Over the last ten years or so my investment approach has moved steadily towards higher quality companies, yet hopefully still purchased at attractive valuations.
This takes quite a bit more time because I have to analyse companies in more detail, but for me this is the right decision as I prefer investing in successful businesses which align with my Quality Defensive Value criteria.
However, during the pandemic I found that researching potential new holdings for the UK Value Investor portfolio, as well as keeping up to date with its existing 34 holdings, was taking more time than I had available.
I didn’t want to shrink the amount of research I was doing per company, so the obvious solution was to reduce the number of holdings. But reduce it to what?
To answer that we’ll need to look at the following points:
What is the theoretically optimal number of stocks to own?
If 34 holdings is too many, at least for me, what is the optimal number?
Before I even begin to answer that, let’s stop and think about why investors hold multiple stocks in the first place. In other words, why don’t investors just invest all their money in one company?
The answer is that most active investors understand that the future is uncertain and that they are not all-knowing. Their favourite company could do the unexpected and perform badly or even go bust if we run into, say, a global pandemic.
So putting 100% of your money into one company is generally a bad idea. But what about two companies, or three, or ten?
To get the ball rolling, here’s a quote from the legacy version of Morningstar’s Investment Classroom:
“if you own about 12 to 18 stocks, you have obtained more than 90% of the benefits of diversification, assuming you own an equally weighted portfolio.”Morningstar Investing Classroom: Constructing a portfolio
If you poke around the web you’ll find lots of similar quotes. That’s because this 90% diversification from 12 to 18 holdings idea comes from the book, Investment Analysis and Portfolio Management.
However, some academics argue that the 12 to 18 figure is wrong and that a portfolio needs 50 or even 100 holdings to be sufficiently diversified.
In short, there seems to be nothing like an academic consensus on the optimal number of holdings.
Also, even if holding 50 to 100 stocks was academically optimal, it isn’t practical if you’re doing detailed company-specific research, so a better question would be:
What is a practical number of holdings for a portfolio of quality companies managed by a single individual?
Since this is a practical question, let’s see what a real world practitioner has to say:
“If I were running 50, 100, 200 million [dollars], I would have 80% in 5 positions, with 25% for the largest. In 1964 I found a position I was willing to go heavier into, up to 40%.”Warren Buffett
Having 80% invested in five companies and 25% in one company may be okay for Warren Buffett, but that’s definitely too concentrated for me and most other non-genius investors.
However, there is a tendency among some of the best quality value investors to hold very concentrated portfolios. Here’s a quote from Lou Simpson, ex-Chief Investment Officer of Berkshire Hathaway-owned GEIKO:
“What we do is run a long-time-horizon portfolio comprised of ten to fifteen stocks. Most of them are U.S.-based, and they all have similar characteristics. Basically, they’re good businesses. They have a high return on capital, consistently good returns, and they’re run by leaders who want to create long-term value for shareholders”Lou Simpson
So Buffett is happy with five holdings, Simpson likes 10 to 15 and Morningstar suggests 12 to 18 holdings for a “fat pitch portfolio“.
Those are generally regarded as very concentrated portfolios. The more mainstream view is that most stock pickers should have something in the region of 20 to 30 holdings.
A reasonable compromise would be to start off with 20 to 30 holdings and, as experience is gained and skill developed, that number could be brought down to something below 20 if it makes sense to do so.
In my case I’m starting off with 34 holdings today, so I think the middle of that 20 to 30 range is a reasonable initial target as I already have more than a decade of experience (how much skill I have is more debatable).
So here’s my goal for 2021:
- I will reduce the number of holdings in my portfolio from 34 today to around 25 by the end of 2021
That’s almost ten fewer holdings which should definitely free up some of my time.
Some of that time will be spent writing blog posts and the next edition of my book, but some will also be spent doing more detailed analyses of potential and existing holdings.
Or as Morningstar puts it:
“When you own too many companies, it becomes nearly impossible to know your companies really well. Instead of having a competitive insight, you begin to run the risk of missing things. You may miss something important in the [financial results], skip on investigating the firm’s second competitor, and so on. When you lose your focus and move outside your circle of competence, you lose your competitive advantage as an investor.”Morningstar Investing Classroom: Constructing a portfolio
So having fewer holdings should hopefully mean better quality research and better investment decisions.
Another benefit of having fewer holdings is that it helps you focus on the highest quality companies at the most attractive prices whilst minimising drag from lower quality companies at less attractive prices.
Here’s Buffett on this point:
“I cannot understand why [an intelligent and informed investor] elects to put money into a business that is his 20th favorite rather than simply adding that money to his top choices — the businesses he understands best and that present the least risk, along with the greatest profit potential.”Warren Buffett
That makes a lot of sense and if you’re pruning your portfolio it leads to an important question:
Which stocks should you hold onto and which ones should you sell?
The obvious answer is that you should hold onto the best stocks and get rid of the worst. In my case best and worst are based on my Quality Defensive Value framework, and both quality and value are effectively non-negotiable necessities.
This website is called UK Value Investor, so why do I insist on quality as well as value?
The answer is that, in my experience, high quality companies tend to perform better, as long as the purchase price is sensible.
For example, I launched the UK Value Investor model portfolio in 2011. Since then a total of 81 companies have joined the portfolio, 47 have been sold or taken over and that leaves 34 in the portfolio today.
Of those 81 companies, 42 were quality companies according to my Quality Defensive Value criteria. The remaining 39 companies were mostly purchased years ago when I was less focused on quality.
The point is there’s a fairly even split between quality companies and non-quality companies in that list of 81 investments.
But if we look at the best and worst performers, that even split disappears.
Seven out of 81 investments produced a loss of more than 50%. Of those seven, six were low quality companies, so low quality companies have made up a disproportionate number of my biggest losers.
At the other end of the scale, 20 investments produced gains of more than 50%. Of those 20, 14 were quality companies, so quality companies have made up a disproportionate number of my biggest winners.
Looking at my portfolio’s five best and worst performers tells the same story, but to an even greater extent:
- Four of my five worst performers were low quality companies
- Four of my five top performers were high quality companies
Even I am smart enough to spot a pattern here, and that’s why I think focusing on a smaller number of higher quality companies is a good idea.
Okay, here’s a summary of the main points so far:
- Owning fewer companies allows more time to be spent doing more thorough research of potential and existing holdings
- Owning fewer companies means that more money can be invested into the highest quality best value companies with the highest expected returns
- Most quality value investors should own 20 to 30 stocks, while experienced and skilled investors may want to concentrate on as few as 10 to 20 companies
The point about investing more in the best holdings is important, so here’s another question:
How much should you invest in each company?
The size of each investment, usually called its position size, is actually a more fundamental factor than the number of holdings.
After all, you could have 100 holdings, but if 90% of your portfolio is in one company then that isn’t very diverse.
In my case my portfolio has 34 holdings, so the average position size is about 3%. But that average hides the fact that my largest position is 5% while the smallest is barely 0.5%.
This raises yet more questions:
What is the maximum amount you should have invested in one company?
This depends on your risk tolerance, your confidence in your skill as an investor, as well as the potential risks and rewards of specific investments. In other words, it will vary from one investor to another and from one investment to another.
In my case, to keep things simple I tend to start investments off with an equal weighting. With 34 holdings that means putting around 3% into any new holdings, although to some extent this depends on how much cash is available within the portfolio to reinvest.
With my new target of 25 holdings (or thereabouts), the average position size will be 4% or so, which isn’t massively different from what I have today.
However, share prices go up and down, so even if the average position size is 4%, it’s likely that few or perhaps none of the holdings will be exactly 4% of the portfolio. Some will grow larger and some will shrink as their share prices go up and down.
At some point you may find that an investment has grown too large. At that point it’s a good idea to rebalance or trim the holding back to something more appropriate.
In my case, my maximum position size rule is:
- If an investment exceeds double the average position size, rebalance it by selling half
With my current 34 holdings the average position is 3%, so if any investment exceeds 6% I’ll rebalance it. The proceeds are then reinvested into new holdings at a later date.
With my new target of 25 holdings the average position size will be 4%, so using the same rule would give a maximum position size and rebalancing trigger of 8%.
Another way to think about how much money you have invested in a company is to think about the actual cash amount invested, rather than the current value of the investment. In other words:
What is the maximum amount of hard cash you should invest in a company?
As a value investor I’m willing to top up investments where the price has fallen, as long as the company’s prospects still seem to be good over the medium to long-term.
However, if a company’s shares keep going down in value, and if you keep topping the investment back up, then at some point you can have far too much cash invested in that one company.
I did this many years ago and ended up watching a big chunk of my portfolio go to zero because I’d repeatedly topped up a position as the share price fell, fell and fell again, all the way to zero.
So I have another rule:
- Don’t invest more cash into a company than twice the default position size
Most brokerage accounts show you how much cash you’ve invested in a company as well as the overall value of your portfolio, so this is easy to work out.
While maximum investment amounts are the obvious ones to think about, it’s also worth spending some time thinking about minimum position sizes. In other words:
What is the minimum amount you should have invested in a company?
This may seem like an odd question. What does it matter if a position is “too small”?
But it does matter.
It matters because you have to spend time reviewing the company and keeping up to date with its evolving situation, and that takes the same amount of time whether the company is 5% or 0.5% of your portfolio.
Why would anyone want to spend hours and hours staying abreast of a company’s situation, reading reports and articles or watching presentations, if the investment is so small that it barely has any impact on the portfolio’s overall results?
After all, if one of your holdings doubles in a year then that’s great, but if that takes it from 1% to 2% of your portfolio then a) who cares and b) think how much more you could have made if the investment was 5% of the portfolio.
This is something which has definitely affected me in 2020. For example, here’s a chart showing the position sizes for all of the holdings in my model portfolio:
There’s a smooth decline in position size from 5% down to 2%, but then there’s a big drop off to four companies where the position size is less than 0.5% each.
Three of those four holdings are already on my sell list. In fact, they’re only in the portfolio so I can learn more about their problems (unsurprisingly, all of these tiny holdings have had serious problems).
Holding onto companies to learn more about what went wrong is fine, but only so far. At some point the bulk of the lessons should have been learned, and spending time following companies that are not appropriate for your portfolio is time that could be better spent elsewhere.
So expect to see post-sale reviews of three of these small positions in the near future.
The remaining tiny holding is Mitie, which I’ve owned for almost a decade.
Mitie is a borderline case. It has the potential to be a Quality Defensive Value investment, but it has to successfully pull off the turnaround its been working through for the last five years or so.
So what should I do? Should I sell Mitie as it doesn’t already meet my quality criteria, or should I hold on in case the turnaround works out well?
I think a good way to answer that is to ask another question:
Would you feel comfortable topping up a small investment to the default position size?
In other words, if I’m not comfortable with Mitie as 4% or 5% of my portfolio, then it shouldn’t be in the portfolio at all.
More generally, I think this is a good way to manage smaller holdings.
If you wouldn’t top a position up to the default position size, then what is it doing in the portfolio?
This leads to a simple rule on minimum position sizes to balance out the rule on maximum position sizes:
- When an investment falls to less than half the default size that investment should either be a) topped up to the default size or b) sold
This should produce a portfolio where all holdings pull their weight, all are important and none are inconsequential.
While these rules cover what to do when a position grows very large or very small, they don’t say much about what to do in less clear-cut situations where a position seems a bit too large or small relative to its attractiveness.
So here are a few thoughts on:
The benefits of active versus passive position sizing
Historically I have used a passive position sizing strategy. In other words, I didn’t adjust position sizes on a per holding basis.
Instead, all new investments began at something close to the average position size, depending on how much cash was available. After that, position size was driven by share price gains or losses rather than any active decision on my part.
This is similar to the passive position sizing approach used by indices such as the FTSE 100 and 250 (and the passive funds that track them).
It’s okay up to a point, but if you’re managing a concentrated portfolio of quality stocks I think there’s a better way: active position sizing.
With active position sizing you deliberately choose how much to invest in each specific company. In other words:
- Above average holdings have above average position sizes
- e.g. 6% to 8% in my case
- Average holdings have average position sizes
- e.g. 4% to 6% in my case
- Below average holdings have below average position sizes
- e.g. 2% to 4% in my case
In my case, above average holdings are those that combine quality with defensiveness and value. Average means holdings that combine quality or defensiveness with value. And below average means holdings that have only one or none of those quality defensive value attributes.
Here are a couple of quick examples:
You scan the market and find an exceptional business generating consistent double digit growth and returns on capital (a Quality company), operating in the energy supply market (a Defensive market) with a 5% dividend yield (offering good Value). You decide to buy the company and allocate 5% of the portfolio to it, which is more than your average position size of 4%.
Alternatively, what if one of your best holdings runs into minor problems which cause its share price to halve. It might go from 5% of your portfolio to 2.5%. Does it make sense to have just 2.5% invested in one of your best holdings? You decide that it doesn’t, so you top it back up to 5% (as long as that doesn’t break the rule about investing too much cash into one company).
In an ideal world it would be possible to do this with millimetre precision, adjusting each holding to precisely the “correct” weighting.
In the real world this just isn’t possible or practical, because a) the future is uncertain and b) adjusting position sizes will generate costs from stamp duty and broker fees, and if the adjustments are too small the fees will more than offset any potential benefits.
More realistically, it only makes sense to actively adjust position sizes when the adjustment is over a certain size, say adjustments of at least £1,000 and at least 1% of the portfolio (e.g. adjusting a holding from 3% to 4%).
Also, it would be a bad idea to do this every day as it would likely lead to excessive broker fees dragging down returns.
Instead, my preferred approach is to limit purchases, sales or rebalancing adjustments to no more than one or two per month. In other words:
Make regular but infrequent adjustments to improve the portfolio
My old approach to portfolio management was to almost always make one trade per month, typically alternating between selling a holding one month and buying a replacement the following month.
This one-trade-per-month approach stops me from overtrading or getting bored from inactivity, and I’ve been doing it for over a decade.
The idea is to nudge the portfolio towards higher quality companies at better value prices, while taking profits from more expensive holdings or removing weak holdings.
However, alternating between buying and selling does have limitations as there isn’t always something I particularly want to buy or sell in any given month.
In short, I think a more flexible approach would be better.
I still like the rhythm of concentrating on one main investment decision each month, but that decision should be based on this question:
How can I tweak the portfolio to make it better?
If you ask yourself this question once each month, and if you’re building a concentrated portfolio of quality companies with active position sizing, then you’ll probably get one or more of these answers:
- Remove an existing holding that is expensive or low quality
- Add a new holding which is high quality and attractively valued
- Trim back a holding which is oversized for its attractiveness
- Top up a holding which is undersized for its attractiveness
- Do nothing. The portfolio is near perfect.
These actions can be combined in various ways, so a typical month might include one of the following:
- Selling an existing holding and leaving the proceeds in cash
- Buying a new holding using the existing cash buffer
- Selling a holding to fund the immediate purchase of a more attractive replacement
- Trimming back one or two overweight holdings to fund the purchase of a new holding
- Trimming back an overweight holding to top up an underweight holding
- Trimming back an overweight holding and leaving the proceeds in cash
- Topping up an underweight holding from cash
- Doing nothing if there are no obvious improvements to make
A simple way to start these decisions would be to list all your holdings each month along with their position size and a score for how much you like the stock.
In my case I’m trying out a simple system where stocks are given a score of 0, 1, 2 or 3, based on how many of the Quality Defensive Value attributes they have (zero is bad, three is excellent).
Sort the list by position size and you’ll quickly see any anomalies, such as an excellent investment with a small position size (a candidate for topping up) or a weak stock with a large position size (a candidate for trimming back or closing down).
This may seem like a lot of work, but if you limit yourself to one or two trades each month then I think this should be relatively easy to implement.
The goal of these adjustments is that the portfolio should be weighted towards quality defensive value stocks and away from expensive, cyclical junk.
Building a more concentrated portfolio of higher quality better value companies
So there we have it. There is some anecdotal evidence that investors who are focused on high quality companies should run a relatively concentrated portfolio of 20 to 30 companies. And if they really know what they’re doing, perhaps 10 to 20 companies.
In addition, concentrated investors often use active position sizing to tilt their portfolios towards the best holdings with the best expected risk-adjusted returns.
This idea of running a concentrated portfolio makes a lot of sense, and is based on these fundamental assumptions:
- Owning fewer companies allows more time to be spent doing higher quality research per company, hopefully resulting in better investment decisions and better results
- Owning fewer companies allows the portfolio to be more heavily invested in the highest quality companies at the most attractive prices with the best expected returns
I’m going to start this journey towards running a more concentrated portfolio of higher quality better value companies by pruning my holdings back from 34 to 25 or so by the end of 2021.
Who knows; if that goes well, perhaps I’ll be down to 20 by the end of 2022.
The proceeds from these sales are likely to be reinvested back into the portfolio highest quality, most defensive, best value holdings.
Feel free to share your thoughts on position sizing, number of holdings and so on in the comments below.
Mark Hull says
I had been thinking that my time with you had come to a natural end, as our investment decisions have been diverging over the last three year since retiring and my priority switched more income based investments. However, I really welcome the decision to rebalance the portfolio to around 25 holdings, while allowing individual holdings to rise to as much as 8% before top slicing.
I do have concerns over the largest two sectors Retail and Support Services, personally not keen and hence hold neither. Still, very happy with where your insight and stock screen have taken my portfolio up 92% since 2014, looking forward to the rebalancing over the next year or two.
Merry Christmas John.
John Kingham says
Hi Mark, Merry Christmas.
I’m glad to see your portfolio has done well over the last few years. I also think the model portfolio should evolve towards your tastes as I’ll be rebalancing out of the smaller lower quality holdings and topping up the higher quality and higher yielding holdings.
Jonathan Merrick says
After email correspondence with you I, of course, received a sneak preview of some of the new features you are introducing to operation of the portfolio. However, I have enjoyed reading the above article explaining the new modus operandi in much more detail.
I have greatly enjoyed subscribing to your Newsletter over the years. Perhaps the one aspect of the way the portfolio was run that did not always chime for me was the rigid monthly one in one out . The one trade a month I loved but having to buy and sell alternately, although not usually a problem, did not always sit well with gyrations in the market. So the new system really answers my prayers!
Moreover, I like your comment that a share worth only 0.5% of the portfolio is not worth the time and hassle. Best to get rid and move to a leaner fitter portfolio! Looking forward to how the portfolio shapes up in 2021. Happy Christmas to you!
John Kingham says
Hi Jonathan, I agree.
I set up the old alternating monthly buy/sell routine to give structure to the portfolio management process. However, as you point out, buying or selling in a given month wasn’t always the best thing to do, and this year it became clear that this self imposed restriction was doing more harm than good.
One trade per month, or thereabouts, will remain, but now the trade will be whatever I think is best to position the model portfolio for future returns.
I think the big change is that existing holdings will be topped up and trimmed back depending on how attractive I think they are. The idea is that:
1) above average holdings (i.e. above average number of Quality Defensive Value attributes) should have above average weights
2) average holdings should have roughly average weights;
3) below average holdings should have below average weights (or be sold)
Also, new companies should only join the portfolio if they’re better than what’s available within the portfolio. And if there’s nothing attractive outside the portfolio, cash from dividends or rebalancing will be reinvested into existing holdings (I’ll probably do a one-page review of any rebalancing decisions).
And yes, tiny holdings below 1% or even 2% will either be topped up or sold, so expect to see the portfolio’s smallest holdings exiting stage left over the next few months.
In principle I agree, but so far I have been unable to bite the bullet and sell.
I have the same issue with 4-5 shares out of 35 that are worth £500-800 having lost 70% of their value. The problem is I keep waiting for a recovery,. WIll they improve after Covid? although some were doing badly before Covid. One, TED BAKER, fell so low I concluded I may as well keep as sell, as can do very little with small sum raised.
Anyway all the best to you for 2021
John Kingham says
I tend to be the same. I’m reluctant to sell losers because a) I don’t like to lock in the loss (I know that’s irrational but hey, I’m human), b) I like to see how turnarounds work out so I can learn more about those situations.
This would be fine if there was no downside, but there are downsides.
1) Holding on to these tiny positions means I have to commit mental and emotional energy to them, and those finite assets could be better allocate elsewhere (looking for winners rather watching losers).
2) “waiting for a recovery” is the sort of thing that can turn an investor into a speculator. You just sort of sit there with your fingers crossed “hoping” for things to get better, but hope is not a strategy.
3) If a 0.5% position grows by 400% then it will give you a 2% gain in your portfolio. What’s the point of that? Hence my question about topping up to the average position size. If I’m not confident enough in a holding for it to be 4% or 5% of the portfolio, then what is it even doing there?
So I’m going to be selling a lot of these small weak holdings so that I can allocate more of my time, energy and capital to what I think are the best holdings rather than the weakest.
Bob Barnacle says
This IMVHO is the flaw :-
“Owning fewer companies allows more time to be spent doing higher quality research per company, hopefully resulting in better investment decisions and better results”
We can never know fully what is happening in any particular company, or what may happen in the future.
Diversification rather than concentration, is the imperfect answer to an imperfect situation.
“If significant risk exists in a single transaction,
overall risk should be reduced by making the purchase,
one of many mutually independent commitments.”
WB (conflicting quote as are many of WB’s)
Prefer like Graham to hold 50 plus stocks.
Thoroughly research for long-term criteria at the outset, then let events and surprises take their course, while rebalancing back to equal-weight centred bands, providing those long-term valuation measures remain within reason.
If the long-term fundamentals do change, then accept, adapt or switch horses.
So possibly a low conviction investor ?
The article raises so many questions on a subject that should concern all investors that have yet to fully digest and reflect.
Thank you for raising the subject. Will read many times more..
This just a first knee-jerk reaction.
All the best for the new year.
John Kingham says
Broad diversification has very much been my approach through most of my time as an investor, so I agree with your point that it’s a very useful tool and is probably the way to go for most investors.
I think diversification across many holdings (30+) makes sense when you’re using a predominantly quantitative strategy, like index tracking or Magic Formula or Ben Graham’s Net Net approach.
Once you start looking at each individual company in more detail, and once you have a few dozen investments under your belt so you at least have some idea what you’re doing, then I think concentration is probably the way to go, regardless of whether you’re focused on quality, value or whatever.
And I definitely agree with Graham’s point that we can’t know everything. I think he said (paraphrasing) don’t try to count every last bathtub coming out of the factory as it won’t help you know where the business is going to be in five or ten years. Even so, I do think it’s possible to differentiate between mediocre companies and excellent companies, and between fair prices and bargain prices, with some inevitable blunders and bad luck along the way. And then, based on that, to set position sizes accordingly.
As you say, regardless of whether someone decides to hold 50 stocks or 5, it’s a topic worth thinking about.
Happy New Year (or at least a less rubbish one).
The only thing I would like to add is to consider the time length to construct such portfolio. In theory if an investor was aiming for 20+ portfolio of quality companies they have two realistic option:
1. If they wish to invest all of their capital immediately into 20 holdings then the only thing they can do is be prepared to hold it indefinitely because chances are they will be over paying for some companies and only over time will they generate a decent return.
2. Invest over a 5 year period and add a position when stock trails behind historical PE ratio. I think this is what stumped me for 3 years. Since I was looking for PE ratio of less than 15! Now I realise that for a quality company with minimal debt a higher PE ratio is not unreasonable.
Warren Buffett approach was similar to how Alexander the Great tackled the Gordian knot. Buffett didn’t want to over pay or wait for years to build a quality portfolio hence we was prepared to take a very concentrated approach.
John Kingham says
I think Buffett’s approach if he was running a few million would be to allocate capital as and when opportunities arose. But because his demands for returns are so high there aren’t many opportunities, so he bets big when he finds something he likes.
With Berkshire it’s different because it forces him to break this approach to some extent. It’s so huge that many of the best opportunities aren’t large enough for him to bother with (an investment with a 100% annual return is a waste of time if you can only allocate 1 million out of a 100 billion fund).
I agree also on another note I’ve switched to tracking the performance of my portfolio against FTSE All Share index rather than S&P 500. I think the recent inclusion of Tesla and the general over reliance of S&P 500 on FAANG + Microsoft stocks makes it difficult to make a like for like comparison. Whilst the FTSE All Share Index performance is driven by a wider range of stocks. Interestingly I’ve read that without the tech stock the S&P 500 would have been underperforming the last few years.
John Kingham says
I think benchmarks should be based on their relevance to the portfolio being benchmarked. So my portfolio is 100% in FTSE All-Share stocks, so that’s my benchmark.
If a portfolio is mostly allocated to S&P 500 then that should be its benchmark. If it’s from a mix of different exchanges (LSE, NYSE etc) then perhaps a global equity tracker makes the most sense (and if there are bonds or other asset classes then perhaps a Vanguard LifeStrategy fund should be the benchmark).
You should consider writing a post on benchmarking and index tracking for future. Personally I think its an equally important element of investing to competently judge your own performance.
In my own case the main indicator for my portfolio is TSR. As a result I benchmark companies in my portfolio against similar companies both based on market returns and returns generated internally via KPI. I think for a buy and hold investor TSR is a pretty nifty tool.
S&P 500 would fail on my KPI parameters because gains are attributed to inflated PE ratio rather than actual improvement in earnings per share. In fact if you look at outlooks
posted by many company managers the forecasts of the managers do not correlate to valuations. The only reason I can put forward for the performance of S&P 500 index this year is the intervention of Federal Reserve. This is something really to be mindful of since if your portfolio is buoyed by market sentiments rather than returns generated by the company it can easily dissipate at a moments notice.
I guess my mentality is similar to the German Mittelstand because long term return is dependent on the profitability of the company. A company should internally generate returns for its owner and by default will eventually gain a premium on the market.
John Kingham says
Benchmarking is an interesting topic. I try to keep mine simple and I have two separate benchmarks:
1) Beat a FTSE All-Share tracker on a total return basis. For me this is a sensible benchmark because all my holdings are in the FTSE All-Share and are fairly evenly spread between between large, mid and small cap. Ultimately, if I can’t beat the All-Share over ten years then I’d be better off as a passive investor (although that is infinitely more dull).
2) Exceed a 10% annualised total return over a suitably long timeframe (at least ten years). This is a level of performance I think is achievable as an income and growth investor and is likely to be considerably better than the general stock market’s performance over the longer-term. (UK market typically returns about 7% annualised over the long-term).
Of course, these gains should be reflected in dividend growth as well as price appreciation, otherwise those gains could be driven by optimistic sentiment rather than actual growth in the underlying companies and their ability to generate cold hard cash.
Steve Kirk says
A very obvious way to diversify is to have more than one portfolio.
I have my Defensive Value portfolio that I manage pretty much along the same lines as you do but with my SIPP I invest through global funds and ETFs. That gives me much more diversification than holding individual shares and also allows me access to non-UK markets where I wouldn’t have the experience and knowledge to pick individual shares.
It’s a different, low maintenance approach as I only rebalance once a year and check I’ve not bought any real clunkers but I have to say it’s outperformed my UK value portfolio significantly in the last five years! That’s partly due to my inexperience as an active investor (I cringe when I look back at some of the value traps I’ve invested in over the years) but partly inevitable when you look at how the US marlet for example has performed.
Anyway, now I have a more defensive portfolio of about 20 shares that I am more comfortable with and however they perform in the next few years, I’m even more comfortable that my SIPP will tick along in the background.
Maybe I’m stating the bleedin’ obvious but having more than one portfolio, and managing them in a different way, certainly works for me
Happy New Year
John Kingham says
Hi Steve, I think that’s how most people do it to be honest. I’ve had a chat with various people over the years and very few have 100% invested in individual stocks.
Even my family and I have some money in funds, either Vanguard Lifestrategy funds or the manual equivalent, i.e. split between global stock trackers and global bond trackers.
We’re probably 30% in global funds which is more than I’d like, but as you say the global market has done well in recent years thanks to the US bull/bubble.
The remaining 70% is invested in the same stocks as the UKVI model portfolio, and that’s also where any new savings go. Hopefully in the long run these stocks will materially outperform the passive trackers.
Most people I speak to have something around 50/50 between funds of various sorts and individual shares, probably because they don’t fell confident enough to go all in on stock picking. And basically I agree with that and I think something like that is the way to go for investors who want to invest directly in companies.
Steve Kirk says
Interesting to hear how you split your investments between the UKVI portfolio and your funds. My split is probably the reverse of yours i.e. 70% managed funds and 30% UK stock selection although I didn’t set out particularly with this in mind. Rather it’s a function of the managed funds outperforming my UK share portfolio for the reasons above.
It’s an important point as it’s the only reason I’m happy with a concentrated portfolio of 20 UK shares. If my split was in line with yours I’d definitely go with your 25+ shares. I think it’s worth making the point in future posts that the assumption is, say, a 50/50 split with other investments just to be very clear.
By the way, I’ve also implemented a rule to sell shares below £1000 in value for the same reasons you say. They are never going to get back to what I paid originally and not worth the effort of keeping them so better to recycle into another purchase. So ‘adios’ to Mitie and John Menzies!
John Kingham says
It’s really about position size at the end of the day and what you’re comfortable with in a single company. For example:
If I was 100% in individual stocks (which I would were it not for pesky things like corporate pensions) then an average position size target of 5% would give 20 holdings (and perhaps a maximum position size of 10% before rebalancing).
If I was 50% in a global tracker and 50% in individual stocks, then I might hold just 10 companies, but still with that 5% average position size.
To keep things simple on this site and in my investments I just work on the assumption that the portfolio is 100% in individual stocks. In reality I have some money in funds, but I’m not really interested in those and at some point I’d like to sell out of those funds and move the money into my shares accounts.
Nicholas Kellagher says
An interesting post – and good to see that you have graduated to focusing on higher quality companies and reducing the size of your portfolio to increase the impact of individual holdings and improve the quality of time spent on review.
As you know, I gave up on the UK market some time ago and focus on global and US funds/ITs as that is where I perceive the long term growth to be.
Company diversification is achieved through using funds rather than companies, but in practice there is considerable overlap in the holdings.
As for review, I download the factsheets for the funds from trust net on a monthly basis and check their quartile position of a number of time periods; those funds/ITs consistently in the lower quartile rankings are sold and the proceeds invested in the highest ranking funds at that time, after review of the holdings.
I appreciate that this is a long way from the way that you invest, but over time, I have grown to appreciate the sayings of Terry Smith and Warren Buffett that it is better to buy a wonderful business at a fair price, rather than a fair business at a wonderful price
Those businesses with high returns on capital and competitive advantage will generate far more return over the long term, than less attractive businesses, even if you have to pay what looks to be a full price initially.
Your new forecast model will probably help to support that conclusion as well.
John Kingham says
“Those businesses with high returns on capital and competitive advantage will generate far more return over the long term, than less attractive businesses, even if you have to pay what looks to be a full price initially.”
That’s definitely the direction I’ve gone in over the last couple of years.
In terms of valuation, I’m quite happy to pay “what looks to be a full price” if that means paying a relatively high PE or getting a relatively low dividend yield, because those metrics are largely irrelevant.
What matters is that the price looks to be cheap relative to the company’s intrinsic value according to a conservative but realistic discounted dividend model.