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How to Diversify Your Portfolio

Richard Hemming

We are often asked how to set up a portfolio and this week’s Under the Radar Report Issue 298 continues our 3 part series on portfolio management, giving subscribers a detailed run down on the importance of diversification and how you can diversify your portfolio. Please watch the video below: 

What is the state of the market for small caps?

The global economy is growing. For evidence just look at the yield of 10 year US Treasury bonds, which has climbed from just over 2% in September last year to close to 3%. This is having huge effects.

One of those is that market volatility is climbing. You need to be constantly looking at your portfolio, because it’s no longer a case of “a rising tide lifts all boats”. Second, stocks that are benefiting from this economic growth are outperforming. You have to be careful on this front because investment timing is much more important. Remember what happened after the music stopped last time? Mining companies and contractors got smashed; some went out of business.

How can portfolio management help you?

Objective of the portfolio is to invest in companies with uncommon and unappreciated growth potential, or with significant opportunity for earnings recovery or balance sheet reconstruction, which the bigger end of the market cannot offer.

There’s no hiding from the fact that small caps are volatile. In fact, even big caps are also volatile. Just look at Telstra.

A well balanced portfolio reduces your stock specific volatility or risk.

How many stocks should I own?

The Small Cap Portfolio owns 19 holdings; at the top end of our range, while the Blue Chip Value Portfolio owns 22;

10 is too few to reduce the stock specific risk and reduce the volatility; 15 is about right.

Talk about diversity later; but one key is that a big difference for individual investors and what we look at is Return OF Capital not simply Return ON Capital.

What do you do with outperforming and underperforming stocks?

The market has been kind to speculative positions, which boost the returns in the short term.

We think it’s important to take profits and reduce exposure.

On the other hand there are always going to be stocks that don’t perform well. We think that it rarely works to buy more or average down.

Keeping these stocks in the bottom drawer is often the best course of action.

What does diversification mean?

Not just choosing different stocks you randomly like; via sector; via industry; via offshore businesses; via fund of funds; differing capital structures.

Owning some mining or mining services businesses can give you exposure to US$ denominated industries.

Austal (ASB) 70% of its income comes from US Navy contracts; Select Harvests (SHV) from almonds priced in US$

Don’t be afraid to own cash. The Small Cap Portfolio holds 25% of its value in cash. In the smaller end of the market it’s not unusual to be asked to put your hand in your pocket. We think that this is a good thing, as long as it’s for growth initiatives.

How do I go about looking for sector diversification?

A big difference is that you’re not trying to beat an index. The ASX200 is a good guide but the largest sector weightings the banks and resources represent 40% of the index.

Such concentration is ridiculous.

You are trying to avoid unacceptable risk or overexposure to any one investment theme. What are you are looking for is economic diversification.

How important are dividends?

Dividends are a by-product of looking for value. They represent a good way to reduce the risk of your portfolio.

There is nothing wrong with owning a mature business which is producing excess cash.

In our latest issue 298 we have a pie chart of the portfolio in terms of forecast allocation of income. It is a good illustration of what I’m talking about.

What is Under the Radar’s performance?

Both our products – our Small Cap Report and our Blue Chip Value report run portfolios. Of the two Blue Chip is more focussed around portfolio management.

We know that most people own some Big Caps like Banks, Telstra, BHP and even Qantas from its IPO. We help you get them into a working portfolio.

In terms of performance, our dividend portfolios on average are returning 23% a year – see Issues 289 and 290; while our pure small caps portfolio has outperformed the ASX Small Ords Index by 50 percentage points over the past seven years and is performing close to double digit – See Issue 295.

About the Author

Richard Hemming

Investment analyst and Editor of Under the Radar Report

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