How to construct a winning stock portfolio for 2022
Fundamentals 20-1: You are unlikely to invest in only one stock. Rather you would probably invest in several stocks. Essentially this is your stock portfolio. This article is a case study on how to construct such a stock portfolio.
Over the 12 to 13 months, I have analyzed and valued about 23 companies (hereinafter referred to as “panel”). As my valuation is based on a long-term view of the business, I am confident that values of these companies are still valid today.
As such I thought it might be instructive to see how I could construct a stock portfolio based on these companies. I would then track their performance over the years. This should provide some insights on how to establish and manage a stock portfolio.
The focus is not on individual stocks but rather the portfolio. For those who are not familiar with my portfolio concepts, search for the following articles:
At the same time, if you want to know about the individual stocks covered here look up the specific posts in my blog. You can jump to the appropriate company from the “Index of Companies Analyzed” page.
Disclaimer. This post is to illustrate how to construct a stock portfolio. While I have used real life companies to illustrate how to established a stock portfolio, it is not a recommendation to invest in them.
Contents
- Portfolio parameters
- How to select the stocks
- Portfolio for 2022
- Ensuring diversification and low correlation
- Pulling it all together
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Portfolio parameters
I defined a stock portfolio as a collection of stocks that an investor has selected. This then raises the following questions when it comes to constructing the stock portfolio:
- How do you select the stocks? I am a value investor so my stocks are selected based on value investing principles.
- How many stocks should you have? I target 30 stocks in my portfolio. Studies have shown that the benefits of diversification become marginal when you go beyond 30 stocks.
- How much to invest in each stock? As a first cut, I allocated the same $ amount to each stock. As the portfolio becomes more established, I could allocate a bigger $ amount to those where I have more conviction. But this is something to consider later.
To start off, let us assume that we have USD 100,000 available for investment. Based on 20 stocks and assuming the same level of conviction in these stocks, the plan is to allocate USD 5,000 per stock.
The stocks are from 3 different regions - Malaysia, Singapore and US. For ease of comparison, I will report all values in USD based on the following exchange rates:
- USD 1 to RM 4.20
- USD 1 to SGD 1.36
- USD to AUD 1.39
I have assumed that the transaction cost for each purchase or sale is equal to 0.5 % of the market price.
How to select the stocks
The first step is to compile some basic statistics of the panel as shown in Table 1. The parameters I have chosen - region, sector, investment type and size - are those that I used to assess the portfolio diversity.
- Region. I have used the stock exchanges where the companies are traded as the geographical location.
- Sector. As most of the companies operate in a number of industries, I have used the main operating sector of each company as the reference.
- Investment type. I classified my investment into a number of categories:
- Turnarounds refer to those that are experiencing some temporary problems relative to their peers.
- Compounders are those that can compound their value. These will have a moat and have Earnings Value with growth > Asset Value. You will note that there are no Compounders in the panel.
- Cyclicals refer to those in cyclical sectors such a steel companies. If the company is experiencing some issues on top of the cyclical ones, I would classify the company as a Turnaround.
- Quality Value companies refer to the fundamentally sound companies that are undervalued.
- Size. I have used the market capitalization on the review date as the measure of size. In this case, the market capitalization is based on the number of shares outstanding and prices as of 31 Dec 2021. For an apple-to-apple comparison, I have converted all to USD. Note that the information for this parameter was extracted from TIKR.com* stock platform.
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| Table 1: Panel Profile |
Selection process
I am a bottom-up value investor. This meant that the portfolio comprises of stocks that were selected based on my value investing approach.
I do not plan my portfolio profile and go and look for stocks. Rather the portfolio profile is the results of the individual stocks that I have picked. As such my portfolio construction process can be summarized as follows:
- Identify and invest in the individual stocks.
- When I have about more than a dozen stocks, I then review the stock portfolio for diversity.
- I have a number of portfolio guidelines to assess that I have the balance between risk and return.
The first step to decide whether a stock is an investment candidate is to determine the intrinsic value of each of the stocks as summarized in Table 2. In the table, I have summarized the various values based on the analyses posted in my blog.
- AV. This is the Asset Value. In most cases, this is the Book Value.
- EPV or Earnings Power Value. This is based on a Free Cash Flow to the Firm model assuming zero growth.
- EV with growth. This is based on either the single stage Free Cash Flow to the Firm model or the Residual Income model. In both cases I have assumed a steady growth in perpetuity.
- Magic F or “Magic Formula”. This is a term used to describe the investment strategy explained in “The Little Book That Beats the Market” by Joel Greenblatt.
- Acquirer’s M or Acquirer's Multiple. This is a metric favoured by Tobias Carlisle.
If you want to know more about each of the valuation terminology, refer to the Definitions post in my blog.
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| Table 2: Panel Valuation Notes: EV with g. In some cases, these are Optimistic EPV. If there are conservative and optimistic growth scenarios, I used the optimistic one. |
I then determined the margin of safety for each metric as summarized in Table 3.
Margin of safety in % = [ (Value / Price) - 1] X 100
I am looking for at least 25 % margin of safety. My first choice is to look for a margin of safety based on the EPV. Most of the companies under Bursa Malaysia and SGX met this criterion.
However, I have chosen to invest in all the Bursa Malaysia and SGX companies shown irrespective of whether they met the EPV criterion. The rationale for selecting those that do not meet the EPV > 25 % margin of safety are:
- For those undergoing a turn around, I would consider a margin of safety based on the Asset Value. That is why I have chosen to invest in Boustead Plantation and New Toyo Int. If the Turnaround is a Graham Net-Net, I would ignore the EPV. That is why I have chosen to invest in Eksons.
- For the cyclical companies I have relied on both the Asset Value and Earnings Value with growth for the margin of safety. Examples are Petron Malaysia and Dayang.
- For the Quality Value companies like K FIMA and Dominan, I have relied on the Asset Value as I do not believe that there will be any impairment of assets.
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| Table 3: Panel Margin of Safety Notes: EV with g. In some cases, these are Optimistic EPV. If there are conservative and optimistic growth scenarios, I used the optimistic one. |
For the companies in the US, Table 3 shows that almost all do not meet the EPV > 25 % guideline. The only exception is Timken Steel.
However, I would still invest in the Quality Value ones such as Leggett & Platt and Cummins. This is because they have margin of safety under the Earnings Value with growth.
Note that the US companies all have negative margins of safety based on the Asset Value. This is because of their stock buyback programme.
Portfolio for 2022
The portfolio investment plan based on the stocks chosen is summarized in Table 4. I have assumed that the minimum number of shares that can be bought or sold under Bursa Malaysia and SGX is 100 shares. For the US, I assumed that you can buy 1 share.
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| Table 4: Investment Plan Note Assumed that we can buy individual shares in the US companies |
To estimate the number of shares that can be bought, I divide the equivalent of USD 5,000 by the total transaction cost. Remember that my portfolio guideline is to have USD 5,000 per company.
For example, for Eksons with a market price of RM 0.65 per share, the total number of shares that can be purchased
= [Amount allocated in RM] / [Purchased cost]
= [ USD 5,000 X RM 4.20 exchange rate ] / [ price of 0.65 X 1.005 ] = 32,147.
The factor 1.005 is to cater for the 0.5 % transaction cost associated with each purchase.
The number of shares to buy is then 32,100 based on rounding down.
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Ensuring diversification and low correlation
If I follow the Modern Portfolio Theory (MPT), I will have to look for uncorrelated stocks based on the variance and co-variance. It is a statistical/quantitative process. For a retail investor, this is not a practical approach.
- Firstly, you do not have the computation power to calculate the variance and co-variances for 20 to 30 stocks.
- Besides, variances and co-variances are not static and changes over time. So even if you could compute them, there is the question of their validity.
- MPT computes variance and co-variances based on stock prices. In other words, correlation is based on stock price movements. There are other ways to look at correlation.
The goal is to have a number of uncorrelated stocks. Instead of looking at this numerically, I looked at it qualitatively. I established a way to assess diversity. My view is that the more diversified the portfolio, the less the correlation between the various stocks.
To ensure diversification, I assessed the degree of concentration under several criteria. I focused on the following criteria.
- Regions as represented by the stock exchanges.
- Sectors or industry.
- Market cap or size.
- Business performance - Turnarounds, Compounders, Cyclicals.
The idea is to select stocks based on different factors. These could be economic, political, technological, and even market sentiment factors.
For each criterion, I classified the stocks in the portfolio into several groups and use this as the basis to assess diversification. My rules of thumb for diversification are:
- Single stock concentration - the market value of a stock should not be more than 10% of the market value of the total portfolio.
- Group concentration - the market value of the stocks within a group should not be more than 30% of the market value of the total portfolio.
I then analysed the stock portfolio based on the various groupings as illustrated below. Note that the grouping is based on the information from Tables 1 and 4.
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| Chart 1: Portfolio Profile - Region/Stock Exchanges |
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| Chart 2: Portfolio Profile - Investment Type |
As an example, the 25% for the Turnarounds is computed as follows:
Total investments in the Turnaround stocks are:
= Investments in Eksons, White Horse, Parkson Holdings, Boustead Plantations and New Toyo Int.
= USD 4,993 + USD 4,992 + USD 4,997 + USD 4,993 + USD 4,997. Refer to Table 4.
= USD 24,972
Total investments in Turnarounds as % of total amount allocated = USD 24,972 / USD 100,000 = 25 %.
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| Chart 3: Portfolio Profile - Market Cap or Size |
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| Chart 4: Portfolio Profile - Sector |
Note that I have computed the % based on the total amount allocated rather than the total amount invested of USD 79,549. This is because I will also be investing all the balance cash when I find other investment opportunities.
You can see that by allocating the same amount to each stock in a 20 stocks portfolio, I am not likely to exceed the 10% single stock criteria. However, there may be a possibility of this if I allocate more to the ones with higher conviction. At this juncture, there is not something to worry about.
In terms of group concentration, to a certain extent this is also governed by the number of groups for each criterion. For example, for the Region criteria, I only have 3 groups - Bursa Malaysia, SGX and US. In theory if all the regions have the same amount allocated, we will have 33 % in each group. The point I am making is that when assessing the diversification, we have to take this into account.
At this juncture, the following have exceeded the group criteria:
- Region. Bursa Malaysia accounted for 50 % of the portfolio. To reduce this, I will have to look for more US and SGX stocks in the future. At this juncture, since I am very familiar with the situation in Malaysia, I am happy to have 50 % allocated to Malaysia.
- Investment type. The Quality Value stocks accounted for 35 % of the portfolio. I am prepared to live with this % as these represented the less risky stocks among the various categories of investment types.
Pulling it all together
If you knew which stock would give the best return, you would be an idiot not to put all your money into this one stock. In reality you do not know the future so you spread your money to several stocks. You hope that if one does badly, the others will do well enough to offset the bad performing one. This is the rationale of having a portfolio of stocks.
The more stocks you have, the lower the risk, but also the lower the amount of gain. Portfolio construction is thus getting a balance between risk and return.
Return is relatively straightforward to assess. I look at return as = total gain (capital gain + dividend) as a % of my investment.
On the other hand, risk is a bit more challenging as I do not follow the volatility school. Rather I view risk as a permanent loss of capital.
To minimize the investment risk, I first look for stocks that will have a low probability of a permanent loss of capital. That is why my stocks were selected based on value investing concepts.
At the same time, since I cannot foresee the future, I invest in a number of stocks. This post is an example of how I have constructed a stock portfolio. I will be tracking the performance of the stock portfolio to illustrate how to manage it.
I hoped that you will use what I have done as a reference to construct your own stock portfolio.
There are of course other risk mitigation strategies. I just covered selecting stocks based on value investing concepts and having a stock portfolio as examples. If you want to know more about other risk mitigation strategies, look up the following:
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Disclaimer & Disclosure
I am not an investment adviser, security analyst, or stockbroker. The contents are meant for educational purposes and should not be taken as any recommendation to purchase or dispose of shares in the featured companies. Investments or strategies mentioned on this website may not be suitable for you and you should have your own independent decision regarding them.
The opinions expressed here are based on information I consider reliable but I do not warrant its completeness or accuracy and should not be relied on as such.
I may have equity interests in some of the companies featured.
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