By GABRIEL LOWENBERG. Special to The Globe and Mail, Published Wednesday, Jan 8th, 2014
What do layer cakes and investment portfolios have in common? The better ones start by building solid foundations, then add a little icing on the top.
This may strike you as a simplistic metaphor. But if, like most investors, you are constantly trying to balance risk and reward, I suggest you keep the image in mind. It’s a useful way to gauge whether your financial recipe is working.
As a money manager, I always begin by building a robust base for my clients’ stock portfolios. I then spice them up with a judicious bit of sweetener.
To my mind, a strong foundation means that three-quarters to 100 per cent of a stock portfolio’s total value should always be invested in blue-chip, steady, stable companies. The remainder – the icing – may be invested in riskier equities.
The exact percentages will vary, according to market moods, suitability and appropriateness for the client and their risk tolerance. There are times to carefully add risk and times to reduce risk.
I think about it this way: Is the overall market in a risk-averse or risk-seeking mood? In 2006-07, when the U.S. Federal Reserve was raising interest rates to slow down the economy, it was a time to reduce risk. In contrast, the current environment is one in which the Fed is suppressing rates to near zero until the economy recovers and U.S. unemployment falls. This can be a rewarding time for risk-takers.
As a money manager, one of my central tasks is to assess the overall direction of the U.S. economy, because Wall Street feeds the global appetite for risk. If the outlook is bullish for the United States, you can then decide how much icing to spread on your portfolio. But in my opinion, the risky component should never exceed one quarter of your holdings.
The bulk of your stock portfolio should always be in those solid, stable, blue chip companies I mentioned earlier – but that doesn’t mean you can simply forget about them. People are always telling me that you can buy blue-chip, dividend-paying businesses and then go to sleep. I couldn’t disagree more: All securities require continuous monitoring and analysis.
You may remember a company called Eastman Kodak Co., which analysts repeatedly cited as being a cheap blue-chip stock. It was in the S&P 500 until December, 2010. It filed for bankruptcy protection just over a year later.
Hewlett-Packard Co. provides another case in point. When I started as an analyst at Gluskin Sheff in 1991, HP was considered the peer of IBM. Then its management proceeded to destroy shareholder value by making acquisitions instead of embracing change. Over the past five years, investors who slumbered would have lost about half the money they had invested in the company.
What I look for are companies with riskless revenue. The two best examples I know are Visa Inc. and MasterCard Inc. (I own shares of both these companies for clients.) The credit card giants get paid their fees, regardless of the profitability of the product or service being sold, or whether the credit card holder pays his or her bill to the issuing bank. The risk to Visa and MasterCard are in volume and regulation – not in pricing.
I also like mature companies that are doing smart things to grow their business. Consider Loblaw Cos. Ltd.’s acquisition this year of Shoppers Drug Mart Corp. While there are risks in any merger, my math suggests the synergies created by folding Shoppers’ costs into Loblaw’s infrastructure will easily exceed management’s own estimate of $300-million over the next few years.
The vast majority of my clients’ portfolios are invested in blue chip equities like these and a very small percentage is devoted to icing. The key question is always how much icing to put on. Not enough, and you may miss some opportunities. Too much, and you can ruin the whole thing.
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