The Yield Portfolio II: Stock selection

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Following on from a fortnight ago, I want to turn my attention to populating those sector allocations I presented with stocks. Of course, sector weights and stock selection should evolve over time but I will fix on “Ron’s portfolio” with a June 25-27 start date in this pedagogic series to maintain clarity. When the series ends, I can then quickly refresh the whole process referring back to these postings.

The number of stocks I choose depends more on spreading risk across the portfolio in case one or more turn out to be duds – and even blue chips on occasions become duds – than following a more general rule! I published a series of reports on this site and elsewhere on how many stocks one needs in a portfolio. After extensive statistical simulations at different points in time I conclude that round 8 – 15 is a useful guide in normal times and that might rise to 15 – 25 in volatile times, such as during the GFC. In all circumstances, one has to balance the difficulty of finding enough good stocks with the benefits to volatility.

When I construct a ‘real’ portfolio, I want to allow for not just ordinary volatility (measured by standard deviations) but a share price possibly imploding – almost to zero in rapid fire. Sadly it has happened to me so now I want to manage that risk even better! If I want 20 equally-weighted stocks, each gets 5% weight or $5,000 in a $100,000 portfolio. But when I introduce sector weights, clearer thinking is required. I have reproduced Table 1 with its sector weights from my previous column for convenience.

Table 1: Allocations of a $100,000 portfolio under two scenarios

Source: Thomson Reuters Datastream & Woodhall Investment Research.
Note: These numbers were current on 25 June 2014.

If I approximately round the ‘Tilts’ weights to the nearest multiple of $5,000s, I might have two stocks in each of Energy and Industrials but eight in Financials! That makes no sense to me – I don’t want eight stocks in one sector – particularly the relatively safe Financials sector. Moreover, I wouldn’t want to choose ‘too many’ stocks in a weak sector. My rules tell me to put an extra stock in a strong sector (judged by risk-adjusted return – but more of that later) and subtract one from a weak sector. Not exactly a scientific process – but not far from it.

The next thing I need is my ‘Top 10’ for each sector. It takes me back to 1997-1998 when I devised and programmed the first electronic sound recording charts for ARIA – a system they used for a decade or so! This top 10 for stocks is much simpler. The list in Table 2 is simply based on expected yield with a cut-off requirement for market capitalisation, expected yield and consensus recommendations. I’ll show you my hybrid yield/conviction top 10’s next time.

Table 1: Sector top 10s

Source: Thomson Reuters Datastream & Woodhall Investment Research.

Staples got no stocks (deleted from Table 2 for brevity) even though it was allocated $10,281 in Table 1. No stocks in that sector met my standards. Three sectors only get one stock. Moreover, as I will discuss next time, I wouldn’t want WOR (WorleyParsons) representing my Energy exposure as most people – including myself – think of WOR being better assigned as a mining services’ company. That means two sectors, Energy and Staples, do not get any allocation!

I now think I have given enough background to show next time how I chose my portfolio. Thereafter I will discuss some of the finer details.

I will be ‘off-line’ in August as I take a trip ‘back home’ to spend a month with my brother. I am really looking forward to that but also to posting the last bits of the jigsaw on this topic that is also so dear to me. If nothing else, I hope readers realise there is a lot more to building a portfolio than choosing a list of stocks and a dartboard – but sometimes the dartboard will win. Winning in the long-run is what counts. I should also point out that I know that there is also more than one good way to build a portfolio – but the others are not for me.

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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