If you want a diversified portfolio, you need to consider what's driving the profits of each of your holdings.
Why diversify? Well, investors seek diversification for a number of reasons.
Stock-specific risk can be diversified by increasing the number of holdings, in order to mitigate the effects of a blow up in any particular stock.
Market risk can never be totally eliminated within a stock portfolio, however it is possible to decrease the level of correlation within a portfolio. For example, investors could favour small caps over large caps. This could work because you can find small caps whose profit drivers are less exposed to the overall economy.
Alternatively, you could reduce the number of holdings and have a few 'farm bet' type positions. However, this approach will increase your stock specific risk.
Lastly, equity market risk can be reduced via hedging or other alternative strategies. However, here I'm going to focus on the long-only equity aspect of investing.
Identifying profit drivers
You can think of key profit drivers as falling within three overlapping spheres:
1) Administrative -- how is the company run?
Examples of the things you can look for are who are the key personnel and what are their motives? Some companies are run more for the interests of their directors than the shareholders. I tend to avoid 'colourful' businessmen, as you rarely make any money out of investing with them.
Similarly, serial stock option issuers are worth avoiding. Above all, I avoid companies with unusual and unclear business models. I would say a classic example of the latter is the ill-fated Aero Inventory.
2) Operational -- how it performs compared to its rivals?
This is the area where 'science' can play a large part since you can compare a host of operational metrics across industry competitors.
For example, comparing a company's gross margins compared to the industry will help you understand their competitive position. For retailers, metrics such as sales per square foot might be useful. For companies dependent on intellectual property, like the big pharmaceutical firms, you could look at R&D spend as a percentage of sales.
The list is almost endless, but the key point is to focus and identify what is likely to move earnings and prices in future.
3) Strategic -- what are strategic end drivers?
This is usually the most important of the three. Industries like mining and many energy companies are strategically exposed to the prices of the commodities that they deal in. Indeed, most companies are exposed to an overriding macro factor. Consumer goods companies are exposed to consumer spending cycles etc.
A simplistic view of this approach would be to define companies in terms of having cyclical or defensive qualities. In reality, a company's prospects are far more complex. Defining a strategic profit driver may appear to be a science, but in fact it is more of an art.
Don't believe the Beta hype
Portfolio theorists try to argue that all these key profit drivers can be captured in the beta of the stock. However, by definition this is always a historical measure, and will tell not necessarily tell you the future.
Markets change and there is an art to identifying and diversifying the profit drivers within a portfolio.
Some practical examples
So how can you apply this to your portfolio? Here's an example:
|Spirent||Telecoms testing||Strong||Strong vs. Ixia and Alcatel||Telecom upgrade cycle|
|De La Rue||Printing||Recently Weak||A world leader, but variable|
due to recent events.
|Demand for bank notes|
|Aveva||Software||Very Strong||A world leader||New energy and|
|Cineworld||Cinema operator||Good, although has|
had various owners.
|Good. Top 3 in UK. Depends|
on 3D and film output.
|Attendance is counter-cyclical|
I believe that Spirent (LSE: SPT) has relatively secular growth prospects. A new generation of wireless devices are coming out and they will create demand for upgrades to 4G. Spirent is better placed in 4G than Ixia or Alcatel, so while its margins already compare very well with its competitors, I believe it is set to expand.
De La Rue (LSE: DLAR) is a world leader in bank note printing. While end demand is growing in a stable manner, it recently had some paper quality issues which have significantly affected this year's profits and cast doubt on its reputation. The share price has taken a hit as a result. For De La Rue, I think the key driver will be can it repair its reputation and keep winning contracts.
Although Aveva (LSE: AVV) is a software company, its fortunes are tied to the prospects for new builds in the energy and shipbuilding industries. Therefore, its profit driver is not really dependent on overall business IT spending, but rather a few niche verticals which are driven by energy and shipping prices.
In the case of Cineworld (LSE: CINE), cinema attendances are usually seen as counter-cyclical but they are also dependent upon good movie releases. Furthermore, Cineworld's growth prospects are also tied to the success of 3D films, as it can charge more for these films. Will 3D take off? Will cinema goers start balking at paying higher prices for them?
Although, purely an illustrative example. You can see that, strategically, these four stocks are diversified. They range from cyclical (Aveva) to counter cyclical (Cineworld). However, they contain significant operational risk (De La Rue, Cineworld) and possibly some administrative issues (De La Rue, Cineworld).
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