moneyweb investment seminars - wayne mccurrie
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Portfolio construction – risk and rewards
Eggs and BasketsWayne Mc Currie
The classic investor cycle
Why did I everbuy this ?
I really got badadvice
Revival
Excitement
Optimistic
Euphoria
Doubt
Anxiety
Denial
Fear
Depression
Panic
CapitulateDesperate
Despondent
Doubt
Optimistic
FUND INFLOWS
FUND OUTFLOWS
I will not do thisagain !!
What a good
choice I made !!
This is a really
good investment
Look at last years good return
Don’t worry the market
is consolidating
Temporary setback
I am a long term
investor
I must get out.Cash is King
Market Cycle
Maybe I panicked!
Was it right tosell ??
This is the best
thing I have ever
done !!
MAXIMUM
RISK
MAXIMUM
REWARD
THINGS
CAN’T
GET
BETTER
THINGS CAN’T
GET WORSE
Navigating choppy waters:The economic cycle
PEAK SLOWDOWN BOTTOM RECOVERY
Good news
Strong
growth
Inflation low
Interest rates
low
Things can’t
Get any
better
Start of
down turn
Inflation
rising
Interest
rates rising
Inflation
moderating
Interest rates
at peak
Economy in
trouble
Things can’t
Get any
worse
Inflation
falling
Interest
rates down
Growth
inproving
MAXIMUM
RISK
MAXIMUM
REWARD
And
4
This all looks very good –
until you live each day in a
down market
Average return of ±12%
Equity does increase
Over time but
with
VOLATILITY
BUT the monthly losses can be huge!!
And you can lose money over five years
What is diversification and how does
it work?
Diversification is simply put:
• DO NOT put all your eggs in one basket
• DO NOT buy all “The Same Theme” shares
• TRY and offset some risks
• RISK DIVERSIFICATION is the only FREE LUNCH
in investments
Example 1Bidvest and Anglo American
Both gave you the same
return over 14 years
But look at the volatility !!
Anglo American
Bidvest
Anglo AmericanReturn history
This is the number to look at
BidvestReturn history
This is the number to look at
Now construct a portfolio50% Anglo and 50% Bidvest
Anglo was 40 and Bidvest was 28 – so in
a 50/50 portfolio – you would expect the
new number to be (40+28)/2 = 34
And look at the risk now
This is the number to look at
Anglo was 40 and Bidvest was 28 – so in a 50/50 portfolio – you
would expect the new number to be (40+28)/2 = 34
BUT YOU GET 27
This is the free lunch
DIVERSIFICATION
Example 2Harmony and Standard Bank
Harmony
Standard Bank
The risk profile for Harmony
This is the number to look at
And the risk profile for Standard Bank
This is the number to look at
Now construct a portfolio50% Standard Bank and 50% Harmony
Harmony was 69 and Standard was 26 – so in a 50/50 portfolio
– you would expect the new number to be (69+26)/2 = 47
Harmony was 69 and Standard was 26
You get almost three times as many sleepless nights investing in
Harmony as investing in Standard bank
And this is the answer for Harmony and
Standard Bank
This is the number to look at
Harmony was 69 and Standard was 26 – so in a 50/50
portfolio – you would expect the new number to be
(69+26)/2 = 47
BUT YOU GET 44This is the free lunch
DIVERSIFICATION
Portfolio Construction
Rationale
“…the art of successful portfolio management is not only to be able to
identify opportunities, but also to balance them against the risks
that they create in the context of the overall portfolio.”
Robert Litterman, Goldman Sachs
Bottom-up &
Top-Down views
Portfolio
Construction
Rationale
Balances risk and return
• Risk allocated according to opportunity + conviction
• Most people don’t do this…
Minimise risk
Allocate risk efficiently
Diversification benefitsCorrelation in portfolio construction
Cash Bonds ILB’s Property Resi Findi
Cash 0.04 0.01 -0.06 -0.09 -0.14
Bonds 0.04 -0.10 0.37 0.05 0.23
ILB’s 0.01 -0.10 -0.05 -0.03 -0.04
Property -0.06 0.37 -0.05 0.26 0.55
Resi -0.09 0.05 -0.03 0.26 0.59
Findi -0.14 0.23 -0.04 0.55 0.59
Portfolio construction in practice
Challenge in composing a portfolio
For a good orchestral performance you require:
• Clarity:
· Emphasise the melody
· Allow for interpretation / expression
• Balance:
· Can’t have some instruments drowning out others
What makes a good portfolio?
Clarity• Expressing investment view
· Top Down + Bottom Up – Ideas and themes
· Shares you like and shares you don’t like
• Note: View = Highest expected return
Balance• Dividing risk appropriately between opportunities
• Making use of diversification
• Ensuring exposure to the main market drivers
Why is this important for investors?
Portfolio construction aims
Clarity• Expressing investment view
Balance• Dividing risk appropriately between opportunities
• Making use of diversification
• Ensuring exposure to the main market drivers
Repeatability
Skill versus Luck
Stability
Better risk-adjusted returns : Fewer negative surprises
Summary
Portfolio Construction
• Clarifies view of where to take risk (opportunity + conviction)
Repeatability
• Balances risk and return in the portfolio
Stability
• Enhances the investment process
Better decision-making
“You cannot manage outcomes, you can only manage risks.”
Peter Bernstein
“To do good work, one must first have good tools.”
Chinese Proverb
Equity Process
Equity investment philosophyConcept of normalised value
LEVEL
TIME
Irrational Pessimism
Low PE's in relation to past PE'sOnly bad newsLow earnings base in relation to trend earnings
Growth in trend earningsa fundamental underpinover time
Intrinsic Value
SELL
BUY
High PE's in relation to past PE'sOnly good newsHigh earnings base inrelation to trend earnings
Irrational Exuberance
MomentumInvesting
Margin ofSafety
Share Price
Shares trading below fair
value will drift to the top
Shares trading above fair value will
drift to the bottom
Three Pillars of Conviction Stock selection
Value / Cheapness
• Analysis & Evaluation
Quality / Risk Considerations
• Look and Listen
View / Theme Consistency
• Set your views
All 3 are required to identify “Leaders” & “Laggards”
Pillar 1Value
Fundamental valuation of companies - normalised,
through-the-cycle considerations
Rank companies based on these normalised valuations
Discuss different scenarios, both value implications and
probability of them playing out
The cheaper the stock, the higher the value conviction
Pillar 2Quality / risk factors
Rate all stocks based on quantitative / qualitative risk
criteria
• Balance sheet strength (cash & debt)
• Quality of management
• Barriers to entry, strength of competition
• Life cycle phase of the industry / company
• Threat of government regulation, interference
• Litigation risk
• Resource availability, buyer strength
• etc
Pillar 2Quality / risk factors
1very low quality / very high
risk
2below average quality /
above average risk
3average quality / moderate
risk
4above average quality / low
risk
5extremely high quality /
extremely low risk
Quality Ranking
Include stocks that
score average or
above-average on the
quality / risk scoring
system
Quality ranking for financials
Solvency/Capital
Balance Sheet
Strength/Optimis
ation
Barriers to
Entry
(Retail,
Investments
and Savings)
Management
(Quality and
track record)
Regulatory and
Litigation RiskOVERALL
SCORE
SCORE
CONSISTENCY
CHECK WITH
NORMALISED
EXIT RATING
SBK 3.5 3.5 4.0 2.8 3.5 0.95
SLM 4.0 3.5 4.0 3.0 3.5 0.90
LBH 4.0 3.0 2.8 3.0 3.2 0.85
MergeCO 3.5 4.0 3.0 3.0 3.2 0.85
INP 4.0 2.5 3.5 3.0 3.2 0.88
RMH 3.5 3.0 3.0 3.0 3.1 0.92
OML 3.5 2.5 2.5 3.0 3.0 0.75
FSR 3.0 3.0 2.5 3.0 3.0 0.92
NED 2.8 3.0 3.0 2.5 2.9 0.87
ASA 3.0 3.0 2.0 2.8 2.8 0.86
ABL 2.8 2.5 2.5 3.0 2.8 0.72
Overall rankingResource shares
Weighting
Attractiveness
of the industry
25%
Competitive
advantage
25%
Financial
strength &
history
20%
Stewardship
20%
Strategy /
mission
10%
Final score
100%
Final score out
of
5 Ranking
Billiton 15.0% 22.5% 20.0% 17.5% 10.0% 85.0% 4.3 1
Kumba 15.0% 20.0% 17.5% 12.5% 10.0% 75.0% 3.8 2
Impala 17.5% 20.0% 20.0% 10.0% 7.5% 75.0% 3.8 2
Sasol 20.0% 20.0% 17.5% 7.5% 5.0% 70.0% 3.5 4
African Rainbow Minerals 15.0% 17.5% 15.0% 12.5% 7.5% 67.5% 3.4 5
Northam 17.5% 15.0% 17.5% 10.0% 7.5% 67.5% 3.4 5
Anglo American 15.0% 17.5% 15.0% 12.5% 5.0% 65.0% 3.3 7
Anglo Platinum 17.5% 17.5% 15.0% 10.0% 5.0% 65.0% 3.3 7
Mondi 7.5% 20.0% 12.5% 15.0% 7.5% 62.5% 3.1 9
Mvelaphanda 17.5% 15.0% 15.0% 7.5% 7.5% 62.5% 3.1 10
Exxaro 15.0% 15.0% 12.5% 12.5% 5.0% 60.0% 3.0 11
Hiveld Steel & Vanadium 10.0% 17.5% 15.0% 5.0% 7.5% 55.0% 2.8 12
Sappi 7.5% 17.5% 7.5% 15.0% 7.5% 55.0% 2.8 13
Anglo Gold Ashanti 10.0% 10.0% 10.0% 10.0% 7.5% 47.5% 2.4 14
Arcelor Mittal 10.0% 12.5% 12.5% 5.0% 5.0% 45.0% 2.3 15
Goldfields 10.0% 7.5% 7.5% 7.5% 2.5% 35.0% 1.8 16
Harmony 10.0% 5.0% 5.0% 7.5% 5.0% 32.5% 1.6 17
Pillar 3View / theme
Identify phase of the investment cycle
• Growth, output gap, inflation, interest rate cycle
• Identify best/worst themes/styles/sectors/stocks for the phase
Bottom-up and top-down themes / views
• Jointly identify stocks best / worst placed for each view
View conviction
• Determine our level of conviction for each view / theme
Pillar 3View / theme
Government policy to become more populist and labour friendly, more intervention and higher
taxes are possible – lower market rating?
Private sector de-leveraging lead to large government stimulus → infrastr. spending –
Construction to benefit (e.g. MUR, GRF, AEG)
Industrialisation of BRICS, resource supply constraints tobias bulk resource prices higher –
favor low-cost suppliers (e.g. BIL, ARI)
Balance sheet repair to suppress consumer spending - rates will fall further – bonds, property
Growth bottomed, but still no inflation threat, rates to stay low – early cyclical (e.g. FSR, NED)
View / themes
Include stocks that
stand to benefit from
the views / themes
that are identified
Themes affecting SA equity shares over
the near term …
Theme / ViewConviction
levelStocks impacted by view
Rate cycle and consumer
spending
Prospects of lower rates remain but
consumer de-leveraging may keep
spending muted
High WHL, TRU, FOS, IPL, BAW,
BVT, SHP, MSM, JDG, LEW,
SHF, SBK, FSR, NED, ASA
China and Global EM
urbanisation and
industrialisation
Growth in EM from urbanisation and
rebalancing of EM domestic
economies leading to greater domestic
demand and wealth
High BHP, AGL, KIO, EXX, ARI
SAB, BTI, SBK, CFR
SOL, AMS, IMP, NHM
ACL, EHS, AEG
Corporate re-investment in
domestic economy
Manufacturing led businesses benefit
from re-stocking cycle and cash rich
SA corporates begin re-investing for
growth
Medium SBK, FSR, NED, ASA
Manuf.: AEG, AFE, AFX, IPL,
BAW, SHF
Growth from Sub-Sahara
Africa
Strong growth out of West Africa
resource exposed countries, FDI led
growth to drive domestic economies
High MTN, BAW, SHP, GRF, AEG,
MUR {SBK, FSR}
Europe at risk Fiscal retrenchment and austerity
measures to temper economic
recovery
High BVT, SHF, IPL, BAW, OML
Themes affecting SA equity shares over
the near term (2)…
Theme / ViewConviction
levelStocks impacted by view
Healthcare development Investment in HIV ARV’s by
government, and improvement of
public sector healthcare delivery.
Regulation of drugs and private
hospital price lists.
Medium NTC, MDC, LHC, APN, AIP,
CLS,
… AEG, MUR, GRF, WBO
Easing of fears of a total
collapse in the global
financial system
Stability in global financial systems
returns as fiscal austerity measures
result in a gradual improvement in
western country fiscal positions
Medium ANG, GFI , HAR
Domestic equity markets … Equity exposure in life companies to
drive improved returns and growth in
EV’s.
Medium LBH, OML, SLM
Domestic fixed investment Underinvestment over the last 2
decades to result in further social
infrastructure investment in the long
term, govt. execution could mean the
next 2 years are weak
Low AEG, MUR, GRF, WBO, PPC
Thank youWayne Mc Currie