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In this week's Weekly Insights:

-The Basics Of Portfolio Construction
-Jumpin' Jack Flash Lives In The Seventies
-Conviction Calls
-All-Weather Model Portfolio September Review
-Research To Download

By Rudi Filapek-Vandyck, Editor FNArena

The Basics Of Portfolio Construction

On my observation, the investment services industry is focused too much on providing the next hot tip and individual stock recommendation. Granted, there is obvious, natural demand for such 'information', but it is also my observation many an investment portfolio suffers from a lack of structure and/or a well-thought out strategy.

Hence, this week I am sharing my own thoughts and experiences with structuring and running an investment portfolio. May it help and assist those investors currently in the dark when it comes to defining a strategy and structuring their own longer-term oriented equities portfolio.

First up, I can report from personal experience, from the moment you are running a structured portfolio, you no longer are an investor in stocks. Just like a coach of a sporting team, you stop concentrating on each of your players individually. Instead, you start realising, and appreciating, the effort made as a team, though you never want to lose sight of the individual components, of course.

Putting a team together, which in this case equals a basket of stocks, starts with the realisation not all players on the field can be hot blooded race horses. The sun doesn't shine every day, all day and we must accommodate for four seasons that cannot be perfectly anticipated each and every time.

Hence we need some race horses, but equally a selection of sturdy, reliable muscle-machines that can pull a load when the weather is cold and the ground is wet and muddy. Apart from the occasional exception, a well-diversified selection means the portfolio never sees all stocks rallying or all falling on a given day, in particular not with share market momentum as polarised as it is this year.

As an added benefit: come the next period of share market weakness, we might feel less inclined to sell everything and hide under the bed.

All-Weather Portfolio

Focus and momentum for the share market changes regularly, and often occurs completely unexpectedly. Instead of constantly shedding and selecting new stocks in order to minimise our losses and avoid missing the boat, once we have that structured portfolio in place, we find ourselves in the role of the master coach overseeing the team, making smaller changes here, and a minor recalibration over there, in response to a changing outlook.

Before we find ourselves in such a position, we need a basic road map as to how we get there and where to get started. In my case, I started with my own research into All-Weather Performers; reliable, proven business models with a track record of performance, not hindered by economic cycles to generate shareholder wealth.

How many stocks should I choose?

Over the past years, I have come to the conclusion that 6% as a full weighting for any given stock is an excellent target. It implies when the portfolio is fully invested the basket contains between 16 and 20 stocks, on average. That's a reasonable number that can still be overseen and managed, assuming they're not all high risk fly-by-nighters that need to be watched constantly.

As part of portfolio management, decisions can be made to allocate half-weightings, or reduced weightings, and in some cases of high conviction an overweighted position, but I would refrain from allowing any position to become too small or too large. As far as the first option goes: it's okay to have a punt every now and then, but if it's not worth owning at a sizeable allocation, is it even worth the energy and attention, let alone the risk?

There is no universal golden rule about what maximum size should be allowed, but I'd be hesitant to allow any given allocation to grow beyond 9% of the total. The reason is simple: risk. Take profits if you must. Consider it part of portfolio management.

On the other hand: don't feel like you need to top up on allocations that haven't worked out and shrink in portfolio importance. Better to always ask that question: where is my money in the best of hands? As impregnated as we all are by this idea that 'cheaper' stocks perform better than those that have already outperformed, the most often made error is selling the winners too early and putting more money into the laggards and losers.

I can guarantee you all this will be the first of lessons that will be learned, time and again, through running an investment portfolio.

As per the lists on the website currently, my research has identified 21 All-Weather Stocks, of which some are still "potential" and others are carrying a question mark. Should we simply buy all of them?

That wouldn't be much of a diversified structuring, would it? All-Weather stocks are spread out over multiple segments and sectors, but most share the same basic characteristics, including above-average Price-Earnings (PE) multiples, which means they potentially can land in or out of favour all at the same time.

Equally important, most investors want income from their portfolio and All-Weathers, if only because of their valuation, are not ideal for short-term income purposes.

It is for this reason that I decided back in late 2014, when we launched the All-Weather Model Portfolio, that a selection of income providing equities would be the second pillar of the overall portfolio strategy. A third pillar consists of emerging new business models and technology disruptors by applying a quality assessment to the many newcomers on the ASX over the semi-decade past.

In practice this means I am combining the likes of Amcor ((AMC)), CSL ((CSL)), REA Group ((REA)), TechnologyOne ((TNE)) and Wesfarmers ((WES)) with higher dividend yielders Aventus Group ((AVN)), Super Retail ((SUL)) and Telstra ((TLS)), and with the younger businesses of NextDC ((NXT)), Pro Medicus ((PRO)) and Xero ((XRO)).

View From The Portfolio Control Room

For the sake of creating a starting point, let's assume we allocate 33% to each of the three pillars. Next things to do: team play, fine tuning and overall macro strategy. Do we lean more towards risk aversion? Can we be more aggressive with our risk-taking? Do individual valuations require profit-taking and trimming of positions? Is there an opportunity out there we'd like to include? Should the portfolio increase its cash allocation given market jitters?

All these questions, and many others, will pop up along the way but from now onwards you can address them through allocating more here and less over there. It goes without saying, to make such decisions requires we know the basics about the companies we own, and we can make a reasonable judgment about what is happening in markets. Neither fear nor hope has ever proved to be a successful strategy in the long run.

One extra benefit is we learn a lot about the companies we own. Always best to know what we own, and why. My own experience also tells me we must never consider our stock choices and portfolio allocations as set in stone. Ignore individual losses and gains. Always keep an eye on the future. Make decisions that seem right. And make those decisions for the team.

Not selling because you're sitting on an individual loss while all the evidence is telling you you should, is not smart team play.

But equally: accept your execution won't be perfect, and luck has its own role to play.

What About Income?

Equally important is that most of the companies in the All-Weather Model Portfolio pay a dividend, but that should never be the sole reason to include a stock. Taking a team approach, we should combine the 5% offered by Aventus with the sub-1% offered by CSL as well as the zero pay-out from Xero.

The average yield for the total basket is what counts. Forward looking estimates only. The All-Weather Model Portfolio on average yields between 2.5%-3%, which may not seem a lot given the banks are back yielding 4% and more, as is the ASX200 index, but that extra -1% missing in yield has been compensated through relative outperformance.

The portfolio can always sell a few extra shares if/when we need that extra bit of income.

You'd have noticed I don't try to have all main sectors of the market represented, which is equally a valid portfolio strategy. Neither do I use rather traditional definitions such as 'defensives' or 'blue chips', which I personally find outdated. AGL Energy ((AGL)) officially belongs to the defensives on the ASX. Have a look at that share price since 2017 and try not to shudder.

Size does matter, however, and smaller cap stocks come, on average, with higher risk and more volatility than larger caps. So this should be one extra consideration for the average, risk-conscious investor.

The Portfolio also has that added goal to prove to investors All-Weather Stocks are worth focusing on and investing in, so the selection of stocks tends not to include the banks when looking for dividends while cyclicals, being the anti-thesis of the All-Weathers, are simply not an option.

You Have Options

In the current context of potential concerns about sticky inflation and rising bond yields, a decision can be made to include a selection of banks, other financials and cyclicals (miners, energy producers, contractors and engineers, etc) and this would simply fit in with the portfolio strategy as described above: adjust relative allocation according to comfort/discomfort with the inflation outlook (to the best of your abilities).

In similar vein, with investor focus currently on re-opening beneficiaries, this too can be integrated in our portfolio and strategy. One warning though: make sure your portfolio doesn't get hooked into one (too) dominant theme as that makes all of the above redundant. Running a diversified portfolio is by definition an admission that we cannot accurately forecast and anticipate all events and momentum changes every single time. So, yes, we are at times giving up on more potential upside, while looking for compensation in different circumstances.

Besides, a number of companies currently in the All-Weather Model Portfolio stands to benefit enormously from re-opening borders and economies, even though they might not yet be seen as key beneficiaries by the majority of investors who prefer to crowd together in airlines, airports and leisure companies.

Sometimes the allocation to new trends and focuses occurs without actually having to make a change in the portfolio!

I know some among you like to take a punt, and many do it more than regularly. You can always put a decent portfolio together and include a special reservation for your more risky, short-term, adrenaline-filled adventures.

And if you're into ETFs instead of individual shares, or a combination of the two, that can be accommodated too.

If all of the above is genuinely new, I highly recommend adopting and applying the basic principles. It'll change your life as an investor, not to mention the additional skills and insights that come with it.

Jumpin' Jack Flash Lives In The Seventies

Apparently we now are all googling 'stagflation' in response to higher-for-longer inflation numbers and question marks about global economic momentum leading into year-end.

Rule number one in finance is while everyone uses the same key words, the meaning behind those terms is far from universal, even under the best of circumstances.

And stagflation is one such prime example. Higher inflation and slowing growth are two characteristics of what constitutes 'stagflation', but it sure ain't the stagflation that dominated the 1970s, which is the logical point of reference for everyone googling today.

As per always: details matter and one would have to have an extremely subdued view on the outlook for the global economy to anticipate a rerun of the 1970s which, among many other factors, included mass unemployment and negative economic growth combined with enormous volatility on share markets, ultimately culminating into that (in)famous magazine cover by BusinessWeek: The Death Of Equities.

Ironically, that cover was published on August 13 of 1979 – 40 years ago, plus two months.

This time around economies are less carbon-fuel intensive, countries are opening up, businesses are online and services oriented and inflation is sticking around because of bottlenecks and disruption. Global gas not oil is leading the charge, but the damage done to household budgets is still real, of course.

Consider that global oil prices are up some 12% this quarter, while the price of natural gas is up 25% in the US and nearly 75% for the euro area. Forget about inflation, the real question mark here is about household budgets and consumer spending.

Thus far, most forecasters are still holding out for relatively firm global growth next year, and a lot of this forecast is based upon pent-up demand being unleashed as cashed-up consumers celebrate their newly discovered freedom as vaccination rates surge and lockdowns end.

I suspect those forecasts will be proven too optimistic. Higher gas prices will have an impact, and so will a certain degree of caution among those all-important consumers. But it will require even higher prices for gas and oil before global spending gets squeezed into the next economic recession, after which we can all unite around that comparison with the 1970s.

But until then… don't get sucked in. Stagflation today is not a repeat of the 1970s. Though, that doesn't by default mean there are no risks for the outlook. Ongoing strength in fossil fuel prices would, at some point, force the recovery to come unstuck. So be careful what to wish for.

The 1970s also were a fast-moving, glorious period for music, but I don't think punk is about to make a come-back either. Johnny Rotten singing No Future seems more than just a tad out of context today.

Conviction Calls

In case anyone missed it, Morgan Stanley on Friday raised its price target for Macquarie Group ((MQG)) to $240 which coincides with the broker's Model Portfolio increasing its exposure. Macquarie has also been added to the broker's Focus List, which only contains nine other inclusions.

Downer EDI ((DOW)) was removed from the Focus List.

Macquarie is the pre-eminent representative of ESG investing and asset allocation on the ASX and this is exactly the why behind Morgan Stanley's increased positive view on the asset manager's growth outlook, and premium valuation.

It goes without saying, Morgan Stanley's rating is Overweight with an In-Line sector view.

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Apart from Macquarie, Morgan Stanley's Focus List comprises of APA Group ((APA)), BlueScope Steel ((BSL)), Computershare ((CPU)), Qantas Airways ((QAN)), QBE Insurance ((QBE)), REA Group ((REA)), Scentre Group ((SCG)), Telstra Corp ((TLS)), and Westpac ((WBC)).

The Focus List is a selection of stocks for which analysts have the highest conviction on a twelve month horizon.

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Analysts Jules Cooper and Josh Goodwill at Shaw and Partners are -in their own words- passionate about software. The broker has allowed them to launch a regular update on the local industry which both hope will bring to life the companies, the people, the products and the investment opportunities the sector offers on the ASX.

As tends to be common practice, Cooper and Goodwill have selected their top three of sector favourites: Whispir ((WSP)), Nitro Software ((NTO)), and Gentrack Group ((GTK)).

Equally noteworthy, there is only one Sell rating among the 13 stocks covered, and two Hold ratings. These are respectively for Iress ((IRE)), PushPay Holdings ((PPH)) and WiseTech Global ((WTC)).

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Analysts at Wilsons published their shopping list for the re-opening of state and national borders in Australia: Accent Group ((AX1)), Adairs ((ADH)), Breville Group ((BRG)), GUD Holdings ((GUD)), Integral Diagnostics ((IDX)), Kathmandu ((KMD)), Monadelphous ((MND)), NextDC ((NXT)), Pexa Group ((PXA)), Qantas Airways ((QAN)), Ramsay Health Care ((RHC)), REA Group ((REA)), Sealink Travel Group ((SLK)), Seven Group Holdings ((SVW)), Silk Laser ((SLA)), Sky City Entertainment ((SKC)), and United Malt Group ((UMG)).

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Pacific Smiles ((PSQ)) has been removed from Wilsons' list of Conviction Calls following an already strong rally in the share price in anticipation of businesses resuming to 'normal' post lockdowns.

Stocks that have retained their inclusion are ARB Corp ((ARB)), Collins Foods ((CKF)), Aroa Biosurgery ((ARX)), ReadyTech ((RDY00, and Plenti ((PLT)).

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Lastly, stockbroker Morgans has identified 23 stocks with material catalysts revealing themselves during AGM season. Notable opportunities are believed to be in Corporate Travel Management ((CTD)), Reliance Worldwide ((RWC)), Tyro Payments ((TYR)), and Lovisa Holdings ((LOV)).

Other stocks mentioned are a2 Milk ((A2M)), ALS Ltd ((ALQ)), Catapult ((CAT)), Credit Corp ((CCP)), Data#3 ((DTL)), GrainCorp ((GNC)), ImpediMed ((IPD)), Incitec Pivot ((IPL)), Karoon Energy ((KAR)), Money Me ((MME)), Micro-X ((MX1)), New Hope Corp ((NHC)), and Nufarm ((NUF)).

All-Weather Model Portfolio September Review

Share market volatility and All-Weather stocks in September, monthly review:

https://www.fnarena.com/downloadfile.php?p=w&n=05085E2D-05E6-F1CC-01A08A892D29F9E9

Research To Download

RaaS on AML3D:

https://www.fnarena.com/downloadfile.php?p=w&n=AC2486DF-EB6D-D76A-571F34A5CF9BCC94

(This story was written on Monday 18th October, 2021. It was published on the day in the form of an email to paying subscribers, and again on Thursday as a story on the website).

In addition, since FNArena runs a Model Portfolio based upon my research on All-Weather Performers it is more than likely that stocks mentioned are included in this Model Portfolio. For all questions about this: info@fnarena.com or via the direct messaging system on the website).

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BONUS PUBLICATIONS FOR FNARENA SUBSCRIBERS

Paid subscribers to FNArena (6 and 12 mnths) receive several bonus publications, at no extra cost, including:

– The AUD and the Australian Share Market (which stocks benefit from a weaker AUD, and which ones don't?)
– Make Risk Your Friend. Finding All-Weather Performers, January 2013 (The rationale behind investing in stocks that perform irrespective of the overall investment climate)
– Make Risk Your Friend. Finding All-Weather Performers, December 2014 (The follow-up that accounts for an ever changing world and updated stock selection)
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