During the course of publishing this blog, I have previously written two articles about my portfolio review process, the first providing a general insight into my review process and the second providing a more detailed description of my half-year reviews. In today’s article, I’m going to provide more detailed about my quarterly portfolio review process, specifically, the metrics I review and decisions I make based on these.
In the original article, I provided a brief overview of the four types of monitoring I undertake; daily, monthly, half-yearly, and annual. The basic premise of this programme is to ensure that I understand and am comfortable with how my portfolio is constructed. Namely;
- Position sizing (individual position and tranche weighting)
- Portfolio diversity (cap size, sector and geography)
- Holding performance (price movement and fundamental analysis)
- Risk analysis (concentration risk, sector risk, company risk, macroeconomic risk)
- Capital management (profit/loss taking and capital deployment)
Each one of these issues is a key part of enabling my to identify risks and opportunities in the portfolio but also to ensure I’m comfortable with how I’m exposed these. I want to be fully aware of potential scenarios and actively choose the risks I’m exposed to and the opportunities I pursue. The quarterly portfolio review ensures that I sit down and confirm exactly how individual companies are performing and how my portfolio is structured.
Determining the relative size of positions is an important part of risk management. The basic principle is that the larger a position is, the bigger an impact it has on the performance of the portfolio. For example, the price movements of three holdings worth 33% each would heavily influence a portfolio, whereas those of a portfolio with 30 holdings worth 3% would have significantly less impact.
Within my portfolio, I monitor position size by individual holding and by ‘tranche size’. No holding should be worth greater than 10% or less than 1% of the total portfolio. In addition, I split the portfolio into three parts, or ‘tranches’, which I’ve written about before. I aim to have the largest ten positions weighted at 50-55% of the portfolio value, the smallest ten at 5-10%, and the remainder at 40-45%.
My thinking behind this approach is that it enables me to open ‘starter’ positions in the middle of the portfolio once I have undertaken research and determined I wish to invest in a company. These companies either perform strongly over time, in which case I often add more to them, or begin to underperform, in which case I remove capital and allow them to become smaller relative to the other holdings
As such, when I undertake my quarterly portfolio review, one of the first things I measure is the relative weightings of individual positions to determine whether I want to add, maintain or reduce any.
- Is any single position (excluding cash) worth more than 10% of the total portfolio value?
- Are my largest ten holdings worth between 50-55% of the total portfolio value?
- Are my smallest ten holdings worth between 5-10% of the total portfolio value?
- Are any positions worth less than 1% of the total portfolio value?
Secondly, I explore how diversified my portfolio is. There are many ways of classifying company type;
- Company Size
- Geographic location (of either operations or customers)
Within these categories, I want a hold a spread of sectors (no sector worth more than 20% of the portfolio) and a spread of company sizes (no more than 10% in micro caps and no more than 25% in small caps).
I’m not overly concerned about geographic location – I hold minor weightings to the US, Japan, Europe, Switzerland and Asia but the majority of the companies in my portfolio trade internationally. Personally, I find it more important to think about the links between different geographic areas and sectors and work to spread my exposure to multiple factors. Diversification in and of itself doesn’t eliminate all risk but it helps to minimise potential negative impacts of events and trends in the marketplace.
- Do any sectors in the portfolio comprise more than 20% of the total value?
- Do microcaps comprise more than 10% of the portfolio’s total value?
- Do smallcaps comprise more than 25% of the portfolio?
- Are my geographic weightings in line with targets?
Although I describe myself as an investor, meaning that I intend to hold positions for years rather than months, my portfolio performance relies on my ability to generate and secure returns over the long-term. As such, the use of momentum indicators in my quarterly portfolio review acts as a flag to help me identify positions for sale or potential top-ups.
For example, if a position has experienced a price increase of greater than 30% in six months, I like to take some profit off the table. Likewise, if a position has declined more than 30% in six months, I want to understand why.
These are not a guaranteed buy or sell signal, but a flag to examine my thesis and ensure I’m still comfortable with the position. Ultimately, I seek to maximise returns over the long-term – after all, the aim of the game is to maximise my portfolio returns rather than become a card-carrying ideologist and share price performance is key tool to help monitor and protect those returns.
More important than the share price performance, however, is getting an understanding of how the actual company is performing. To do this, I check a number of key metrics to get a quick ‘temperature check’ of each company’s performance and an indication of whether they are still an attractive investment.
- Earnings per Share should be growing
- Free cash flow per share should be positive or growing
- Share count should be steady or shrinking with the company buying back shares.
- The operating margin should be level or growing.
- Net debt should be flat or decreasing.
- Return on Equity/Capital Employed should be positive or growing.
Tied to diversification, my risk analysis process entails me thinking critically about the potential threats to my portfolio. These threats affect individual companies, sectors and countries in different ways. For example, as interest rates rise, equity prices tend to fall – a portfolio that is ‘long only’ would expose me to that risk. A collapse of a labour market, perhaps because of strikes, would affect a company’s ability to manufacture and deliver goods. A new technology could be invented that replaces an entire industry.
The key during this stage of the quarterly portfolio review is not to list far-fetched and unlikely doomsday scenarios but to think carefully and strategically about the possibility and impact of different risks. If, for example, a government is making noises about nationalising an industry, I have to decide how likely I think it is to happen and whether I want any exposure to that industry in my portfolio.
Risk exposure is a highly personal decision rather than something that shouldn’t be dictated by others. I approach risk by thinking about the worst possible outcome – an event I would do almost anything to avoid – and working backwards from there until I’ve reached a scenario which I would be more comfortable with facing.
Take, for example, losses in a portfolio. Let us pretend that I have only a single asset – my portfolio – and that I had accumulated £10m within it. This sum of money is sufficient for me to live off the income of the portfolio and fully pay my rent (I decide not to buy a house, as I want to invest everything in the stock market). In this scenario, a 100% loss on my portfolio would be catastrophic and would destroy my quality of life, financial stability and ability to support my family.
To guard against this risk, I could take a number of measures including:
- Diversifying across different assets such as property and cash
- Split the portfolio into self-managed and professional managed pots
- Diversify the range of institutions the money is held with
- Diversify across companies sizes, sectors and geographies,
- Split between individual holdings and ETFS/funds
None of these steps removes 100% of the risk of loss but each gradually dilutes individual risks. The odds of my property becoming worthless are slim, especially at the same time as an entire portfolio. Cash could theoretically suffer from hyperinflation but hopefully this isn’t a likely outcome. By handing some money to a professional manager, I could benefit from an alternative approach to my own (or the risk that I am actually a terrible investment manager).
Risk comes in many forms and can affect your family as well as yourself. The obvious risk is that of capital losses but risks can also come in the form of fraud, theft and illiquidity. Taking time to consider these risks, map out their likelihood and taking steps to mitigate and protect against their impact is a worthwhile process.
The final step of my quarterly portfolio review is to look at my overall capital deployment within the portfolio. At its broadest, I split my portfolio into two parts – equities and cash/bonds in a 90/10 split. Within the equity position, I aim for a 5% dividend yield and between 25-35 equity positions. The majority of these are individual equities but I also hold trackers and funds for international/specialist areas.
Outside of this, I think more broadly about my holistic balance sheet. I check where I have capital deployed and is that it is still the most effective use of it relative to alternatives. When interest rates were at 2%, investing in equities seemed like a no brainer, but as mortgage rates, interest rates, and bond yields have crept up, this is no longer such a simple decision.
Every family requires easy access cash for day-to-day expenses, savings for long-term goals, capital for investment and retirement, and a safety buffer for unexpected surprises like a flat tyre or broken boiler. I monitor my ‘buckets’ to ensure that I can meet my immediate needs at the same time as working towards longer-term aspirations.
Ultimately, the quarterly portfolio review helps ensure my strategy and tactical execution of that strategy are effective. It’s enables me to identify and mitigate risk but also to make the most of opportunities in the market. The key is not to undertake a tick box exercise but to take the opportunity to think critically about the portfolio and individual positions I hold, to question my thesis on each, and ensure I’ve left no stone unturned in my management approach.