Relying on value means your portfolio is too volatile

“I want to create a second source of income within the next two to three years,” says Alexander. “I need to save large amounts to support my children’s university education and future expenses, such as their weddings. And I want to have a substantial income after age 60 to maintain our standard of living. I contribute to an employer pension, but this is not likely to pay out more than €1,000 a month. I hope to get an annual return on my investments of 6 per cent over the long term.

I also have cash savings of around £265,000, earning an interest rate of about 1.5 per cent a year, euro-denominated cash worth around €50,000 and gold worth around €10,000.

I have been investing for just over three years, and have a medium risk appetite given that I am prepared to lose up to 20-25 per cent of the value of my portfolio in a given year, or over the short term. I am prepared to be patient and take a long-term view, holding investments for five years plus, as I don’t need to draw on the portfolio in the near future.

I usually invest in fallen angels – out-of-favour dividend-paying companies with long track records and strong balance sheets. For example, I bought Royal Dutch Shell (RDSB) when the oil price was very low and UK housebuilders after the vote to leave the EU in 2016, and then sold them after a large gain within a year. I bought BT (BT.A) after an accounting scandal, but its price keeps going down. And I bought Petrofac (PFC) following the news that it was being investigated by the Serious Fraud Office.

However I think I am too risk-averse because I don’t invest in growth stocks with high valuations, for example ones that have a high price-earnings (PE) ratio and don’t pay a dividend. I rarely invest in stocks that have increased by more than 50 per cent in the past six months or a ‘market darling’ such as Facebook (FB:NSQ), Amazon (NSQ:AMZN), Apple (AAPL:NSQ), Netflix (NFLX:NSQ) or Alphabet (GOOGL:NSQ) – the 'FAANGs'.

Most of my portfolio is in dividend-paying companies with not much growth potential but strong balance sheets. I feel I should take more risk with growth stocks like the FAANGs, although it seems late to enter these now.

I recently sold a third of my holding in Bowleven (BLVN) when its price hit 38p, it is now 28p (as at 20.09.2018). I bought Rio Tinto (RIO) when its price fell to 3,600p a few months ago due to fears of a trade war. And I bought John Wood (WG.) at 600p a share following oil price weakness.   

I am thinking of buying Lockheed Martin (LMT:NYQ) as defence spending going up, an exchange traded fund (ETF) that tracks Japanese equities, Microsoft (MSFT:NSQ), cyber security companies, mining companies such as Glencore (GLEN) and an agriculture ETF. I might buy ETFs that track developed equity markets if there is a large drop in valuations, and a Turkey ETF as an emerging market play because the PE ratio on this market is low.

I've also been wondering whether I should cut my allocation to direct shareholdings and invest via ETFs to save time, effort and cost.

Alexander's portfolio

NONE OF THE COMMENTARY BELOW SHOULD BE REGARDED AS ADVICE. IT IS GENERAL INFORMATION BASED ON A SNAPSHOT OF THIS READER'S CIRCUMSTANCES.

THE BIG PICTURE

Chris Dillow, Investors Chronicle’s economist, says:

Overall you have quite a safe portfolio. You have large cash holdings, as well as equity in your home and a well-paid job. All of these offer ways of spreading equity risk: in the event of a market fall, you can use your savings to pick up cheap stocks. The fact that this part of your portfolio is almost all in equities should not trouble you much.

You’re also not being too risk averse by not investing in highly valued growth stocks. History tells us that such stocks have underperformed the dividend payers you prefer on average over the long run. The FTSE 350 low-yield index (a measure of growth shares) has underperformed its high-yield counterpart by an average of 1.8 percentage points per year over the past 30 years. This is striking because bond yields have fallen a lot in this time, and this should have benefited growth stocks more than value ones.

Of course, history need not repeat itself. But we’ve a good reason to suspect it might. Investors, however, underweight this fact – perhaps because of overconfidence and/or the hindsight bias. They pay too much for what looks like growth, and too little for companies that appear to have poor growth prospects – the ‘fallen angels’ you like.

It’s difficult to avoid the temptation to buy high-profile stocks that have made others lots of money. But remember that countless investors have been sucked into assets near the peak of the market and have lost heavily as a result.

However, there are two caveats. One is that some of today’s 'growth' stocks – unlike many of their predecessors – have what Warren Buffett calls “economic moats” – sources of monopoly power: think of Amazon or Facebook. And investors have historically paid too little for these moats. I’m not sure you should worry about this. For one thing, investors might well have wised up to that underpricing and so eliminated it. 

Second, there is momentum in shares, both up and down – as you learned from BT. I suspect that a lot of the profits growth investors have made are in fact momentum profits. Exploiting momentum, however, requires lots of vigilance and trading.

Phil Sidebottom, chartered independent wealth planner at WH Ireland, says:

The current strategy of investing in 'fallen angles' will have produced some dramatic swings in value. The holding of Petrofac and Wood Group will have provided significant growth over recent months (if bought at lows), however Glencore, Crest Nicholson (CRST) and Symantec (SYMC:NSQ) will have seen some dramatic losses. This level of volatility exceeds your medium risk profile.

For a relatively young age, your portfolio of £209,440 and cash of £265,000 (plus significant property equity) means you are in a strong financial position to plan your future. Yet care needs to be taken to ensure that you can continue to capitalise on this strong position. Consideration needs to be given to ensure that you are sufficiently insured should you suffer a serious illness or die prematurely. As the main earner, any reduction to your earnings will have a significant impact on the family's long-term financial plan.

Jason Porter, director at Blevins Franks, says:

The composition of your portfolio suggests you are more high risk than medium risk. There is some diversity at an individual stock level, with 33 holdings and some ETFs, which increase the number of underlying companies.

However, it is primarily made up of equities. A portfolio of mostly equities is high risk and a medium-risk portfolio would include more diversity at an asset class level, with a significant allocation to fixed income and an allocation towards more tangible assets such as infrastructure.

There is also a high concentration in oil and gas companies, almost 40 per cent of the portfolio. These companies are greatly affected by external factors, such as the price of oil, and outside the control of company management. Most of the oil sector companies in the portfolio are affected to some degree by the price of oil, and this negates some of the diversification. This sector concentration also greatly increases the risk of a one-off macroeconomic event having a detrimental effect on the portfolio.

HOW TO IMPROVE THE PORTFOLIO

Chris Dillow says:

I support your idea of shifting into ETFs. Even professional fund managers – who have far more time for research than you – only have a handful of good stockpicking ideas, and so ETFs are an easy and cheap way to get a diversified portfolio.

However, I caution about mining stocks. Not only is momentum against many of these, but also the recent slowdown in China’s monetary growth is a lead indicator of weaker commodity prices. There might therefore be a better opportunity to buy into miners later.

Phil Sidebottom says:

Given your commitments and time constraints, I would diversify away from individual stocks and allocate the majority of the portfolio to investment funds. However, I would recommend active fund managers with a good and consistent track record of returns over the medium to long term and in different economic/market cycles. These should then be reviewed on a regular basis and replaced when necessary – if the manager leaves or if performance dips over the medium term.

You should also have a clear plan for cash holdings. Despite the low interest rate environment, cash remains an important asset class to hold. Holding sufficient cash to act as your 'emergency reserve' is crucial, and any planned capital expenditure within the next three years should also be kept in cash. After this, you may wish to consider reducing your mortgage liability.

You also need to clearly define your objectives and understand exactly why you are investing. What is the level of capital required for: 1) Your children's education, 2) Their weddings and 3) How much income do you wish to receive from the portfolio. By doing this, you can carry out a cash flow modelling exercise to show the level of return required to achieve the objectives. This, in turn, will help you accurately assess your capacity for loss and 'risk need'.

Jason Porter says:

It may be beneficial if you went through a formal risk-profiling process. This could clarify your attitude and help to construct a portfolio to meet your goals. Your style of stockpicking – value – has trailed returns of growth stocks in the past few years, particularly in the US. I prefer not picking a single style and invest in funds to get more options. Self-investing is time-consuming and it is difficult to time the correct entry and exit points in individual stocks, or even entire asset classes. The greatest indicator of successful investing is time spent in the market.