Case study on how to manage a stock picking portfolio
Fundamentals 20-1: You are unlikely to invest in only one stock. Rather you would probably invest in several stocks that were selected based on value investing principles. Essentially this is your stock picking portfolio. This article is a case study on how to construct and maintain such a portfolio. It also serves as the jump point to the various quarterly updates of the portfolio. Revision date: 22 Oct 2023
I first wrote this article in Dec 2022 but have been updated in Aug 2023.
As of Dec 2022, I had 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 the values of these companies are still valid today (Dec 2022).
As such I thought it might be instructive to see how I could construct a stock picking portfolio based on these companies. I would then track their performance over the years. This should provide some insights into how to establish and manage a portfolio.
I have a short video to give you an overview of how to construct and maintain a stock portfolio without having to resort of Modern Portfolio Theory.
I will provide quarterly updates as well as periodically share insights about managing a stock picking 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 picking portfolio. While I have used real-life companies to illustrate how to established a such a portfolio, it is not a recommendation to invest in them.
Contents
- Stock picking strategies
- Can stock picking beat the market.
- Is stock picking worth it.
- Stock-picking portfolio vs MPT.
- Constructing the stock picking portfolio.
- Portfolio parameters.
- How to select the stocks.
- Portfolio for 2022.
- Ensuring diversification and low correlation.
- Pulling it all together.
- Maintaining the stock picking portfolio.
- Reviewing performance.
- Risk-adjusted returns.
- Dividends.
- Why quarterly review.
- How to grow the portfolio value.
- Portfolio updates.
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Stock picking strategies
Stock picking strategies are approaches that investors use to select individual stocks for their investment portfolios. These strategies aim to identify stocks that have the potential for strong performance and to maximize returns while managing risks.
I would classify some of the common stock picking strategies into the following:
- Fundamentals – value investing, growth investing and income investing
- Technical – those who use charts, trend followers and those using technical indicators.
- Behavioural – using social media to identify market sentiments, following insiders buying
Can stock picking beat the market?
I am a stock picking value investor as I believe that this will enable me to beat the market.
While beating the market consistently is challenging, it's not impossible. Some of the challenges and how I have addressed them include the following:
- Market efficiency. The Efficient Market Hypothesis suggests that stock prices already incorporate all available information. But we know that markets are not always efficient. It is a question of being patient and finding opportunities when the market in not efficient.
- Transaction costs. Frequent buying and selling of stocks can result in transaction costs which can erode returns. But I am not a trader. I invest for the long term and my average annual stock turnover is in single digits.
- Behavioural biases. Emotional decision-making, overconfidence, and other behavioural biases can lead to suboptimal decisions. I try to have a standard template and investment process to reduce the behavioural biases.
- Risk. Beating the market requires not only generating higher returns but also managing risk effectively. I have a 3-level risk mitigation process to address this. Having a stock-picking portfolio is part of this risk mitigation measures.
Is stock picking worth it?
I am a bottom-up stock picking value investor. Chart 1 below shows the performance of my portfolio compared to that of the Bursa Malaysia Index (KLCI). I think it is an index beating track record.
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| Chart 1: My Portfolio Performance |
Now whether stock picking is worth it depends on individual circumstances, goals, and preferences.
Here are some factors to consider when deciding if stock picking is the right approach for you:
- Time and Effort: Stock picking can be time-consuming and requires research, analysis, and ongoing monitoring.
- Risk Tolerance: Stock picking can be riskier than passive investment strategies like index funds because individual stocks can be more volatile.
- Expertise and Knowledge: Successful stock picking often requires a good understanding of financial markets, accounting, and the specific industries you are investing. You need the skill sets.
- Emotional Discipline: Emotional discipline is crucial in stock picking.
Ultimately, the decision to be a stock picker should be based on your individual circumstances and preferences.
Stock picking portfolio vs MPT
I have a stock-picking portfolio because I am a stock-picker. I am a stock-picker because I believe that this will enable me to beat the market.
The stock-picking portfolio results from my stock-picking investment approach. I cannot be a stock-picker yet follow MPT when it comes to portfolio construction.
A stock-picking portfolio and one based on MPT are two different approaches to constructing a stock portfolio.
Stock-picking portfolios are based on the belief that an investor can identify and select individual securities that will outperform the market. Stock picking can be more subjective and relies heavily on individual judgment, while MPT is based on quantitative analysis and objective measures of risk and return.
For more details on the differences between a stock-picking portfolio and that based on the MPT, refer to "Stock picking portfolio vs MPT."
Constructing the stock picking portfolio
I have called this a stock picking portfolio to emphasize that it is constructed from stocks selected one-by-one based on value investing principles. This is to differentiate it from a portfolio constructed based on the Modern Portfolio Theory.
MPT, developed by Harry Markowitz in the 1950s, is a framework for constructing and managing investment portfolios. It is one of the cornerstones of contemporary finance and provides a systematic approach to optimizing the trade-off between risk and return when building a diversified investment portfolio. The key principles of MPT include:
- Diversification.
- Efficient Frontier and Capital Market Line.
- Risk and return.
- Correlation and covariances.
- Systemic and non-systemic risks.
- Asset allocation.
There are criticism and limitations with MPT. Critics argue that it makes simplifying assumptions such as returns that follow a normal distribution and that correlations remain constant. Additionally, MPT doesn't consider factors like behavioural biases or individual investor preferences, which can influence investment decisions.
In the context of a stock-picking portfolio, there are several factors to consider when constructing one:
- Investment Goals. I am looking at the portfolio from a value-investing perspective.
- Risk Tolerance. I am a conservative investor.
- Diversification. I target 30 stocks as a balance between risk and return.
- Research and Analysis. I am a bottom-up stock picker.
- Monitoring and Rebalancing. I review the portfolio quarterly.
To illustrate the various issues involved in constructing and maintaining a stock picking portfolio, I will first show how to construct such a portfolio. I will then show you how to track portfolio performance via quarterly reviews.
Portfolio parameters
I defined a stock picking portfolio as a collection of stocks that an investor has selected. This then raises the following questions when it comes to constructing the stock picking 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 stock picking portfolio becomes more established, I could allocate a bigger $ amount to those whom I have more conviction. But this is something to consider later.
To start, 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 the 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 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 several 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 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 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 stock picking 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 individual stocks.
- When I have about more than a dozen stocks, I then review the stock portfolio for diversity.
- I have several 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 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 EPVs. 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.
The margin of safety in % = [ (Value / Price) - 1] X 100.
I am looking for at least a 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 rationales 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 EPVs. 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 margins 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 stock picking 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.
Factor 1.005 is to cater to 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 MPT, I will have to look for uncorrelated stocks based on the variances and co-variances. 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 covariances are not static and change 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 several 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 stock picking 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 industries.
- 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 picking 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 International.
= 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 the 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 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 for 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 several 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 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:
Maintaining the stock picking portfolio
There are two aspects to maintaining the stock picking portfolio.
- Keeping track of the various transactions. I suggest that you set up an EXCEL worksheet to do this. This can then provide the transaction history.
- Reviewing and interpreting the results. This should be the main focus. By having a standard EXCEL worksheet, you can then spend time thinking about this rather than on the mechanics of tracking the various transactions.
Refer to “Mac 2022 review of the stock picking portfolio” for details on how I track the various transactions and estimate the returns.
Reviewing performance
There are 2 objectives for each quarterly review:
- To determine the portfolio return.
- To ensure that the portfolio still meets the diversity criteria.
When it comes to returns, you have the following options:
- Look at absolute returns.
- Compare your returns with those of the benchmarks.
- Compare the returns on a risk-adjusted basis.
When it comes to the fund or stock picking portfolio, the return is complicated by the following situations:
- During the period, some of the stocks could be losing money. You could have a negative total gain if a capital loss is larger than the dividends.
- You could have sold off some stocks and been holding cash. Alternatively, you could be holding onto some dividends in cash form rather than have them reinvested during the review time.
- You could have also allocated additional cash to the funds. In other words, the amount set aside for investment is bigger not because of any gain, but because of additional funds.
To cater to such situations, I define the total gain and return in the following manner.
- Total Gain = current value - previous value + dividends.
- The returns for the period = gain divided by the previous value.
- The value here includes any un-invested cash ie the fund value.
I used the market value of the stocks in the stock picking portfolio to calculate the portfolio value. It is the sum of the market value of the respective stocks. The current and previous values refer to the value of the stock picking portfolio assuming it is liquidated.
When it comes to checking diversity, I look at the profile of the portfolio based on the 4 characteristics - region, investment type, market cap, and sector. I check that the profile still follows my rules of thumb.
Refer to the Jun 2022 review titled “The stock picking portfolio has lost money – do not panic” for illustrations of the above issues.
Risk-adjusted returns
When assessing returns, I prefer to look at absolute returns as well as in comparison with some benchmarks.
But if you view volatility as risk, you can include volatility in your assessment of the performance. In practice, there are 4 such measures:
- Treynor ratio.
- Sharpe ratio.
- Jensen alpha.
- Information ratio.
I consider risk as a permanent loss of capital. Nevertheless, I view volatility, as represented by Beta as one proxy of risk. I use the CAPM concept, especially the Beta in determining the cost of capital. As such I also assess the portfolio performance using the Information ratio and the Jensen alpha.
In my Sep 2022 review, I provided examples of how to calculate the Information ratio and Jensen alpha. Refer to “The stock picking portfolio dipped but buy more”.
Dividends
The gains from the portfolio come from 2 sources:
- Capital gains. This comes from the increase in the share price compared to the purchased cost.
- Dividends. These are a share of the business profits distributed by the company.
Dividends are not paid monthly. The most common practice is twice a year although some pay dividends quarterly.
Dividends are lump sum additions to the fund. For each computation, I incorporate dividends into the return assessment only at the end of the year.
In my year-end review, I illustrate how to account for dividends. Refer to” The first annual review of the stock picking portfolio.”
Why quarterly review?
I differentiate between reviewing the stock picking portfolio and reviewing individual stocks.
- When I review individual stocks, the goal is to look for selling signals. I focus on the individual stock and do not worry about how it links to other stocks.
- When I review the stock picking portfolio, I am looking at the collection of stocks as a whole. I would consider how one particular stock relates to other stocks.
As such, the frequency for reviewing the stock picking portfolio differs from that for reviewing individual stocks.
How often you review the stock picking portfolio is related to what you do in the review. My portfolio review goals are:
- Tracking performance. This is a “mechanical” process and is not dependent on the frequency of the review.
- Checking diversity. Based on the past year’s results stock diversification does not change frequently. Checking every 3 months seemed sufficient. If you have a very volatile situation, you may need to check more frequently.
- Checking for investment mistakes. I define an investment mistake as a stock that did not provide an acceptable return after 5 years. An acceptable return is at least equal to the bank’s fixed deposit rate. Returns depend on company performance as well as market sentiments. Since company results are announced quarterly, the most frequent review is every quarter.
For these reasons, I have chosen to review the portfolio quarterly. You could argue that we could have reviewed the portfolio every 6 months instead of quarterly. This is debatable.
For details refer to the March 2023 review “How often do you review the stock picking portfolio?”
Why the 4 diversity factors
I have chosen 4 factors – location, sector, investment type, and size – to assess diversity.
These were chosen because I believe that the stock prices for each group within a factor are not correlated. I have illustrated the correlation in the March 2023 review.
How to grow the portfolio value
There are 2 ways for the portfolio value to grow over time:
- The market price of the stocks in the portfolio increases over the years in line with the improvements in the business fundamentals. The assumption here is that you do not sell these stocks as they are still underpriced. In other words, their intrinsic values have also increased such that the latest market prices are < updated intrinsic values.
- You sell the overpriced stocks and reinvest the proceeds in other underpriced stocks.
Warren Buffett’s current approach is represented by the former – his ‘forever” stocks. I must admit that I don’t have his investing skills and have not found any “forever” stocks.
Rather I rely on the latter approach. The challenge is then identifying the overpriced situations and selling to lock in the gains.
For details on the various issues with growing the portfolio value, refer to the Jun 2023 review titled “How to grow the stock portfolio value?”
Portfolio Updates
In this section, I present the latest picture of stock returns and diversity. This is the position at the end of Sep 2023.
- The portfolio in 2022 did not perform as well as the benchmark. But in the following two quarters, the portfolio outperformed the benchmark.
- In the context of risk management, I am satisfied that the portfolio at the end of Sep 2023 is still diversified.
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| Table 5: Portfolio returns as of the end of Sep 2023 |
Note that I started the portfolio with USD 100,000 at the end of Dec 2021. But towards the end of Dec 2022, I added USD 10,000 to the fund. The returns of the fund should then be based on USD 110,000.
During the past 21 months, I have sold some stocks and added new ones. For the details refer to each of the quarterly reviews.
The portfolio diversity shown in Table 6 reflects not only changes in the stock prices but also the sales and purchases.
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| Table 6: Diversity profile as of the end of Sep 2023 |
To see the details of the analysis and calculation for each of the reviews, you can refer to the respective articles as shown in the following links.
Review date | Title/Links | |
Mac 2022 | 20-2 | |
Jun 2022 | 20-3 | |
Sep 2022 | 20-4 | The stock picking portfolio dipped but buy more |
Dec 2022 | 20-5 | |
Mac 2023 | 20-6 | |
Jun 2023 | 20-7 | |
Sep 2023 | 20-8 | Stock picking portfolio vs MPT |
Table 7: Links to stock picking portfolio articles in my blog
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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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