International Advisory Branch
The U.S. Concentrated Portfolio -
A Practical Investment Management Approach
Jim Allworth, David Rawlings, Andrew Grimes, Portfolio Investments
Successful investors are almost always disciplined - rather than embracing the investment style in vogue at the moment, they prefer to apply time-tested criteria consistently over the long run in their pursuit of above-average returns.
History suggests there are a number of investment disciplines, which, when diligently pursued, will produce good results: value, growth, economy-driven (top down), company-driven (bottom up), and momentum - to name a few. It's the "diligently pursued" part that's harder to come by.
And nowhere is a disciplined approach more necessary than in the U.S. There, the sheer breadth of choice - from among many thousands of companies within hundreds of industries - makes it a challenge to build a portfolio of manageable size that is simultaneously focused on the best opportunity while sufficiently diversified to minimize risk.
To that end, we have developed a portfolio approach designed to incorporate our strategic thinking about the future course of the economy with our in-depth research coverage of North America's leading companies.
Keys to successful portfolio investing
Look forward - Most investors expend a great deal of energy looking backward - trying to predict the future by analyzing how well a company has carried on its business in the past. We believe superior investment results derive mostly from correctly anticipating future changes in the economy or within a specific industry or sector.
Major tidal changes such as the massive run-up in commodity prices in the '70s, the taming of inflation in the '80s, the restructuring of the North American corporate and trading economy in the early '90s, or the convergence of powerful technologies over the past several years, have all had much more to do with comparative investment performance than a simplistic dedication to owning shares in companies which have prospered in yesterday's environment.
Manage risk through diversification - An investor who was always right would only ever be invested in the one stock destined to appreciate the fastest. Diversification is the investment technique which acknowledges that even the best investors are wrong some of the time and seeks to minimize the cost of inevitable mistakes.
Incorporate a 'buy' and 'sell' discipline - Investing often entails an emotional or psychological component. Many investors only want to buy stocks which they can be enthusiastically optimistic about. Once acquired, deciding that the same stock no longer merits their affection or enthusiasm and should be sold, involves a wrenching change of emotional direction.
A useful investment discipline overcomes this weakness by establishing in advance what change of circumstance will require a stock to be sold as well as what criteria will permit it to be included in the portfolio in the first place.
Themes to invest in:
Three powerful themes describe the forces that are likely to shape the U.S. market over the next several years:
The American Age of Affluence
With real incomes rising and equity markets at or near all-time highs, Americans are more affluent today than at any point in history. The growing pervasiveness of entrepreneurialism, the recognition that technology and science can make life more productive and better, and the needs of a rapidly growing segment of the population that is both mature and longer-lived than ever before are all acting to drive consumer spending in predictable directions.
Information Revolution Wars
Several existing technologies - the personal computer, telecommunications, cable and satellite television, and the internet - are converging to lift the global economy firmly into the information age. In the information age, it is the creation, distribution, and manipulation of information that is the central wealth-creating activity.
Muted Cycle Cyclicals
As the strong North American expansion is rejoined by Asia and Europe, more economy-sensitive companies are set to prosper.
Diversification - Investment rewards tend to come from focusing on those parts of the market expected to do the best. Of course, such concentration brings with it an extra measure of risk. If you've miscalculated, or if some unexpected development hurts the prospects of the group or sector your portfolio has emphasized, then performance may suffer disproportionately.
Our portfolio uses just twelve stocks drawn from the 20-to-30 stocks which best fit the research themes outlined above. In order to make sure that we don't inadvertently add a dangerous degree of over-concentration as we shrink a 30-stock buy universe down to a 12-stock portfolio, our process requires that the final portfolio have a similar sector make-up to the larger theme-based list.
For example, the buy universe may be composed of 30 stocks distributed within the four major market sectors as follows:
| Sector Stocks |
|
| Interest-sensitive |
4 |
| Consumer |
13 |
| Industrial / technology |
11 |
| Basic materials |
2 |
We use these proportions to generate sector guidelines for our concentrated portfolio. This distribution above translates into a 12-stock portfolio that should adhere to the following:
| Sector |
Ideally... |
But no
fewer than... |
Or no
more than... |
| Interest-sensitive |
2 |
1 |
3 |
| Consumer |
5 |
4 |
6 |
| Industrial / technology |
4 |
3 |
5 |
| Basic materials |
1 |
0 |
2 |
 |
| to total |
12 |
|
|
The deciding factor - Since our objective is to have our portfolio do at least as well as the broad market, we have adopted a straightforward buy/sell discipline that improves our odds of achieving this:
- Stocks are considered for inclusion only if they are already performing better than the S&P 500 index on a trend basis; and
- Any stock already in the portfolio is sold as soon as it begins to underperform the S&P 500 on a trend basis.
Relative strength (i.e., how a stock is doing relative to the market) is a useful gauge. Studies have shown that stocks which have outperformed in the prior year do better on average in the current year than stocks which have underperformed in the earlier period. Hence the old stock market adage: "Cut your losers and let your winners run."
Our process is always weeding out those stocks which are no longer doing better than the market, and systematically replaces them with ones that are. Relative strength is a comparatively objective measure; it doesn't require someone's interpretation of earnings prospects or good news about business conditions. We've already taken those factors into consideration by limiting ourselves at the outset to only a couple of dozen companies that should enjoy a strong business outlook because they fit our view of the future expressed in the investment themes outlined above.
By using relative strength as the basis of our buy/sell discipline, we are continually adjusting the portfolio so that it contains only those stocks whose strong future prospects are being validated by better-than-average market performance.
Putting it together - Here’s how the process works:
Step #1 - Consider a buy universe made up of the 20-to-30 stocks that best fit our long-term investment themes.
Step #2 - Use the sector make-up of this list to determine how many stocks should be in each of the major market sectors in our 12-stock portfolio.
Step #3 - Eliminate all those stocks from our buy-universe that are performing worse than the S&P 500 on a trend basis.
Step #4 - Use the remaining stocks (i.e., those doing better than the index) to build a 12-stock portfolio following the sector guidelines established in Step #2.
Step #5 - At the end of each month, sell any stock in the portfolio which has fallen into a downtrend relative to the market. Keep the proceeds in cash until the beginning of the next quarter (i.e., January 1st, April 1st, July 1st, or October 1st).
Step #6 - At the beginning of each quarter, select replacements for any stocks that have been sold during the quarter by repeating steps 1 through 4.
How has it worked?
We've tested this approach by picking a number of start dates in the past and then following the step-by-step process outlined above, running each portfolio up to December of last year. As the chart below indicates, portfolios selected and managed this way have usually, but not always, done better than the market over a one-year span. Over two or more years the probability of outperformance is higher.
What does the investor get?
This process doesn't conform to the perfect model of buying individual stocks at their lows and selling them at their highs that many investors believe should be their objective. Rather it focuses on building a manageable portfolio that has a good chance of doing as well as or better than the market without taking undue risk. And it does this by systematically ensuring that the portfolio consists of twelve stocks:
-
whose business prospects are being driven by powerful,
long-term forces;
-
which are out-performing the market on a trend basis; and
-
which are adequately diversified across the major market sectors.
Jim Allworth
Dave Rawlings
Andrew Grimes
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