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IFB01: Optimal Portfolio Diversification for Sectors and Individual Stocks

 Investments

One of the most difficult ideas for beginners is the idea of diversification. If you read any investing publications they all talk about it. But they often don’t discuss the optimal diversification for sectors and individual stocks.  There is so much conflicting information regarding diversification. And how to set up your portfolio for maximum benefit. In this episode, we will tackle this question and much more.

 

  • How to monitors your stocks one you have purchase them?
  • How to use the Value Trap Indicator to find stocks?
  • What sources do you use to find stock ideas?
  • What is the optimal portfolio diversification for sectors and individual stocks?
  • What is the ideal number companies to own?

Welcome to our first session of Investing for Beginners where our goal is to help you become a better investor.

The idea of this podcast started with Andrew Sather, from einvestidingforbeginners.com who has and had lots of success in the blogging and podcast world, with his awesome website and blog and being a founding member of “The Money Tree Podcast”.

When Andrew first became interested in investing he looked around and noticed that there was no real voice to help beginners. There are tons of blogs and podcasts about investing but very little for the beginner. This gave him the idea of starting his own blog to help others that were just starting out. And he did just that, with his blog, podcasts and his wonderful book “The Value Trap Indicator” he has created a place that beginners can go to get premium advice to answers those questions.

He recently asked me to help him start a podcast to spread the word about what he and I are most passionate about, and that is helping others succeed in the investing world and create a better life for themselves and their families.

Our mission with this podcast is to take the time to answer questions of beginners that are just starting out or maybe someone who has been at it for a while and is frustrated with their lack of success. It is never easy and we don’t claim it ever will be. But we believe that everyone can do it,

In our first session, we will be discussing some questions from one of Andrew’s readers. His name is Mason and he just recently graduated from college and has started his new career.

He has some great thought provoking questions for us and it was a ton of fun helping answer them for him.

So here we go.

After you make your first purchase of a stock, what is your method of monitoring that stock?

Andrew: This is a great question and one of the questions that everyone asks when you buy a stock. Of course, everyone wants to sell at the top and buy at the bottom but that doesn’t always happen. One of the growth strategies out there is to buy at a high valuation and ride the stock even higher, but that is another discussion for another time.

What I do is split my portfolio into two parts. I do a regular portfolio that I allow myself to take a little more risk and put a 25% trailing stop on those positions.

For those of you not familiar with a trailing stop, it is a device that you can use to put a limit on the potential loss when a stock or the market suddenly drops. By setting the limit at 25% it allows you some buffer if the price fluctuates on a daily basis but doesn’t drop below that limit. If it does drop to that limit I can sell at that time without losing a large part of my position.

By setting the trailing stop it also allows me to continue to ride my stocks as they rise and protect any gains I’ve made and mitigate the losses if they occur.

Any brokerage account will allow you to place these for you for an additional cost but I prefer to set these stops manually. I use yahoo finance to set alerts for these trailing stops so if any stock falls into target area an email alert will be triggered so I will have a notification.

In the first part of my portfolio, I trade in a Roth IRA, which allows me some freedom from taxes. I can basically sell when I want and not worry about a tax hit from those sales. This is not the case with a regular brokerage account. I will put the trailing stop on all of my positions in the Roth IRA and ride them as long as I can.

The other part of my portfolio I call my dividend fortresses in my eletter. These are companies that have very strong fundamentals. We are looking at balance sheets, income statement, and cash flow statements. I want to see growth and a strong dividend, a strong history of growing that dividend.

I am these dividend fortresses for the long-term. If the market crashes tomorrow. I am still going to be holding these stocks, I am not looking to buy and sell these stocks for a profit. I am counting on owning this stock for 10 or 20 years. And collecting the dividends. I understand that over the years the market will rise over time. And that is how I will make money on these stocks.

Typically I reevaluate these stocks once a year, usually when the annual reports come out. The only time I will sell these stocks is when I see a red flag. Like cutting the dividend, raising the debt levels or a year of negative earnings. At that time I would sell my positions.

I won’t worry about selling at that time. Because I know the longer that I hold onto a company. The more that the value will compound and the more money I will make.

Dave: I want to tag off of what Andrew was saying. I don’t split my portfolio up into different sections. Although I think that is a great idea. As a value investor, I look at every company that I am going to buy. As a company that I am going to hold onto for a very long time.

The trailing stops are key for me to help me mitigate my losses and I also use Yahoo finance to set them manually so I can get an alert so I can make my sell decision at that time.

You have to remember that the stock market is an unusual beast and if you aren’t the kind of person that monitors your portfolio on a regular basis you could get burned really badly. Therefore I would highly recommend that you use trailing stop alerts to keep yourself protected.

Do you use any outside research to find investment ideas, other than the Value Trap Indicator?

Dave: I use the VTI numbers as a screen to help me find a company that I am interested in. I will never, never buy a company just off a screen or off of three or four numbers.

My process once I find a company I am interested in is. I will start looking at 5 years of the 10k or annual reports. I will also go back and read the earnings reports for at least two years. In addition, I am a huge fan of Seeking Alpha. And will look at the writings of people I follow and trust for their insights into the companies as well. I try to get as many different angles about the company as I can before making a decision to buy.

I do watch the news a little to give a flavor of what is going on in the market. But I avoid the “talking heads” as much as I can because mostly what they say is noise. They are paid to be loud and controversial. And their job is to make us make decisions based on our emotions. I avoid them because of this. Our job is to not make a decision. But to think and be rational. We need to make rational decisions, not emotional decisions.

That is one of the hardest parts of investing. Is keeping your emotions in check when things are going well and when things are going bad. The goal is to keep calm in rough waters.

Another thing I will do is look at industry reports for the company that I am interested in. To get a better idea of the economics of that industry. And see how my company fits into that industry.

Andrew: Well, Dave is obviously modeling his approach after one of the greats, Warren Buffett. Who spends hours of his days reading. Even to this day he spends four to five hours a day just reading. A lot of times he is reading the 10k or annual report. Which can be daunting because you pull this document up at SEC.gov. And every company files them, they have to and it can be over 100 pages. But, once you start getting comfortable with them. Maybe you start by reading some analyst reports from Seeking Alpha. And you start to get comfortable with the lingo. Then you can use that as a springboard to your success.

Personally, I am a chef who likes to eat his own cooking. So that means that all the stocks that I buy are from the Value Trap Indicator Strong Buy. That being said, what I will do is I will screen for companies just like Dave does. And after that, I will use the Strong Buy indicator from the Value Trap. Then from there I will take it one step further and look at the earnings growth.

This is an area that I feel is not talked about enough. Benjamin Graham in his book spoke about earnings growth as an aside. But he mentioned that he would look at the earnings growth for many years. I will extend that out to ten years. And you can find the numbers with the VTI, which will give you a three-year average. But you can extend that out to ten years.

In my research letter, I will look for companies that have great earnings growth. And you can find plenty of them. I have found companies with earnings growth of 17% for over ten years. A lot of these companies that grow that much continue to grow over the years.

I have done research on some of these companies that have had such great growth over the last 25 years. And it shows that these companies continue to grow over not just one, two, five years. But 10 years or more at greater than 15% growth. And that kind of compounding just gets me super excited.

Are there any ways that you look for companies to buy?

Dave: What I use is to screen is Finviz.com. And I will use numbers that I learned from Andrew’s great book “7 Steps to Understanding the Stock Market.” I will use the metrics that he talks in the book. I have read it many, many times and it has proven to be a great resource for me.

I will use those numbers as a starting point for setting my screen up. It has become a Monday morning ritual for me. I will pull up Finviz, enter the numbers from Andrew’s book. And start to filter companies that I can look at start to doing a deeper look into.

As I go through these screens I may come across great companies that are maybe not at a point where I will want to buy them currently. Either because the price is not right or the valuation is too high. What I will do with those companies is stick them in a watch list. So that I don’t forget about them but they will stay forefront in my mind.

My reasoning for setting up watch lists is to keep these companies that I have done the work to understand. But are not at a point to purchase in my view. And I will wait until they fall to the price I am looking for and then I will buy at that point.

To get back to your question, once you start to use Finviz you will start to see that the filters that you set will reduce the number of companies to look at from thousands to maybe 40 or so, depending on what is going on with the market at the time.

For example, right now the market is on an upswing and very little is struggling but a year ago or so everything was much lower and there were more opportunities. You will notice as you do this screening that certain sectors will pop up as they are beaten up by the market. Currently, you will see a lot of financials and oil companies as they have been beaten up over the last year or so.

Dividends

Is there any strategy for buying a company or companies that are Strong Buys in a sector, such as oil?

Andrew: You will see sectors come in and out of favor in the market. Oil over the last several years has lagged the rest of the bull market as it has struggled.

This is a common question as the Indicator will show several strong buys in a certain sector at one time. I don’t advise buying all five companies that show up, rather I would pick one of two that you favor.

When you buy a stock of a company you are buying into that sector. I will give you an example, a few years ago in February 2015 I recommended a stock that after I bought it went up almost 50% in a few months, there was a stock split which drove it up even more. And since then it has come back a little bit but it has still given me a nice return.

Another example I will give you when Hormel (HRL) went up recently their main competitor, Tyson Foods also saw an uptick in their stock as well.

That being said I wouldn’t worry so much about finding the best and pull your hair out trying to make a decision. Instead, I would look at the VTI is giving you a Strong Buy and go with the company you are favoring or look at using the VTI to buy low. You are using the Indicator to buy at a discount or below the companies intrinsic value, which is always part of my strategy.

My strategy will change as I am looking at buying at a discount to book value, discount to earnings or discount to sales. Having this strategy allows you change what you are looking for.

A vast number of the VTI companies will have the same look but maybe there will be one thing different about one of them, for example, one will have a much lower debt to equity ratio. Maybe one company will have a really low ratio compared to everyone else. And that company is the one that I am almost always going to take because that is the company with the lower risk.

And I will go back to earnings growth because along with the valuations you have to have earnings growth with it. As long as you see a trend or a record of earnings growth.

Again I will look at the dividend history as well. I would rather take a company that has a lower dividend, if it has a longer history of raising that dividend then I want to get in on that company.

Dave: Warren Buffett said that diversification was for the weak. And what he meant by that was he doesn’t worry about sectors he concentrates on buying the best company he can find.

When we buy a stock we are buying a piece of that company and what I think about is this a company that I want to own for a long time. The question you should ask yourself, is this a company I would want my family to own for 100 years.

As you look at the oil industry, there are lots of great companies out there and with the sector being beaten up the last few years there were some great prices then but as the price of oil has started to rise over the last six months the prices have risen along with it. And maybe the valuations are crept up as well and the prices are little higher than they were a little bit ago.

Another idea I want to tack onto is the idea of dividends and debt to equity ratio. One of the companies that I have looked at is Chevron. They have been paying a dividend for about a 100 years or so. Not really that long buy quite a long time. But because they have been struggling lately they have been borrowing money to pay that dividend. And the trouble with that is that as the interest rates start to creep back up that money they borrowed becomes much more expensive. This eats into their earnings and growth that Andrew was speaking about.

This is an aspect that is not talked about a lot. And is one of the things that you can discover as you dig into the companies more.

As you try to decide which company is the best for you. Is that any company that is coming up as a Strong Buy in the Indicator is going to be a good choice. And you won’t go wrong. You need to remember that investing is a game. If you make a mistake then sell the company and move on. It’s not worth getting an ulcer from.

What is the optimal portfolio diversification across sectors and individual stocks?

Andrew: I am going to take my bone and chew it across the floor with the comment that diversification is for the weak.

I don’t agree with that at all. I know a lot of value investors hold true to that and I know it works for a lot of them.

Personally, I want to stay diversified. I am not so irrationally confident and humble enough to understand that you can find great companies at a great price. You can put too much percentage into one or two can really hurt you in the long run.

My whole strategy is limiting the losses. And that is how you are going to win in the long run. Diversification is a great way to do it.

I do want to be diversified across sectors, I don’t want to have ten oil stocks or 50% of my portfolio. I want to have a group of stocks that do well when the economy is doing well. And I want to have a group of stocks that do well no matter what the economy is doing.

For example take a look at tobacco, people are going to smoke when they are unemployed. Or if they are at a party. But you take the retail world. And people are only going to go shopping when they have money falling out of their pockets.

That being said I also disagree with the idea that you need to hit every sector. As we discussed earlier, different sectors will become more attractive and less attractive based on where the price goes. And how the market treats them. So you want to get into a sector when the individual stock is cheap. Not just because you want to increase exposure to that sector.

Stay away from what is hip and trendy. Those stocks have historically done very badly. And I stay away from them. Look at the internet stocks in the 2000s and railroads when they first came on the scene.

As we always talk about the numbers. This helps you avoid falling into those traps because the numbers will help you stay away from these stocks.

Dave: I will not buy a stock just to buy a stock in a sector. I agree with Andrew about not having ten oil stocks, or ten bank stocks. I don’t have a checklist of sectors and will buy a tech stock just to tick off the tech sector on my list.

What I try to do is look at the companies that are being presented to me at that time and will make my decision at that time.

The thing we have to remember about the market is that in the short-term it is a voting machine and in the long run it is a weighing machine.

You have to realize that what is hot and trendy is usually not going to last or stay that way. The way you make money in the market is looking at the boring companies. Like Coke, American Express, Johnson and Johnson. That is where the money has been made over the long haul.

We have to remember that diversification has to be such. That we are not buying companies just to plug them into a sector, so we have that sector. Diversification is a tool to use to avoid loss.

Is there any limit or amount of companies you should own in your portfolio?

Andrew: When I launched my eletter a few years ago I was starting at the ground zero and working my way up from there. And I was personally contributing my life savings to this and I had a limited amount of capital. You will need to build up the diversification over time.

As you are starting out the first year you can start to build a groundwork for diversification. When I first started out every month I took my money and bought one stock every month. And then eventually I branched out and bought my second stock.

Now after three years. I am approaching the point where I want to make sure I am not over diversified.

My diversification target is 15 to 20 stocks. I am somewhere in the middle between the hardcore Value Investing side. That says you should hold 10 stocks and watch that basket closely and the other end is saying you should hold hundreds of stocks. That is just too much for me.

There are studies that show that your risk lowers as each position you add. And it kind of plateaus out at around 20 to 25 stocks. Once you reach that level your risk doesn’t continue to lower at all.  

In fact, as you go over that number your returns will suffer. As you increase your positions your ability to beat the market actually decreases. So if your goal is to beat the market you need to stay in the 20 to 25 positions range.

I don’t personally weight my positions 5% across my portfolio but you can do that and I have no problem with that. I tend to favor my dividend fortresses more and they are a bigger proportion of my portfolio than the others.

Dave: I also have a goal to be at 15 to 20 stocks as well. When I started out I was not flush with cash so I had to start small with one company and then gradually built it up over time.

Dollar cost averaging is something that can work and it is a good tool to use. There are studies that have shown that it can have some advantages but it is not a panacea and it is not perfect. It can help even out some of the rough patches in our investments.

One of the reasons I try to stick to that limit of companies is that I realize I am not smart enough to keep track of more than that. I am not Warren Buffett or Monish Pabrai and I can’t keep track of as much as they can.

If I own 50 to 100 companies, it is just too much for me to keep track of all those financials. When I read through those financials and try to keep up with all the information it takes me a long time to do that. So, for me a portfolio of 15 to 20 is doable. It falls into my circle of competence and is something I can be comfortable with.
When I buy these companies, I look at them as friends that I am hopefully going to be friends with for a very long time. And I would rather have a small group of friends that I can rely on. It is just an easier way to go for me.