Sunday, January 27, 2013

Portfolio Construction: An Art or Accident?


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.

How to do it?

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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