Part 3 – Lesson 16

Overview


Creating a balanced portfolio of stocks is an essential part of the investment process that warrants just as much time and attention as researching and valuing the individual components of the portfolio.  There are several factors to consider when constructing your portfolio:

  1. Number of positions

  2. Investment timeline of the individual positions

  3. Industry exposure

  4. Factor exposure

  5. Geographic exposure

Number of Positions


In Part 3, Lesson 15, we discussed maximum position size.  Investors with higher risk tolerance may set a maximum position size of 10%, whereas with investors with lower position may set a max position size in the 2-3% range.  The max position size set by an investor has implications for the number of positions that an investor can ultimately hold in his/her portfolio.

For example, if an investor has a max position size of 10% and chooses 10 high conviction stocks, then, this portfolio will only consist of 10 positions.  Even with a 10% max position size, an investor does not need to invest up to their max position size on every position.  Here is a hypothetical portfolio of 20 stocks where the investor has a 10% max position size.

In the above portfolio, the investor has the highest conviction in its top positions, GOOGL, FB, and AMZN.  Alternatively, if the investor has relatively equal conviction in all its positions, he or she may want to simply assign a 5% portfolio weighting to each of the 20 positions.

Investors who are comfortable with higher max position sizes will generally end up with a portfolio with a lower number of positions.  For example, an investor with a 10% max position size will need at least 10 positions at a minimum to fill his/her portfolio.  An investor with a 3% max position size will need at least 33 positions to fill his/her portfolio.  An investor with a 2% max position size will need at least 50 positions to fill his/her portfolio.

What is the ideal number of positions in a portfolio?

There is no correct answer to this question.  If an investor has high conviction in a select few companies and has high risk tolerance, this investor may be comfortable with a small portfolio of stocks.  An investor with lower risk tolerance may choose to hold a larger number of securities.

The objective of adding more positions to the portfolio is to reduce risk through the diversification of exposure to any single company.  However, there are eventually diminishing benefits to adding more positions once you’ve reached critical mass in your portfolio.  For example, if you compare the Dow Jones Industrial Average, which consists of 30 stocks, vs. the S&P 500, which consists of 500 stocks, the performance of the two indices over time is remarkably similar.

We favor building a portfolio of high conviction companies in the 20-40 position range.  This is a personal preference based on our risk tolerance and is not a recommendation for all investors.  We like portfolios around this size since it accomplishes our goal of diversifying our exposure to any single company, while avoiding having to be an expert in too many different companies.  In other words, we’d rather invest in 20 high conviction ideas over 60 low conviction ideas.

Investment Timeline


The investment timeline of your individual positions will affect how much of your portfolio you will need to turnover.  For example, if an investor has a portfolio of 30 stocks that all have 12 month investment timelines, then, this investor will need to have new ideas ready to replace these ideas as the investment thesis plays out.  In practice, it is unlikely that the investor will need to replace all 30 stocks in 12 months because the investor may decide to stay in those stocks if there is still further upside.

However, if an investor has a portfolio consisting of 15 stocks with 12 month timelines and 15 stocks with 3 month timelines, then, this investor will need to come up with new ideas on a regular basis in order to consistently replace the short-term (3 month) ideas.

Idea velocity = the pace at which an investor is finding new ideas

This leads us to an important takeaway: pursuing long-term ideas means less work over-time.  If an investor is focused on producing quick short-term gains, this requires a very high idea velocity.  In other words, this investor will need to continuously find and research new ideas.  Whereas, an investor with long-term ideas can afford to be a bit less active in their approach vs. a short-term investor.

Based on an investor’s risk tolerance and investment goals, every investor must decide on their own if they’d like to pursue long-term or short-term ideas (or a combination of both), but our preference is to hold investments for the long-term.

Industry Exposure


Take a look at the mock portfolio we included earlier in this lesson:

Before reading on, consider how you feel about this portfolio.

Every stock in this portfolio is an Internet company.  While many of these companies are high-quality companies with good long-term growth, there is zero industry diversification in this portfolio.  If the Internet sector were to experience a broad-based slowdown or contraction in valuation multiples, this portfolio would be susceptible to quick downdrafts in value.

We prefer portfolios that have more balance and exposure to different industry sectors.  However, we are not in favor of industry diversification if it means selecting investments that an investor does not know or understand well.  In other words, we do not believe in sacrificing conviction and quality of the investment thesis simply to achieve industry diversification.  For example, we’d rather have 5 very high conviction ideas in 1 sector rather than 5 medium conviction ideas in 5 different industry sectors.

Factor Exposure


“Factors” in investing are generally thought of as macro drivers that affect an entire industry or economy.  Here are a few examples of factors:

  1. Interest rates
    • The value of certain companies’ equity is highly dependent on the level of interest rates in the economy.
    • For example, companies with high degrees of financial leverage are sensitive to changes in interest rate levels.
    • For high leveraged companies, you may observe that their stock prices trade down whenever there is a spike in interest rates.
    • REIT stock prices are sensitive to interest rates since many REITs are dependent on debt financing to fund their real estate investments.
  2. Industry specific drivers
    • Any broad industry growth driver can be thought of as a factor. For example, online advertising is a factor that influences broad swaths of the Internet sector.  If online advertising were to slow on an overall basis, it is likely that all the companies exposed to online advertising would also slow.
    • Wireless subscriber additions are another growth factor that affects wireless phone companies. If the industry were to mature and the pace of overall subscriber additions slow, then, all wireless companies are likely to feel this slowdown.
  3. Commodity prices
    • Commodity prices can affect the top-line and bottom-line for many different types of companies. For example, the revenue of oil companies is highly dependent on the oil price.
    • Likewise, the costs of an airline are highly dependent on the oil price.
  4. Employment cost
    • Companies that employ large numbers of individuals can be exposed to changes in prevailing labor rates in the economy.
    • For example, companies with large numbers of minimum wage employees (such as Walmart, Starbucks, Target) have been affected by large changes in the minimum wage in recent years.
  5. Housing starts
    • Specific macroeconomic drivers can be highly correlated with the growth of certain industries.
    • For example, the growth of Home Depot is influenced by new home formation in the United States.

There are many more factors that what is listed above, but why do factors matter?

Simply put, if an investor’s portfolio consists of companies that have similar factor exposure, then, the portfolio will be particularly sensitive to specific risks.  For example, if an investor owns a portfolio of companies with high sensitivity to interest rates, then, this portfolio will likely suffer losses during periods of increasing interest rates.  Similarly, if an investor owns a portfolio with high sensitivity to oil prices, the entire portfolio will suffer losses when the oil price moves in against the portfolio.

An investor can generally lower the risk profile of his/her portfolio by ensuring that the portfolio is not overly exposed to any single factor.

Geographic Exposure


When constructing a portfolio, deciding on the allocation to US stocks and international stocks is an important consideration for many investors.  Our bias is to invest primarily in US stocks since we understand US companies and the US economy much better than any other region in the world.  Additionally, we feel that the rule of law and stable political climate of the US provides a positive backdrop for investments in US companies.

However, investors with deep understanding of foreign geographies may feel comfortable investing in the equity of companies outside of the US.  Since the risk profile of many foreign countries is higher than the US, investors in international stocks should seek returns that compensate them for taking on additional risk.

Although many foreign geographies have a higher risk profile, a portfolio of domestic and international equities reduces reliance on any one geography.  If the US were to enter a recession but emerging markets were able to still show growth, the portfolio would benefit from having positions outside of the US.

Ultimately, the amount of foreign company exposure an investor takes on in his/her portfolio should be based on the risk tolerance of the investor and the investor’s familiarity with that geography.