Eschew herd mentality and prosper

In 2009, Martijn Cremers and Antti Petajisto of the Yale School of Management analysed the performance of several different investing styles.

In 2009, Martijn Cremers and Antti Petajisto of the Yale School of Management analysed the performance of several different investing styles.

An analyst at US hedge fund Cove Street Capital, Eugene Robin, recently summarised the results: "What seems fairly obvious to us is that widely diversified portfolios that hug their respective indices are either the outcome of excessive amounts of money under management or a firm's business decision to stay close to an index and take advantage of a whole host of behavioural finance flaws that enable fee-paying mediocrity."

Let's translate that: despite evidence that investors can outperform the index with a thoughtful and idiosyncratic portfolio, more professionals are indexing to protect their lucrative fees. In 1980, about 60 per cent of US mutual funds bore little resemblance to the index - they were actively managed. In 2009, that figure had fallen to just 20 per cent.

Economic cycles

In Australia, the dominance of resources, energy and banking stocks, which account for 63 per cent of the local market, adds to the danger of the approach.

Many investors now have a large proportion of their portfolio in highly leveraged banks and extremely cyclical resources and mining-services companies.

This offers the appearance of safety but exacerbates the danger.

I recommend keeping banks to 10 per cent or less of your portfolio, including any bank-issued income securities. One should remember that blue chip is not a synonym for safety or value.

So, where do you put your money?

Only a dozen or so of Australia's 200 largest stocks currently earn a positive recommendation from Intelligent Investor, compared with more than 20 late last year, when share prices were falling.

To prosper, one must seek unconventional stocks. Nevertheless, blue-chip stocks should form the base of a sound portfolio.

Cash flow rainmakers

Woolworths and Metcash, two defensive, high-quality businesses, presently offer enticing grossed-up yields of 6.9 per cent and 10 per cent, respectively.

These mature companies won't reproduce the incredible growth of the previous decade but they are reliable cash flow rainmakers.

The insurance sector also holds some promise, although, as with the banks, we recommend keeping your total exposure to no more than 10 per cent. The combined limit increases to 25 per cent for financial services companies in general.

Computershare now trades on a price-to-earnings ratio of 17 and, due to the dearth of corporate activity and low returns from its cash holdings in key markets, such as Canada , earnings are expected to fall in 2012.

These are temporary issues. The company is unlikely to be a multi-bagger, as were our recommendations following the tech wreck, but it holds plenty of appeal for patient growth investors.

Good opportunities remain in the energy sector and, as ever, speculative stocks are plentiful, although we recommend you allocate no more than 10 per cent of your portfolio to them.

Power of no

Even so, there aren't enough great opportunities to create a robust portfolio at present. That would leave you with a reasonable portion of your portfolio in cash.

There are four reasons why this shouldn't concern you.

First, you probably already own some high-quality businesses that you would only sell at exceptionally high prices. Second, you might own other financial assets, such as gold, which can help preserve your purchasing power against inflation.

Third, the strength of the local dollar means there are some very good opportunities overseas.

Finally, consider legendary investor Seth Klarman's advice:

"Some argue that holding significant cash is gambling, that being less than fully invested is akin to market timing. But isn't a 'yes' or 'no' decision the crucial one in investing? Where does it say that investing means always buying something, even the best of a bad lot? An investor who can't or won't say 'no' forgoes perhaps the most valuable tool available to investors."

Building a robust portfolio takes time. Holding cash when prices are unattractive means you'll be prepared when the next correction comes.

Nathan Bell is the research director at Intelligent Investor, This article contains general advice only (under AFSL 282288).

Want access to our latest research and new buy ideas?

Start a free 15 day trial and gain access to our research, recommendations and market-beating model portfolios.

Sign up for free

Join the Conversation...

There are comments posted so far.

If you'd like to join this conversation, please login or sign up here

Related Articles