Introduction
One of the
distinguishing characteristics between many individual’s portfolios and those
that are professionally managed is whether the individual positions fit
together to achieve one or more specific purposes. In my own personal portfolio
is a collection of securities that came to my attention from time to time after
taking care of my professional responsibilities. As a professional whether
building a financial services individual securities portfolio or managing
accounts investing in diverse mutual funds, hedge funds, and in some cases
separate accounts, I construct individually-focused portfolios. If investing is as I believe an art
form, the professional construction of portfolios is, if anything, a higher art
form.
That great philosopher
Yogi Berra is reported to have said that “One can see a lot by observing.” In a
12 hour spread I was exposed to two examples of a collection of individual
components being selectively put together into a much more impressive and useful
result. Saturday night my wife Ruth and I attended a wonderful concert by the
New Jersey Symphony Orchestra. For their second number they beautifully played nine
selections from Sibelius’s “The Tempest” which were aided by members of The
Shakespeare Theater of New Jersey, with speeches and acting from Shakespeare’s
“The Tempest.”
The various musicians
and actors all contributed their specific talents to a sterling performance. (I
am biased as Ruth is the Co-Chair of the NJSO.) While listening to each
individually would have been pleasant, the combination of the music and the
words produced a unified experience under the skillful direction of conductor Jacques
Lacombe.
The next morning in
church, the second lesson appointed for this Sunday came from 1 Corinthians, and
dealt with God’s assembly of humans and the mutual dependence of our various
body parts, e.g., our hands, eyes, ears, etc., needed for us to function as a
complete body.
These two experiences
reinforced in me the critical need to construct and keep current portfolios
that attempt to fulfill their specific missions. I believe this is particularly
important now. This past week the S&P 500 rose to 1500, a level that has
not been seen for five years. Luckily for us as investors, the stock markets
have marched to a different tune than what was being sung or perhaps wailed by
many economists. The tradition in the marketplace is that in general,
economists and their kissing cousins central bankers, come to the market late,
and eventually exaggerate the good news that is being adequately discounted by
the market. I am not too worried about a major decline until they jump on board
as the market train pulls out of the station and urge the public to participate
in these goodies. At some point in the future this may once again happen. If
and when it does, we are likely to go through a spasm of speculation driving
first marginal company prices higher which in turn drive sounder company stock
prices higher as they would appear to be cheaper than the flying speculative
stocks. This in turn is likely to bring on a meaningful decline in stock
prices.
While I would like to
promise to our accounts that we will recognize the exact peak and pull client
money out at that time, unfortunately the only thing that I can promise (like
most of the rest of the professional investment community) is I will not identify the
peak concurrently. History suggests that the unlucky ones get out of the market
early in the decline and count their savings from large losses all the way
through the bottom and most of the way back up.
With these cyclical
thoughts in mind, my job is to construct portfolios that enjoy a good bit on
the way up, not to get too badly hurt on the decline, and reasonably fully
participate on the recovery.
There are two general
approaches to professionally constructing portfolios. The first is to subscribe
to some top-down asset allocation approach. This is usually based on either particular
economic views or historical extrapolation of past performance of various
published securities indexes. As someone who has built a large number of
individual securities and fund indexes, I can tell you they all have built-in
biases. These biases have to do with the expected size of an investor’s assets
that would be employed in investing into the index. For example, you would
construct the index differently for the 100 share buyer than the five million
share buyer. One of the biggest challenges in building an index is how and when
to update the index. Markets are continually redefining securities. The
question as to when you replace or add components can be effectively gamed by
traders. Most indexes are built by publishers to define what they believe is
the center of a specific market. They are not in the business of designing
prudent investment portfolios for various needs. Most equity indexes are based
on what the companies make, where they are located, and/or their market
capitalization weight. These slices are
not of great value to me as a bottoms-up individual stock picker as well as a
selector of funds that are similarly focused.
What do I look for?
The instruments in my orchestra are as varied as those in the NJSO. While I am not about to describe in detail my “secret sauce” of how I assemble portfolios for different needs, I will share a list of attributes that are not part of the normal asset allocation practices:
· Degree of
horizontal/vertically integrated
·
Value Added
·
Size of protected Moat
·
Direction of Operating Margins compared
to historic levels
·
Unutilized Debt Capacity
·
Does the current CEO have an expectation
of being there in 5 years?
·
Ability to be disruptive
·
Labor relations
·
Percentage of revenues devoted to pure
research
·
Percentage of revenues from acquisitions
·
Revenue, operating pre-tax income and
compensation per employee
·
Compensation ratio
·
Pricing power
·
Growth in EBITDA
·
Ownership by management and other
employees
·
History of beating internal and external
estimates
·
Percentage of revenues in net
exports
·
Size of overseas cash and balance sheets
·
List of the Top Ten owners of the stock
Each of these items
could represent the critical decision tools for the individual securities or
funds. The art form is to pick the correct metric, or if you will the music,
but not let any one type of instrument play too strongly and remove appropriate
balance to the account. Unlike a piece of classical music, portfolios need to
be updated and rebalanced periodically. (Newer interpretations of classical
music are also useful, but they are not likely to have as radical changes as
some portfolios will require.)
What are the metrics
that you use in picking funds/securities?
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