The last article discussed a number of things I didn’t do to build my newsletter portfolio. This column will turn to the things I did. Some of these may appear like a broken record from past articles but warrant repeating. None of this is rocket science and I’m sure not a rocket scientist. Perhaps that’s a good thing as this quote from one of the smartest guys ever to set foot on the planet may attest to. After investing and losing a substantial portion of his wealth on the South Sea Company (Bubble) about 300 years ago, Sir Isaac Newton lamented, “I can calculate the movement of the heavenly bodies, but not the madness of men,” obviously including himself in the ridicule.
First, like any great structure or business, all good portfolios must start with a solid foundation. That foundation was formed in large part with the companies mentioned in the last article, which are currently my largest positions. These are larger companies with solid financials that are highly unlikely to suffer long-term setbacks. They might all fluctuate 20 to 50 per cent with short-term market gyrations or temporary business setbacks, but are unlikely to go broke and will generally recover to grow out of those setbacks.
Second, I diversified across all business sectors. I categorize companies into 17 different sectors, which include the following:
- non-bank financials
- electric utility
- real estate/hotel/leisure
- business services
- oil and gas
- metals and materials
- precious metals
- alternative energy/environment
This is somewhat different than how the financial industry categorizes sectors and it’s not the only item where I differ from convention. Smaller sectors may only have one company in the portfolio, whereas large sectors may have three or four companies.
I also diversify geographically with mostly individual stock investments in Canada and the United States, utilizing exchange-traded funds (ETFs) for diversification across the rest of the world.
If you can accurately predict where the market is going you don’t need to diversify, but absent that seer skill, diversification is critical. Market participants and pundits basically fall into two categories — those that know they can’t predict short-term market gyrations and those that think they can. Those that fall into the latter category will always point out where they were correct but omit where they erred. I have made annual predictions each January since starting my newsletter and my track record has been pretty good, but I don’t make major shifts because of those predictions. I do it more to poke fun at the whole process.
Third, because short-term predictions are pretty much impossible, I have done something in this portfolio almost every month since its inception regardless of market level. I try to find companies that represent good value at the time. When markets are low there are more companies that represent good value, and when markets are high there are less companies that represent good value, but there are always some companies that are either overpriced or underpriced during all market conditions. Writing a monthly newsletter has forced a beneficial level of consistency to my approach.
Fourth, as written previously and of critical importance is focusing valuation criteria around cash flow and free cash flow. I also look at the historical 10-year growth rate in revenue, cash flow, earnings and dividends, looking for consistency and using judgement in deciding whether future growth will likely be similar or change. I don’t follow hard rules but like growth at reasonable prices (GARP). High growth rates combined with high cash flow yields are ideal but difficult to find. This portfolio has higher growth companies than my more conservative Registered Retirement Savings Plan and Tax-Free Savings Account.
As the portfolio grew, I added to existing positions of my favourite companies that were reasonably priced at the time.
Finally, I use options to enhance returns. More than 70 per cent of the deposits were made on the Canadian side, yet currently both U.S. and Canadian sides are almost equal. While the total portfolio has doubled, the U.S. side has quadrupled thanks to the effective use of options. Options are considered high risk instruments, and if used in a trading or speculative way they are. However, in the next column, I will delve into how I complement stocks with options in true investment fashion.