CONCENTRATED PORTFOLIO: A RISK MANAGEMENT

“Don’t put all your eggs in one basket” is a widely known investing principle that we believe every investor and trader should follow. Diversification is a concept of risk management in investing wherein an investor would spread his capital among different stocks, hoping in the end, that he made more right decisions that the wrong ones wouldn’t matter.

Our diversification process starts by choosing the baskets and not spreading the eggs. We firmly believe that assessing the quality of each stock we are planning to own is the key to successful stock market investing. As a result, we ended up with a few baskets that meet our standards, and with this handful of quality stocks, we concentrate our capital. This is what we call the Concentrated Portfolio approach.

Concentrated portfolio is the product of thorough analysis. When you start to look at stocks as businesses instead of pieces of traded paper, you will see things differently. You will gain confidence in your investment decisions because you studied each of one carefully. To help you start your concentrated portfolio, we prepared you a checklist below you can use as reference on how to choose the companies you should include in your stock position.

#1: Avoid companies in price-competitive industries (commodity-type businesses)

When the only thing that’s keeping a company alive is because it offers the lowest price, you think twice before investing. These are the type of companies that do not provide differentiation in their products or services and the only thing that attracts customers is price. When a new competitor emerges or another company discovered a more efficient way of producing the goods, the market will shift in against the company.

#2: Look for companies with upward trend in sales and earnings for the past 10 years

What separates a great business from a good company is consistency. A great business is one that has history of strong performance and can withstand economic downturns or unfavorable industry trends. An upward trend in sales would mean that the company is growing and may have been acquiring market share from competitors (if sales growth is faster than industry growth). Consistent increase net earnings is a sign of competitive management. Please note that it doesn’t mean that the trend in sales and earnings should be always upward, in some cases the company will face uncontrollable events. What matters is despite these circumstances, the business has the ability to quickly recover.

#3: Always look at long term debts

A great business does not rely heavily on loans. Because of its ability to generate cash consistently, funding the day to day operations of the business is not a problem. We are very concerned for businesses that depends on loans to sustain operations, some of the reasons are:

1. Interest expense can significantly impact operating profit.
2. Cash is used in paying principal and interest instead of expanding the business operations
3. The company might be struggling with competition

These three (3) points are the basic items we consider when choosing the companies to be part of our portfolio. Depending on the industry, we add other items to refine our criteria. When strictly applied, a lot of companies in the stock market may not meet these requirements, hence, the options left are those that possess the characteristics of a great business. Successful risk management does not depend on the number of stocks you own, but on the quality of each stock you put your money into.