Market Shadows Newsletter: Exploration into Value Stocks
By Paul Price
Last week I spoke about how to get started putting a cash investment into a well-structured portfolio. We covered the minimum number of different companies (20) that I think need to be represented. We also determined that you need to balance position size as measured in dollars rather than by an equal number of shares.
The next very important concept is diversification by industry group. The Value Line Investment Survey lists 98 separate categories by business line. Some of those are subsets of larger groups. An example of that would be Retailing. Within this broad industry that list no fewer than 6 subgroups. A few examples of such stocks are shown in the brackets.
1. Retail Building Supply (HD, LOW, TSCO)
2. Retail – Soft Lines (TJX, ROST, ANF)
3. Retail – Hard Lines (COH, TIF, BBY)
4. Retail – Automotive (AZO, KMX, AN)
5. Retail Store – (WMT, COST, KSS)
6. Retail – Wholesale Foods (WFM, KR, SYY)
Other Industries that overlap are utilities, which Value Line breaks down by geographic regions and non-national banks which are also covered by location.
I don’t pay much attention to Value Line’s timeliness rankings as they are mostly momentum based. Top-rated industry groups are usually the ones that have already run up in price.
It’s important to spread your 20 or more stock selections among quite a few different industries. Companies in the same business, but located in different parts of the country, may not be dissimilar enough to qualify.
Unless you have a good reason for over concentrating I’d want to have at least 15 totally unrelated companies out of your first 20 picks. Once your portfolio size gets larger you can allow for some additional overlap. Initially, though, you would have to decide between Home Depot or Lowes, Coach or Tiffany, or pick either Wells Fargo and J.P. Morgan Chase (if those were both solid candidates).
In part one we held back about 30% of our cash for future opportunities. I put some of my personal reserves to work this week by doubling my stake in Express Scripts (ESRX) because it got whacked by over 12.5% on election day.
When you know why you own something you can confidently jump on price declines. That’s because of your prior knowledge of what the company is truly worth. If you count on market movements to tell you what a stock should sell for you’ll probably be too scared to buy more on large dips.
There were numerous chances to buy Apple (AAPL) on sharp pull-backs during 2010 and 2011 for those willing to ignore crowd noise. Needless to say, buying AAPL’s dips back then worked out well even after it exhibited ‘death-crosses’ and violated various moving averages.
Let’s recap basic portfolio building rules:
- Avoid putting more than 5% or your total capital into any one stock
- That means owning at least 20 different names- More than 20 is OK
- Spread your holdings over at least 15 unrelated industry groups
- Start out with approximately equal dollar values of each stock you buy
- Have a clear idea of what your 12- 18 month price target is based on fundamentals
- Only deploy about 70% – 80% of your cash initially unless the market is really cheap
- Avoid leverage except in extraordinary periods
Following these rules to live by will keep you out of trouble. You’ll avoid the most common pitfalls. You’ll have the chance to outperform the market if you have good stock picking skills and/or simply avoid the obviously bad segments of the market.
Avoiding leverage is a key factor in resisting the urge to panic sell when you should be buying. I’ll be discussing that further in future articles.