Picking better eggs and baskets

This article was first published on Livewire Markets
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In this wire, we discuss building a diversified portfolio without sacrificing on returns. Not only is it essential to diversify your eggs across different baskets, it’s equally important to make sure you’ve got concrete eggs and steel baskets.

Focus on defense, but don’t forget about your offense

Given the current focus on regulation and risk management stemming from the Royal Commission, it’s not surprising to see most funds err on conservatism with their approach to investing. Willingness for fund managers to deviate from industry norms with asset allocation or stock selection is at all time lows. I’d like to highlight that there is nothing wrong with this approach. In fact it’s perfectly understandable given there is no incentive for salaried fund managers to punt one’s career unnecessarily. It’s safer to stick with commonly accepted mainstream trends. However the result of this is herd behaviour often represented by portfolios with an over-diversified soup of stocks that closely resemble an index Exchange Traded Fund (ETF). You’d expect to be getting average returns if you’re sticking to the herd.

Whilst the focus on risk management is important, there are many ways to achieve this without blindly increasing the quantity of stocks in your portfolio. For enterprising investors, just because you’re focusing on downside protection doesn’t mean you should lose focus on your offensive game. We’re here to make money. So we need to find the optimal trade-off between risk and return. I’d proffer this balance is not optimal in a portfolio with hundreds of stocks. So what’s the right balance? Here’s some food for thought below.

You are already life-diversified

From a life perspective, you are most likely quite diversified already. If you own a home or investment property, you already have significant exposure to property. If you have an offset account with your mortgage, you will already have exposure to interest rates. If you have a mainstream superannuation account you will most likely be highly diversified already – ‘balanced’ funds typically hold thousands of investments across all asset classes. If you run your own business, then you have already dedicated significant personal funding and time to one equity investment. If you’re employed full-time, your wealth is strongly linked to your employer and the industry they’re in.

As you can see, even before you’ve started actively investing, you will likely have exposure to specific asset classes and industries. When it comes to stock market investing, you should consider filling the gaps in your life. For example, if you’re employed by an Australian company, focus internationally. Start by looking for stocks in different geographies and industries for companies that you aren’t already exposed to.

Your customers will protect you

The stocks in your portfolio have customers and these people and businesses are your customers too. They are the ones who will protect you from the next downturn.

Your customers should be widely dispersed across the world. Your customers should also be diversified across multiple industries and product lines. The trap that professional fund managers fall into is they become sector specialists. They become biased towards one industry with a concentrated set of customers. As an individual investor, you have the freedom to float across industries and capture the most loyal customers of each country in each sector.

For example, Fuchs Petrolub (FPE.DE) is a boring family-owned company in Germany. It also happens to be the largest independent lubricant manufacturer in the world. Fuchs makes custom lubricants for industry-critical machines. They service customers all over the world in all industries ranging from manufacturing, auto, aviation, construction and racing. For as long as friction exists, there will be a need for lubricant. By investing in just one company, you’ve accessed a loyal global customer base diversified across geographies and industries.

Think of the underlying customers in your portfolio as adding a layer of reinforcement to the shells of your financial eggs, and giving you further protection against a falling market.

The false comfort of quantity

Conventional practitioners of diversification are uncomfortable with a portfolio consisting of a small number of stocks. They believe there is a magic minimum number of stocks they must hold which will protect their portfolios from any downside. In reality it is the quality of your holdings which is far more important than the quantity. As we saw in the Global Financial Crisis (‘GFC’), when markets crash, all stocks crash. It doesn’t matter how many you hold.

Quality companies are the ones that will bounce back quickly from downturns. These companies have loyal customers and their products or services will always remain valued by society. They will continue to generate profits through any macro environment. Quality companies will have a prudent attitude towards debt so are unlikely to default.

Instead of focusing on reaching a magic number of companies in your portfolio, focus on the goods or services each company offers. Focus on the quality of their product offering. How essential to society are their products and services? A quality company will have customers continuing to buy their products through any cycle.

Concluding remarks

The mainstream approach to diversification states that purchasing a large number of different stocks is the safest and best-performing choice regardless of market conditions. Followers of this approach seek to build a financial safety net by gathering together many stocks. The trap here is that over-diversification of your stock portfolio is neither an effective safety net in difficult times nor an optimal growth strategy in good times. While it is sensible and valuable to seek a variety of investments, there comes a point when blindly adding to the quantity of different stocks you own does little or nothing to improve the quality of your portfolio.

Remember, your ultimate aim as an investor is to make money in a way that effectively balances risks and returns. Rather than following the conservative herd, you should begin by looking at your stock portfolio within the context of your financial life as a whole. Avoid the temptation to acquire ever-increasing numbers of stocks. and devote yourself to seeking a limited number of high quality companies.

The aim of a well diversified portfolio is to serve as wide a range of loyal clients as possible by investing in as small a number of companies as possible. Rather than focus on more eggs and more baskets, focus on choosing concrete eggs and steel baskets.

Happy compounding.

3 ways you can beat the fundies

This article was first published on Livewire Markets
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It’s ironic I’m writing my first wire to outline techniques you can use to beat professional fund managers. The fact is, most people assume that professional fund managers have an informational edge over everyday investors. This isn’t true.

These days public information is so widely available and accessible that seeking out detailed information on any listed company isn’t that hard.

Some think fundies have access to meet with company management which gives them an additional informational advantage. This is true only to an extent. The edge is in the ability of fundies to eyeball CEOs and get a sense of the qualitative aspects imperative to a successful business, like culture. But that aside, from an information perspective, these days transcripts of analyst calls can be easily found online. Even if there are meetings, CEOs will always tow the company line and tell fundies what the market already knows.

The only other advantage fundies have isn’t informational. It’s time. They have time to dig out the information because it’s their full time job. But you’ll be pleased to know that there is a finite set of information available. Just because they spend 10 times more hours researching a company doesn’t necessarily mean they have 10 times the advantage over you. There’s only so much relevant information available. At the end of the day, one person still has to synthesise it all and make a call.

As long as you dedicate the appropriate time to turning over the rocks, you can do just as well as us fundies.

Assuming you have the time and patience to do this, here are 3 ways you can beat the fundies at their own game:

1. Ignore the noise and seek out the true source of information

Focus on facts first. Don’t get distracted by macro themes and economic forecasts. Forecasts and thematic investing make for great newspaper reading, but they aren’t factual. It’s based ultimately on others’ opinions. The closer you can get to the true source of information, the better quality information you’ll have to make decisions. You are investing in stocks after all, not economies. And if you look hard enough, you can always find companies that will grow through all types of economic environments.

So instead of reading others’ opinions, your time is better spent understanding a company. What are its business lines? What products do they offer? Who are their customers? What advantage do they have over their competitors? You can find this all online. Start with the current annual report. Then go back historically to see if management have delivered on its original plans. Management presentations, substantial shareholders lists, remuneration and KPI information should all be available on a company’s website. If you find the details about the firm’s activities too complicated, you should move on to the next company.

Social media platforms can be a great source of customer information. Check feedback from customers. How do staff feel working for the company? This information isn’t hard to find. It’s a matter of dedicating the time to it. Spend more time with the true source of information and less time on others’ opinions.

2. Fish in under-fished ponds

Fundies face many structural constraints that you don’t. Larger fund managers are incentivised to spend more time managing the risk of their business, rather than their portfolio. They end up reverting to herd mentality. You can see this when fund managers hold the same stocks, in the same markets.

As a private investor, you don’t face these same constraints. You have the freedom to search in other sectors/markets. You don’t have to find sexy stocks. Boring stocks can be just as profitable. Notice the latest fad and and start your search in the opposite direction. Find companies that have a small public share float. These are founder-led companies where the owners still own a significant portion of the shares. Large fund managers must deploy their capital and companies with small public share floats just won’t capture their attention.

Your advantage is entering into an under-researched trade so you can maximise your chances of finding a good company at a reasonable price. For Australian investors, it’s very easy to get the full list of companies on the ASX sorted by industry on the ASX website. The significant shareholders list is provided in every annual report.

Besides from searching based on sectors, you can look for opportunities in other international markets. Start with markets that others aren’t talking about. There are many free and paid online tools that you can use to find solid companies in these markets. Most allow you to apply a filter that you can use to research further and narrow down your choices to just a few. Take advantage of these little-known companies with less analyst coverage. As the company lays down its promising business expansion plan, you could be in the privileged position of paying the undervalued price before it makes its ultimate positive earnings announcement. Thus, you’ll beat the fundies who will have to deal with a crowded market later on.

3. Focus on quality, not quantity

Fund managers have a business to run as well as a portfolio to manage. Their priority is to spend time marketing to increase the size of their fund and therefore fee income. As they become larger, they are forced to deploy more money in the stock market. Inevitably they can’t spend too much time analysing any one company. Instead they start with the market index and tilt according to which sectors they think will do well. This leads to bloated portfolios that correlate highly with the index. This approach to investing won’t give you significant outperformance – it will give you average returns.

Since you don’t have these constraints, take your time to seek true quality in companies. Start from the ground up and focus on quality over quantity. A concentrated portfolio of solid companies you know intimately will perform better than a scatter-gun portfolio of thousands of stocks you haven’t spent much time understanding.

Concluding remarks

To overtake a car, you can’t drive in the same lane. Don’t assume that fund managers have a huge advantage over you. In fact, they face many structural constraints that you don’t. Choose a different but wiser approach to investing in the stock market and you can beat the fundies. Rely less on hearsay and develop a culture of getting factual information directly from the reliable source. Analyse all the information at hand and focus on quality over quantity. Be patient and be willing to invest in non-mainstream brand name companies. If you approach investing the same way as everyone else, you’ll get the same outcome as everyone else. Happy compounding.