Portfolio Construction

Towards the end of Q3 in 2019, I was feeling increasingly nervous about the markets which seemed to be going on a never-end bull run and decided to ex-examine my portfolio construction with a view to de-risking and strengthening it. This process was fairly illuminating as despite holding a well-diversified portfolio of up to 40 positions, I had a ‘Tail’ of tiny positions worth over 15% of my portfolio which were dragging on performance. In this article, I’ll explain more about my approach to portfolio construction.

Adding New Positions

When adding new positions, I buy tranches of stock worth approximately 3% of the total value of my portfolio. These tranches gain or lose value relative to other positions in the portfolio, occasionally aided by me taking profits or buying additional tranches. As my portfolio grows in value, I increase the size of these tranches, always aiming to keep them to around 3% of the total portfolio value.

The idea behind this is simple; diversification. By buy equally sized tranches, I help support diversification across different companies in the portfolio and in doing so strengthen my overall portfolio construction.

Portfolio Design

Any portfolio manager will be able to tell you that over time your portfolio will change in structure based on the performance of the underlying assets. Imagine that you had £3,000,000 to invest and bought 30 positions of £100,000 each. If you didn’t look at the portfolio for twelve months, when you came to look at it again, you\’d find a dramatically different portfolio to the one you had left. Some companies would have become more valuable and others less so. Some companies could have gone bankrupt and others might have doubled, or even tripled in value.  As a result, the construction of the portfolio would have fundamentally changed from one which was equally diversified across different sectors to one which is was more reliant on some than others.

A traditional portfolio manager may try to tell you that the second portfolio is less diversified than the first. You have fewer companies (28 as opposed to the original 30), and depending on which ones have changed in value, you may now be ‘over concentrated’ in certain sectors. For example, if the five companies to grow the most were all banks – and then the UK hit a recession, your portfolio would suffer a far great hit if it mirrored the second rather than the first portfolio. As such, your risk profile has increased, as headwinds affecting the banking sector will now disproportionately affect your portfolio compared to if you were equally weighted across a variety of sectors.

My Portfolio Construction Model

Having said this, I don’t try and mirror the first pie chart at all and instead follow a model I call the ‘Head, Body & Tail’ model. The ‘Head’ are my top ten picks – companies which I feel have the strongest potential; either already demonstrated through positive price movement, or those which I believe are likely to positively re-rate within the next 12 months. This part of my portfolio comprises between 50-55% of the portfolio’s total value, allowing me to concentrate capital in what I perceive to be the best opportunities without ‘betting the house’ and risking destabilising the overall portfolio on a single position.

To pick these, I undertake fundamental analysis, looking for the strongest performing companies on the market, and combine it with macroeconomic analysis, where I consider the likely future outcomes of various factors such as global interest rates, commodity prices, employment, and inflation. In a sense, this does increase my risk profile, but I believe my active management of the portfolio and benefits of concentration outweigh the mildly increased risk.

Next, I have the ‘Body’. These comprise the middle 30-40% of my portfolio and play an important role in portfolio diversification. These positions are in steady companies with good dividends, low debt and are generally spread across a number of different sectors. They tend to be companies I’d be happy to hold if the stock market shut down for the next ten years.

Finally, I have the ‘Tail’ – the lowest valued 10-15%. This is usually where you will find companies that I have significantly mispriced and suffered negative re-ratings over time. These positions have included some previously covered clunkers such as Carillion and Centrica – both of which I sold out of with over 50% losses (in the case of Carillion, I actually held into the collapse. Big mistake!). This is usually the pool from which I consider candidates to sell from the portfolio. Having said that, just because a company is in the ‘Tail’, it doesn’t mean that it’s an automatic sale decision.

For example, in 2017, I purchased shares in a company called Plus500 at a bit over £15 a share, adding them to the ‘Body’ of my portfolio. The company then suffered a price decline of nearly 70%, falling all the way down to £5 a share and entering the ‘Tail’. At this point, I decided the sales had been overdone; the company was highly profitable and I decided to add to my position as the price began to climb, adding at £8 in October 2019 and again at £9 in February 2020. Today, the share price is back at over £15 a share, leaving me with a healthy profit thanks to my willingness to back a company I felt had significant potential.

Conclusion

Be sure to pay attention to your own portfolio construction – when I conducted my review at the end of 2019, I was surprised to find over 15% in companies that were poorly performing. Failing to monitor these positions can lead to a surprising drag on performance; in effect, I had sold off my strongest performers in 2019, keeping a number of weaker companies in the portfolio – the exact opposite of what I say my strategy is!

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