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Be realistic and reduce your risk

Our reader has unrealistic expectations for what his portfolio can earn, and needs to diversify and reduce its risk
December 1, 2016, Mike Pate & Will Walker-Arnott

Paul is 33 and has a secure job as a civil servant. He has been investing for four years, and has no other investments other than his portfolio. He has no dependants.

Reader Portfolio
Paul T 33
Description

Objectives

"I am aiming for a 15 per cent a year return on average over the next five years," says Paul. "I plan to save more of my income, around £15,000 a year in line with my annual individual savings account (Isa) allowance, towards a £300,000 deposit for a house in London. However, I recognise these objectives may be ambitious and am prepared to wait for longer if necessary.

"As I am young I am prepared to take on lots of risk, although I recognise that high risk doesn't necessarily come with high returns. I don't have a specific limit on how much I would be prepared to lose in any given year.

"I think I can outperform the market over the long term by focusing on shares with certain characteristics. I try to capitalise on momentum and long-term growth by purchasing high-quality companies with defensive characteristics that are trading well. Low debt, strong cash generation, recurring non-cyclical revenue and high returns on capital are some of the key characteristics I look for.

"I also take account of their valuations, but to a lesser extent as I am wary of placing too much importance on short-term valuation metrics. I don't do very detailed analysis as I prefer to keep things fairly high level and think about my portfolio as a whole.

"I actively monitor a long watchlist to keep an eye out for opportunities either from excessive price falls in companies I think have good long-term prospects or where I think the market has not yet reacted sufficiently to good news.

"I believe it makes sense to be fully invested in equities at this stage in my life, especially as bond yields are so low. I think diversification within equities is very important — especially as I tend to hold smaller-cap companies.

"I have 20 shares but intend to expand this to between 30 and 40 as my portfolio grows in value. I try to minimise my overall exposure to economic cyclicality or other common risks as much as I can.

"I have developed my approach since I started investing from being entirely haphazard to being somewhat more disciplined. I am now fairly ruthless in running winners and selling losers, but I believe that my main weakness is to over-monitor and consequently over-trade my portfolio. I aspire to trade less frequently — eg, only buy or sell once a month. I am doing better, although I still struggle with sticking to the rules I set myself as new anxieties or ideas are always popping up.

"I try to stay near fully invested, with a bit in cash to respond to opportunities as they arise, as I have little confidence in my ability to time the market.

"My last three trades were selling Waterman (WTM), and buying Victrex (VCT) and On The Beach (OTB).

I have on my watchlist: Emis (EMIS), Cineworld (CINE), MJ Gleeson (GLE), Cranswick (CWK) and Sanderson (SND).

 

Paul's portfolio

HoldingValue (£)% of portfolio
Boohoo.com (BOO)9,33710.37
Micro Focus (MCRO)7,3068.11
Electra Private Equity (ELTA)6,3357.04
Burford Capital (BUR)6,0056.67
ADEPT Telecom (ADT)5,9276.58
Bioventix (BVXP)4,7415.27
Victrex (VCT)4,6385.15
Zytronic (ZYT)4,5015
Somero Enterprises (SOM)4,3344.81
Rank (RNK)3,9324.37
Craneware (CRW)3,6254.03
Character (CCT)3,6044
Brainjuicer (BJU)3,3153.68
Shire (SHP)3,2983.66
Avesco (AVS)3,0783.42
Hilton Food (HFG)2,8323.15
On The Beach (OTB)2,7293.03
XP Power (XPP)2,4962.77
Pennant International (PEN)2,3642.63
AB Dynamics (ABDP)2,3292.59
Cash3,3163.68
Total90,042

 

THE BIG PICTURE

Chris Dillow, Investors Chronicle's economist, says:

You're right about one thing — a 15 per cent annual return over the next five years is indeed ambitious!

I would assume that equity returns in general would be around 5 per cent a year in real terms, but there is a big margin of error around such an expectation. A 15 per cent return requires either the market to greatly exceed my expectations, or you to hugely outperform it. It is true that your exploitation of momentum should, on average, produce excess returns. But I doubt they'd be as much as 10 percentage points a year.

What's more, in holding smaller growth stocks you are taking on sentiment risk. Your holdings are the sort that would do well if investor sentiment improves a lot. But how likely is this? The fact that aggregate market valuations, as measured by the dividend yield, are around average suggests that sentiment is around average. So the only hope of a big improvement would be if we get an outbreak of over-exuberance, and I wouldn't bet on that.

There's another reason for you not to expect big returns. This portfolio is moderately well-diversified: I say moderately, because some correlation across stocks exists due to exposure to sentiment and momentum. And diversification is a two-edged sword. Yes, it dilutes bad returns on individual stocks. But it dilutes good returns, too. That makes it less likely you will significantly beat the market over time, so I'd expect you to be disappointed with your returns.

It doesn't matter if you simply take it on the chin. It does, though, if you get downhearted and stop investing altogether. As a younger investor, you've got the power of compounding on your side: 20-plus years of moderate returns add up wonderfully. It would be a shame if you threw away this great asset.

Every investor has made plenty of mistakes, so think of them as learning opportunities. I fear that what you might learn is that small growth stocks don't often deliver the returns you expect. But even if this is the case, your mistake is corrigible. So relax!

 

Mike Pate, partner at Killik & Co, says:

The Barclays Equity Gilt Study shows that equities as an asset class have returned on average 5 per cent a year over the past 100 years. You should be more realistic about the likelihood of getting a 15 per cent return a year over the next five years.

Assuming that you achieve on average a 7 per cent a year return and make a £15,000 Isa subscription each year, it will take the fund just over nine years to grow to £300,000.

Although you have no dependants, the £3,000 cash as a 'rainy day' fund seems too low. In a typical growth portfolio, we would encourage clients to retain 5 per cent in cash to ensure there is sufficient cover for unexpected circumstances.

 

Will Walker-Arnott, investment manager at Charles Stanley, says:

This portfolio is certainly not for the faint-hearted, with an asset allocation skewed towards equities and an emphasis on companies at the lower end of the market-cap scale. Using a fairground analogy, rather than seeking the safety of the carousel you have headed straight for the big dipper!

I don't believe this is an appropriate strategy for someone who has a short-term investment horizon and limited assets to fall back on, and is looking to purchase a house in five years' time. Rather, this is a portfolio appropriate for someone who has an investment horizon of 10 to 20 years and plenty of other assets to fall back on.

That said, the investment principles behind your individual stock selection are sound and well thought through. Focusing on companies with low cyclicality and high levels of cash generation is a philosophy I employ myself and, correspondingly, there are companies on the list that I hold for clients: Victrex and Micro Focus (MCRO) are core holdings in my portfolios.

I also like Character (CCT) and AB Dynamics (ABDP), which are on my watchlist. What mark these companies out is strong leadership and the ability to grow earnings consistently through the business cycle.

 

HOW TO IMPROVE THE PORTFOLIO

Chris Dillow says:

There's something else you say that worries me — that "new anxieties" make you trade. For me, the point of wealth is that it gives you peace of mind. If you're often anxious you're doing something wrong. This something might be at the level of asset allocation. If so, perhaps you need a higher cash weighting.

Or it might be that the problem is your stock selection. Small growth stocks are volatile — it's a statistical near-certainty that from day-to-day or even month-to-month you'll see big losses on at least one or two of your holdings. Of course, many of these falls will be noise rather than signal, so not a reason to do anything.

Even if they are noise, however, the mere fact they make you anxious suggests you should tweak your portfolio to diminish that persistent anxiety. One possibility is to hold some big defensive stocks. These have the double virtue of diversifying sentiment risk and delivering good average long-run returns.

Another possibility is to take fewer bets on stocks and instead back the field by buying a tracker fund. You must, however, remember that you have a huge asset that many readers don't have: youth. This makes stock market losses more tolerable because you can top up your wealth with future savings from your earnings. It also means that your mistakes can be corrected over the next few years.

 

Mike Pate says:

While you clearly have an appetite for risk, your investment philosophy and style somewhat contradict this. Seven of the companies in the portfolio have market caps of under £100m and over half the portfolio is in Alternative Investment Market (Aim)-traded shares.

Pennant International (PEN) had negative earnings before interest, tax, negative depreciation and amortisation (Ebitda), earnings before interest and taxes (Ebit) and negative net income in 2015 — not a good example of a business demonstrating strong cash generation, low debt and high returns on capital.

With no dependants, relatively stable earnings and youth on your side, there is a strong argument that being fully invested in equities is a feasible strategy, assuming this aligns with your objectives and risk appetite.

But it also makes sense to diversify, and your strategy to increase the portfolio size from 20 shares to between 30 and 40 is a rational one. When doing this, however, ensure that the portfolio is not too exposed to any one sector. Currently, more than 30 per cent of the portfolio's equity weighting is in consumer goods and services. Having nearly 18 per cent in industrials also seems a little excessive. Guidance for one of our growth portfolios would be closer to 8 per cent.

You may want to consider diversifying into financials, to which you currently have no exposure, and geographically focused funds that would give you access to markets you may not have the expertise or confidence to invest in directly.

 

Will Walker-Arnott says:

I recognise that you are prepared to take on "lots of risk" and willing to extend your time horizon, but I would suggest dialling down the risk so that you don't run the risk of significantly reducing the capital available for a house purchase. I would therefore diversify more: having 38 per cent of your portfolio in the five largest holdings is a big bet, and you may wish to consider taking profits in these and introducing some new securities.

I think that infrastructure funds would be appropriate: these have returns with a limited correlation to the wider equity market and will make the portfolio more robust. I am currently buying the likes of 3i Infrastructure (3IN), HICL Infrastructure (HICL), MedicX Fund (MXF) and Primary Health Properties (PHP) for clients as fiscal stimulus from western governments looks increasingly likely.

Philosophically, I am a great believer in the power of dividends contributing to overall returns and I think this portfolio is lacking good-quality dividend payers that can be relied on to regularly spin off cash payments. Boohoo.com (BOO) is the largest holding, accounting for 10 per cent of your portfolio, and this does not even pay a dividend.

The remainder of the portfolio is made up of low dividend payers and I think you are missing a trick. To introduce the concept of dividend investing, research from the academic Robert Shiller is worth reading.

My other concern with the portfolio is liquidity. If you suddenly find the house of your dreams and want to liquidate the portfolio at speed, I suspect you may have problems with some of the smaller companies. A number of the holdings, including ADEPT Telecom (ADT) and Zytronic (ZYT), have relatively small free floats which could affect your ability to sell quickly.

I would suggest more diversification by adding some good-quality dividend payers and reducing volatility by adding alternative assets such as infrastructure funds.

None of the commentary here should be regarded as advice It is general information based on a snapshot of the reader's circumstances.