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Constructing portfolios

By: Nesan Nair, Stockbroker and Portfolio Manager

When deciding to invest in the stock market, the first objective to determine is what underlying shares we wish to invest in, as well as how much of each we should acquire. Typically, we know how much in total to invest so the proportion that is invested in each share chosen is often referred to as the weighting in that specific share, expressed as a percentage.

             

 Determining your risk profile

But what drives the decision to buy specific shares over others that are available.This decision is largely driven by the nature of the investor. For example, a long-term value style investor will look for unloved shares that have low price-earnings, relative to the market or the specific share’s history or perhaps a relatively high dividend yield. Of course one needs to have some understanding of the company to maintain its earning or dividends in such circumstances, but the value investor is typically a patient individual who is happy to ride the tide of short-term volatility, comfortable that he has done his homework on the company’s fundamentals and that better days for the business are ahead. 

In contrast, however, a momentum style investor will look for shares that are performing well relative to the market. The idea is that the price action, driven by positive market sentiment about a share, will likely continue its trend, until that sentiment wanes or even reverses. Sophisticated techniques for studying the price action have been developed and fall under the banner of so-called ‘technical analysis.’

Most investment and research teams consist of professionals with either a fundamental or value bias and others that are more momentum orientated. It is this blend of views that leads to the creation of a house view of shares and weightings, giving clients the best of both worlds.

Notwithstanding the debate that takes place at investment committees regarding what shares to buy or sell in client portfolios, there are some criteria regarding the construction of portfolios that are accepted by most professionals. For example, decide what your benchmark is before you invest, and determine your investment horizon and risk appetite. These will be largely determined by your investment needs and objectives – for example does the investor want income or capital growth?

Secondly, ensure that you are sufficiently diversified – having a portfolio of 15 stocks is going to be a lot less volatile than say, five stocks. At the same time, be careful not to over diversify. If you have too many stocks, they tend to cancel out each other’s returns and all you end up is the market or benchmark returns when you will be typically be looking to achieve above-market returns. Also avoid very small weightings – if you have them in the portfolio, no matter how well they do they will have little impact on the overall portfolio.

A rule of thumb is that a portfolio should consist of between 15 to 30 stocks – this should provide sufficient diversification reducing overall portfolio volatility without necessarily diluting the overall portfolio return with offsetting returns. The choice of those 15-30 stocks are typically guided by some investment theme that is relevant to the macroeconomic environment. For example, in the current environment a rand-hedge them has proven to provide a universe of stocks that has served investors well. Another example is defensive stocks, as compared to cyclical ones, given the weakening global growth backdrop and slowing demand for commodities. Examples of shares that speak to these themes would be British American Tobacco and SA Breweries. Another theme is technology – think of shares such as Alphabet (Google), Facebook and Apple – the products and services they provide are becoming more and more ubiquitous in modern day life.

One must remember, though, that the global economy is in a constant state of flux and as consequence, investment themes are constantly changing. Keeping abreast of the latest themes and translating them into individual shares that one can invest in at attractive prices is ultimately what gives rise to the successful investor.

                                       

 

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