Berkshire Hathaway is not a safe enough core holding

ANONYMOUS PORTFOLIO

Notes: Price and value as at 11 December 2013, $1=£0.61

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Chris Dillow, the Investors Chronicle's economist says:

You say you’d like to achieve a 10-15 per cent annual return. Forget it. Settle for less, because the market isn’t likely to do so well.

To see why, let’s assume that shares are fairly priced - which is of course the consensus view. This should mean that the dividend yield on the All-Share doesn’t change, so prices will grow at the same rate as dividends. And let's suppose dividends will grow at the same rate as profits which in turn grow at the same rate as GDP. Now, let’s say real GDP grows at 2 per cent a year and inflation runs at 2.5 per cent. This gives us a nominal increase in profits and hence in share prices of 4.5 per cent. On top of this, we’ll get 3.4 percentage points of return in the form of the dividend yield. This gives us a total nominal return of 7.9 per cent, or 5.4 per cent in real terms.

You want a return of twice this. This can only happen if either the market is currently hugely under-priced, or if you outperform it a lot. Very few people believe the former. And I don’t believe the latter is possible.

Sure, Warren Buffett has delivered great returns. But one way he's done so is by leveraging up his portfolio by using cheap borrowing. You can’t do this.

Which brings me to a puzzle. There’s a big difference between your words and actions. You say you want big, boring companies as Buffett and Graham have advocated. But, aside from those held by Berkshire Hathaway, your portfolio contains only one of these (Glaxo) and a hefty tail of smaller speculative stocks.

I prefer your words. Investing in big, boring companies has succeeded down the years because of two related anomalies. One is the tendency for defensives to do better than they should. The other is that quality stocks - as measured by objective facts such as profits and recent growth - outperform.

To see why these stocks do so well, remember that if some stocks out-perform, others must under-perform. The counterpart to defensives and quality doing well is that riskier stocks and lower quality ones do badly. One reason why they do so is that investors prefer"get rich quick" stocks to 'get rich slow' ones. They see small, risky stocks as a chance to make a big, quick gain and so overpay for them, perhaps because they are over-optimistic about their ability to spot '10-baggers', or perhaps because they just over-estimate the prevalence of such shares.

It is, therefore, over-optimism which causes investors to overinvest in risky speculative shares and under-invest in bigger, proven ones.

But you seem to be guilty of exactly this over-confidence. Has your success in business caused you to become overconfident about the chances of success in investing?

This is not to say that your portfolio is calamitous. If, as I suspect, the market does okay next year, Lloyds and Barclays should rise simply because they are high-beta shares. And your more speculative investments carry lots of idiosyncratic risk which you have largely diversified away. With luck, one or two losers among them will be offset by one or two winners. The problem is that average returns on speculative stocks are low.

Do you need to take such risks? Given the size of your portfolio, an average year should allow you to take £30,000 out of the portfolio while leaving the capital intact in real terms; what matters here are total returns, as you can create your own dividends by selling stocks. This tells me that perhaps you’d be better with more mainstream stocks; remember that there’s nothing grievously wrong with tracker funds.

Sure, few years are average. Although you should expect an average real return of around 5 per cent a year, you should also expect one year in six to lose you around 15 per cent or more. If you feel you can ride out such losses, stick with equities. If not, switch some into cash.

Ben Moore-Brabazon, the divisional director of investment management at Brewin Dolphin, says:

Your portfolio demonstrates a ‘Core-Satellite’ model in its construction namely that you have a large holding in Berkshire Hathaway at the core, with small cap positions representing the further reaches of your investment galaxy. A portfolio structure such as this can provide a good risk-reward pay off, with the core holdings contributing steady returns and the more esoteric investments producing alpha. My predominant concern, however, is that in order to keep within your stated risk appetite of moderate to high, your core holding does not demonstrate sufficient safety to counterbalance the outliers.

Despite this misgiving there are few others beyond Warren Buffet to whom one would prefer to allocate such a large proportion of their portfolio. His track record is peerless, and as a fan of Benjamin Graham’s ‘Intelligent Investor’ you are with the right man. But, with any company so associated with one individual, you do need to consider so-called 'key man' risk. This was recently demonstrated following the announcement of Neil Woodford’s planned departure from Edinburgh Investment Trust. Berkshire Hathaway has confronted this by publicly naming the heir apparent, but it is still a factor worth considering when more than half of your portfolio is held in one stock.

While having a large number of underlying holdings, your portfolio is entirely made up of equity positions. Despite the relative attractions of this asset class, this does make your portfolio particularly vulnerable to any deterioration in global economic performance. With this in mind, you should consider building up a greater exposure to fixed interest instruments. It is also worth noting that reinvested income can be just as valuable as growth in the delivery of long-term returns.

Though Bank of England policy rates seem unlikely to rise until well into 2015, vulnerability does exist further along the yield curve as growth continues to improve. We do not feel, therefore, that the gilt market currently represents sufficient value. However, some attractive returns can be found within the higher yielding parts of the market. These opportunities can be well exploited through funds such as the Baring High Yield Bond Fund (IE0033156484) and the Neuberger Berman Global Floating Rate Note investment trust (NBLS). This fund pays a coupon linked to LIBOR and, therefore, is a direct hedge against rising interest rates. A fund like Pimco Total Return Bond Fund (IE00B70YV858), with its higher quality bond exposure, would also improve portfolio diversification.

These fixed income investments can help you generate the £30,000 in annual withdrawals without having to tap the portfolios’ capital. Achieving a 2 per cent yield on the portfolio should be eminently achievable, but will again require the Berkshire position to be addressed given its lack of dividend.

Around 90 per cent of the portfolio’s underlying assets are listed in the UK and US. You should consider introducing direct exposure to other areas of the global economy, perhaps through European and/or Japanese markets, which are enjoying a recovery. For example consider the Lazard European Alpha fund (GB00B6267W86) or the Baillie Gifford Shin Nippon investment trust (BGS). The trust has a large proportion of smaller companies that should benefit from a resuscitation in the local economy (although be mindful of the premium to NAV).

You have a relatively large number of smaller companies which by their very nature, are under researched but therefore can generate frequent value opportunities. But greater return potential is synonymous with greater levels of risk. To mitigate against some of these risks whilst retaining your sector bias consider investing in Artemis Global Energy (GB00B5640222) or JPM Natural Resources (GB0031835118).

With the funds that you do own it may also be worth checking that you have the cheapest unit classes available. Following the Retail Distribution Review there has been a shift to ‘clean’ units, however the onus will be on you to convert to the best available unit type, for which you are eligible. As we all know costs can severely impact long-term returns. In that regard it may be worth looking at structuring the portfolio as a charitable trust to optimise the portfolio’s tax profile - in conjunction with the correct professional advice of course.