfolios for a big bank and I only included stocks in the top 100 in them. Of course, some ASX 100 stocks are better than others, but more on that in the coming weeks.

I like to have just one stock outside the ASX 200 in my SMSF. This means I can ignore talk of small-cap stocks in the media, except for one, giving me time to concentrate on the main game.

I know a handful of the stocks I avoid will do well – possibly spectacularly well – but I’m looking after my life savings and out of the near 300 stocks outside the ASX 200, it’s easier to pick the ones that do badly. I have a very small holding of one small miner at the moment and that’s my treat. As it turns out, I have made about 50% on it but I could just as easily have lost the lot. And after buying several parcels and reaping price increases, it still represents only about 1.5% of my SMSF.

For the talented investor, there’s a role for the ‘bottom half’ of the ASX 200 in an SMSF. I used to manufacture these portfolios too. I called them ‘High Fusion’ portfolios – a fusion of a High Conviction portfolio and a sprinkling of the smaller members of the ASX 200. This blend is the basis of my own SMSF.

I tend to favour the biggest capitalised stocks in each sector that I invest in – subject to the number of stocks and the broker recommendations. That makes up my version of a High Conviction portfolio.

To turn it into a High Fusion portfolio, I choose the best sectors based on research I publish in my Quant Quarterly and replace the smallest capitalised stock with the best recommendation (‘High Octane’) for that same sector from the whole ASX 200. When a sector doesn’t stand out, it doesn’t get a High Octane stock. In this way, during poor market conditions, the High Fusion portfolio converges to a High Conviction, and this jettisoning of High Octane stocks is exactly what happened to my High Fusion portfolios during the global financial crisis.

Thirteen of my 17 stocks are in the top 100 (about 76% by number of stocks) and they account for about 83% of my portfolio by value. Some readers might say they want more ‘zing’ in their portfolios. But your SMSF isn’t a game – it’s a long-run investment strategy. As for zing, I made about a 40% return in 2010/11 with this strategy. But there are never any guarantees in portfolio construction.

Because 16 of my stocks are in the top 200 and have good broker recommendations, I’m usually happy to buy more of them when the price falls. So I typically look for cheap stocks already in my portfolio. See my previous column for examples. One exception was Harvey Norman (ASX:HVN) – which brings me to the next issue. I’ll give my views on which sectors not to buy (or to bail out of, as I did with HVN) – and then I’ll deal with which stocks to avoid.

Woodhall Investment Research Pty Ltd
ABN 17 141 486 160

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Important information: 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. For this reason, any individual should, before acting, consider the appropriateness of the information, having regard to the individual’s objectives, financial situation and needs and, if necessary, seek appropriate professional advice. Past returns are no guarantee of future performance.

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