Portfolio Construction
Growth
2. Growth – find fast growing companies with a long-term, stable growth record
The companies with the highest investment merit from our perspective have growth records with three key characteristics:
- Fast Growth – usually reflects a good product / service, a good market and a growth-oriented corporate culture where growth is likely to continue
- Sustained Growth – preferably for at least ten years, well beyond shorter term market and economic cycles
- Stable Growth – probably reflects a good investor understanding, especially by institutional investors, of the reasons for the fast and sustained growth
Growth is desirable to meet the stewardship needs of investors for a good return and the fiduciary needs of their advisors for sound investments.
We use historic stock prices to help us identify companies with these characteristics. Historic prices can, of course, be misleading, such as during the tech bubble in the late 1990s, so good judgment is required. We consider other aspects of investment merit, such as valuation (avoid stocks with excessive P/Es), debt (choose companies with debt below industry averages) and profit margins (choose companies with margins above industry averages). We also look for companies with a readily understandable growth story that we think is sustainable.
Performance Perspective Our attempt to identify fast growing companies is consistent with our focus on doing all we can to create and manage portfolios that provide a good return. Our focus on mid cap means that our portfolio gains could exceed the market averages by 1-2%. In addition, our high alphas and high Sharpe ratios imply above average performance. Yet past performance does not guarantee future results and these ratios are based on past performance. Finally, extensive studies demonstrate that it is highly unlikely that portfolios will outperform the appropriate index over the long term.
We think the best current way to provide BRI screening is through separately managed accounts. Therefore, despite the sobering performance research, with considerable humility, we seek to do what we can to outperform a market cap weighted benchmark (click Benchmark above) and rejoice at the good progress to date.
Concentration
3. Concentration – focus research attention and increase investment discipline
We select 24 stocks in order to focus and discipline our investment thinking. Many mutual funds have 50-100 stocks and many SMAs have 35-60 stocks. Fewer stocks in the portfolio are helpful in three key ways:
- Research Focus – fewer stocks can be researched, monitored and, as needed, replaced more easily than many stocks
- Investment Discipline – a limited and specific number of stocks increases the focus on the relative investment merits of companies in different economic sectors/industries
- Small Investors – since small investors often pay for custodial and related services via transaction pricing, fewer stocks mean lower transaction costs, which affect small account performance more
Why did we choose 24 stocks? Adequate diversification to reduce short-term portfolio price volatility is the key goal. Companies and their stocks perform differently at various stages of economic and market cycles. Diversification involves choosing stocks of companies in different economic sectors/industries (i.e., stocks with non-correlated price performance) so that their price fluctuations offset each other. Statistical studies show that a portfolio with 12-15 non-correlated stocks is diversified, but portfolio volatility relative to the overall market declines until the portfolio size increases to about 25 stocks. See FAQ 19, What is the risk? and FAQ 20, How can I reduce risk? for more on our approach to reducing risk.
Diversification
4. Diversification – reduce short-term price volatility by diversification
Diversification for Foundation Financial involves owning a concentrated portfolio of 24 stocks. We use diversification because stocks in each economic sector or industry respond differently to the same economic developments, political events, social trends, and market cycles.
We adopted the following sector weight guidelines to reduce short term price volatility:
- Minimum – own at least 50% of the S&P 400 weight in at least the seven largest S&P 400 economic sectors
- Maximum – own less than 200% of the S&P 400 weight in the same seven largest S&P 400 economic sectors
- Maximum – own less than 25% of the portfolio in any single S&P 400 sector
We want some (at least 50%), but not too much (not over 200%) investment in at least the seven largest sectors. We emphasize the sectors that have biblical values stocks with the best investment merit. Within the sectors, we increase diversification by owning companies in different industries, such as freight, valves, and recreational vehicles in the industrials sector. We chose the S&P 400 for sector weights because this mid-cap index is most comparable to our mid cap investment strategy.
Following are the S&P 400 sector weights and the recent relative FFI weights.
S&P 400 Sector Weights
S&P 400 Wt. |
FFI % of S&P |
|
|---|---|---|
| Financials | 15.6% |
89% |
| Information Technology | 13.6% |
152% |
| Industrials | 16.2% |
100% |
| Consumer Discretionary | 12.4% |
105% |
| Health Care | 12.4% |
109% |
| Energy | 10.2% |
94% |
| Utilities | 7.9% |
167% |
| Materials | 7.7% |
0 |
| Consumer Staples | 3.4% |
0 |
| Telecommunication Services | 0.6% |
0 |
Total |
100.0% |
We were unable to find companies with good investment merit in the smallest three sectors. Good diversification increases the risk-adjusted return for the portfolio by reducing the risk while maintaining the expected long-term return. See FAQ for more on risk and our investment approach to reducing risk.
MPT
5. Modern Portfolio Theories Evalution – tools that help improve risk-adjusted return
Modern portfolio theory (MPT) provides tools that help us compare the characteristics of our portfolios to those of portfolios that have performed well in the past. Nobel prizes have been awarded for MPT research, which is at the core of understanding our free market economy. MPT statistics and related data from Morningstar’s Snapshot report are very helpful in evaluating our portfolio construction choices.
Morningstar data helps us analyze and compare the expected performance of our portfolios in two key ways: (1) with other portfolios with more assets and longer track records, and (2) with benchmarks in the Snapshot program.
How does FFI look based on MPT? … quite good as follows:
- Alphas – generally 15-20, which is 2-3 times the level of many portfolios; high alphas signify good selection of stocks that are likely to outperform the averages.
- Betas / Standard Deviations – the betas are under 1 and the standard deviations are in line with or a little above the benchmark; both imply low portfolio volatility. Low volatility is unexpected for a portfolio with a high alpha; it may result from the relatively steady growth of many biblical values stocks in good and bad markets.
- Sharpe Ratios – the Sharpe ratios are well above the benchmarks; high Sharpe ratios signify above average risk-adjusted return. There are two components of the Sharpe ratio calculation – historic return, which is far above the benchmark, and standard deviation, which is generally in line with the benchmark. Thus, the Sharpe ratios (measures the risk-adjusted return) of our portfolio are quite good.
The benchmark upon which these statistics are based is size-weighted, as discussed in the next section.
Other Snapshot statistics are generally quite positive. Many exceed the benchmark, such as P/E (price / earnings ratio), ROE (return on equity), and ROA (return on assets). Some are below the benchmark, such as long-term debt ratios.
The MPT and related statistics imply that this portfolio has good potential to have a risk-adjusted return above the benchmark.
Benchmark
6. Benchmark – use a relevant benchmark to compare and judge performance
We use a custom benchmark based on market capitalization, since large, mid and small cap stocks tend to perform as three separate groups. Our Growth model benchmark is:
Custom Benchmark for FFI Growth Model
| Description | Index |
Percent |
|---|---|---|
| Large Cap | S&P 500 |
9% |
| Mid Cap | S&P 400 |
61% |
| Small Cap | S&P 600 |
28% |
| Cash | Money Market |
3% |
Total |
100% |
|
Market cap definitions differ and change. Large cap is often for a market cap over billion, small cap is often under billion and mid cap is in between. Market cap is shares outstanding times the stock price. Our portfolio includes some small cap stocks that are approaching mid cap status and some large cap stocks that outgrew their mid cap size. Therefore, we believe that a market cap weighted custom benchmark is the most accurate way to evaluate relative performance.
Asset Allocation
7. Asset Allocation – reduce risk further with portfolios having lower risk asset classes
Previously we mentioned two ways to reduce risk and volatility - diversify and select less volatile stocks. These diversification methods increase risk adjusted return by maintaining return and reducing risk (click Diversification above). Another frequently used risk-reduction method is asset allocation. Asset allocation reduces both risk and expected return.
Three common assets are stocks, bonds and cash. We add a fourth – high yield stocks. The table below shows the long-term return and short-term volatility of these four asset classes.
Long-Term Return and
Short-Term Volatility of Major Assets
| Asset Class | Long-Term Return |
Short-Term Volatility |
|---|---|---|
| Stocks | 9-11% |
High |
| High Yield Stocks | 5-8% |
High/Moderate |
| Bond Mutual Funds | 4-6% |
Moderate |
| Money Market Funds | 2-4% |
Low |
High yield stocks include REITs and royalty trusts. They are our first asset allocation step of risk reduction because: (1) they have a low correlation with stocks; and (2) both their principal (i.e., stock price) and their dividends can grow, which increases their potential long-term return relative to bonds, which have fixed interest and fixed principal.
We provide three asset-allocated portfolios – Growth, Moderate Growth and Conservative Growth. The table below shows the number of securities and percent allocation to main assets for our three asset-allocated portfolios.
Growth |
Moderate Growth |
Conservative Growth |
||||
Number |
% |
Number |
% |
Number |
% |
|
| Stocks | 24 |
97% |
24 |
75% |
24 |
55% |
| High Yield Stocks | – |
– |
4 |
20% |
4 |
20% |
| Bond Mutual Funds | – |
– |
– |
– |
2 |
18% |
| Money Market Funds | 1 |
3% |
1 |
5% |
1 |
7% |
| Total | 25 |
100% |
29 |
100% |
31 |
100% |
| Past L-T Return | 9-11% |
8-10% |
7-9% |
|||
The Past Long-Term Return (bottom line) is a weighted average of average historic returns for the asset classes. Since future returns cannot be predicted accurately, these returns are intended for general education and do not imply any commitment that these returns will be achieved in the future.
Our Conservative Growth portfolio has a sizable allocation to stocks (55%) because we think most well informed investors seek the larger long-term appreciation expected from stocks.
Model Portfolios
8. Model Portfolios – serve investors equally, efficiently and effectively
Model portfolios have three key benefits:
- Focus – investment management attention is focused on the stocks in the model portfolios
- Fair – each client receives equal treatment
- Efficiency – changes in our online portfolio model can be implemented quickly by BridgePortfolio, our provider of back office support and online reporting services
Model portfolios enhance consistency. Consultants and the advisors who retain them to assess investment managers like to see most client accounts managed in a similar and consistent style, since it is more likely to be repeatable. Foundation Financial offers three asset-allocated model portfolios – Growth, Moderate Growth, and Conservative Growth. The same 24 stocks with the same proportionate allocations are in all portfolios.
As an additional service to investors, FFI can facilitate tax-oriented transactions and gifting. However, in order to keep fees low and reduce investment management complications, FFI encourages investors to view investments as being long-term and not subject to interim withdrawal for near term financial needs. See FAQ Can I Withdraw Funds?