This is the last of a three-part posting on portfolio construction. The first explained general decisions, what financial professionals refer to as asset allocation. The second in the series focused on bond holdings. Here I focus on stocks.
Good diversification is the first consideration. Your portfolio ought to hold stocks from many types of businesses. In that way, unexpected disruptions in one sector of the economy will not hurt your overall wealth too much, while at the same time, you will gain by having holdings in an industry that experiences unexpected good fortune. A fully diversified portfolio would hold stocks in industries in proportion to the economy’s overall industrial mix or, more conveniently, the mix of a prominent stock index. Should you anticipate good or bad news in a particular industry, you might put more or less in that industry, but no matter how convinced you are about such information, you should still retain holdings elsewhere to cope with the inevitable, unexpected developments.
Portfolio managers use all sorts of industry breakdowns. Here, with a word or two on each, is the 12-sector breakdown used by the Global Industry Classification Standard (GICS):
- Consumer staples: Including food, soap, cosmetics, and similar companies, this sector tends to offer stable businesses whose sales remain relatively steady in good times and bad.
- Consumer durables: This sector is dominated by the stocks of companies that make things people tend to use over long periods of time, such as autos, appliances, and furniture. Such stocks tend to suffer more than others in hard times because it is easier for people to postpone purchases. They usually recover faster as the economy improves.
- Industrials: Companies in this area produce machinery, chemicals, metals, and basically anything used in the production of other things. For the same reasons as consumer durables, these businesses tend to suffer more than most in hard times and catch up more in recoveries.
- Materials: This sector includes stocks of companies that mine, produce lumber, and the like. Their stocks are even more sensitive to economic swings than industrials, in part because the prices of their products swing in sympathy with gains and losses in sales.
- Technology: These stocks are less sensitive to overall economic swings, but they are highly vulnerable to innovation, which can make the stock of a successful innovator soar and that of a competitor crash. Hype and unpredictability are watchwords here.
- Utilities: This is possibly the most stable sector. These companies see little variation in their sales except in extreme circumstances and are regulated to give them an acceptable profit. They have limited growth potentials but usually offer relatively high dividend flows. Because the dividend is so much a part of their appeal, they are said to behave more like bonds than stocks.
- Transportation: Including airlines, railroads, trucking, and the like, these stocks — especially airlines — are sensitive to the business cycle and fuel prices. Their volatility offers considerable potential for gain matched by considerable risk.
- Energy: It should come as no surprise that this area rises and falls with the price of oil. When prices are high, companies that support drilling and exploration thrive along with the oil companies themselves. High oil prices also place a premium on alternative energy sources like wind and solar. Of course, things work in the opposite direction when oil prices fall.
- Finance: Banks, insurers, brokers, investment banks, money managers all have sensitivity to financial conditions and tend to rise when interest rates fall and fall when they rise. These stocks also move in sympathy to financial markets generally. These days, stocks in this area have become especially sensitive to legislation and government regulation.
- Healthcare: Because it’s a universal need, these stocks combine the stability of utilities (hospitals and medical groups) with the innovation sensitivity of technology (drug companies and medical suppliers). This industry, too, has become highly sensitive to legislation and government regulation.
- Real Estate: Despite the name, these stocks are more related to construction, not location and property. They are, as a consequence, sensitive to the economic cycle and the impact of financial conditions on mortgage borrowing.
- Telecommunications: These stocks are very similar to utilities with the added special sensitivity to innovation so evident in the technology area.
In addition to diversifying your portfolio among industries, it is also important to consider these two additional stock tradeoffs:
- Growth vs. Value: Growth stocks, as their name implies, typically grow their earnings faster than others. When you buy them, you are effectively betting that the relatively rapid growth will continue and the stock’s price will appreciate in tandem. Because growth companies use their earnings to increase their productive capacities, they typically pay a low or no dividend. Value stocks, in contrast, are those that may be growing slowly (though not necessarily) and seem to have been overlooked by the market, allowing you to buy them cheaper than a fair assessment — say from the dividend discount equation — would otherwise warrant. Buying them is effectively a bet that the market will wake up to what it has missed and re-price the stocks up to where they should be. Because they are priced cheaply, they may well pay a higher dividend as a percent of their price.
- Large vs. small:Because larger companies are better established in their segment of the economy, they tend to grow at a slower pace than smaller companies which, for obvious reasons, have more to gain as they establish themselves. In hard times, larger firms are less volatile, but over time, the stocks of smaller companies tend to outperform those of larger ones. Because these smaller companies go out of business more often than larger ones, it is especially important that your holdings are thoroughly diversified.
Individual stock selections aim to feed the best possible holdings into the industry diversification and the mix of growth/value, large/small. Here are four basic ways that stock pickers use to evaluate which stocks are the best possible holdings:
- Look for earnings after tax to lie along an uptrend, not simply overall earnings but the earnings for each share of stock, earnings per share in financial jargon. This information is readily available online from various investor services or in each company’s quarterly and annual reports.
- Look for increasing dividends. If a company is willing to pay out an increased dividend for each rise in earnings per share, it could indicate that management sees these earnings as secure. A rapidly growing firm, however, might break this rule, having need of the additional earnings to increase its productive capacities. Company annual reports or broker reports should make this distinction clear.
- See that there are enough outstanding shares to ensure that there are always buyers and sellers in the market to accommodate your buying and selling needs, what financial professionals refer to as liquidity. Ten million shares outstanding can serve as a reasonable benchmark. Less than this number could make a stock difficult to sell quickly. Some illiquid holdings in your portfolio may have enough other attractions to recommend them, but too many illiquid holdings will create a dangerous inflexibility. Even with attractive names, you should always look for more liquidity.
- Seek lower price-earnings (P/E) ratios. This is a simple division of the stock’s price by the most recent earnings per share. It tells you how much you are paying for those earnings and so is a quick way to determine how expensive one stock is compared to another. All else equal, the lower the P/E ratio the better.
A Last Word
There are a number of ways to achieve the diversifications required of a good stock portfolio of which more in later posts. Even with the most thorough diversification across industries, growth orientation, and size, and so the most stable of stock portfolios, there is no getting away from the inherent volatility of stocks. They are no place for an investor who will need to draw on the money in less than five years.