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Summary Apple remains my largest position at 25.9%. The portfolio risk factor is not necessarily increased with position size. Reflect your knowledge or confidence in a company with your position size. After releasing the details of my Young and Cautious portfolio , one of the most frequently presented criticisms is of the very high allocation to Apple (NASDAQ: AAPL ). My current allocation is just north of 25%. Company Current p/e Current yield Annual dividends ($) Portfolio weighting (%) Apple 13 1.75 110.2 25.9 Aberdeen Asset Management ( OTCPK:ABDNF ) 10.53 5.21 130 9.6 Bank of America (NYSE: BAC ) 13.07 1.13 5.8 2 Coca-Cola (NYSE: KO ) 27.47 3.08 36.96 5 DaVita HealthCare (NYSE: DVA ) 33.16 0 0 11.6 General Motors (NYSE: GM ) 13.24 4 72 7.5 Gilead Sciences (NASDAQ: GILD ) 9.78 1.61 46.44 11.9 McDonald’s (NYSE: MCD ) 24.64 3.12 27.2 3.7 Rolls Royce ( OTCPK:RYCEY ) 8.28 4.18 62.42 7.5 Transocean (NYSE: RIG ) n/a 4 100.8 11 Wells Fargo (NYSE: WFC ) 13.51 2.7 27 4 Note: Average Yield = 2.6% The following comments sum up the main criticisms of the portfolio, which can be found in Young and Cautious – One month on and First Portfolio review – Young and Cautious , respectively. (click to enlarge) (click to enlarge) Although I respect the views of many commentators and contributors, I do not accept that the best strategy for an active investor is to just divide your capital equally among a list of companies that you think might perform well, regardless of their individual valuations and business circumstances. I will set out below why a higher allocation in a common stock does not necessarily lead to higher overall risk for your portfolio, and specifically, why I have allocated such a large percentage to Apple. Risk Risk can be split up into systematic risk and company specific risk, or non-systematic risk. However, for the purposes of this article, only company-specific risk will be analyzed. When talking solely about stocks, it is undeniable that non-systemic risk can be mitigated through splitting your capital among a variety of common stocks. This leads many investors to argue that the best way to reduce risk is to evenly distribute your capital over all your holdings. For example, 10 stocks with 10% weighting, or 20 stocks with 5% weighting. Many writers disagree on the ‘perfect number’ that provides the best risk/reward scenario for an active investor. Arguments generally range from 10 at the low end, to around 40 at the high end of the scale. Anything higher than this leads to a significant amount of money spent through transaction costs, which will impact significantly depending on how frequently positions are bought and sold. A higher number of stocks in a portfolio would most likely warrant the need to just take on a more passive approach through using a cheap index fund, such as provided by Vanguard. The risk that is not mentioned when talking about diversification Apart from individual company risk and systematic risk, one of the most prominent risks inherent in over-diversification is yourself. Your knowledge and time has to be spread over a higher number of companies, undeniably leading to the risk of gaps in your knowledge. This could be not having enough time to go through each company’s quarterly reports and individual valuations. This inefficient manner of investing has the potential to lead to sub-par returns. In addressing this view, investment icon Warren Buffett has stated: Once you decide that you are in the business of evaluating businesses, diversification is a terrible mistake to a certain degree. His reasoning is based on the idea of the mistake of omission in investing: Big opportunities in life have to be seized … Doing it on a small scale is almost as big a mistake as not doing it at all. This is not a scarcely held belief of prominent investors around the world. Below you see how frequently a large position plays a role in those investors’ portfolios: Warren Buffett Wells Fargo 19% Kraft Heinz (NASDAQ: KHC ) 18% David Einhorn Apple 20.5% Carl Icahn Icahn Enterprises (NASDAQ: IEP ) 27.5% Apple 21% Bill Ackman Valeant Pharmaceuticals (NYSE: VRX ) 25% Air Products & Chemicals (NYSE: APD ) 18.8% Chase Coleman Netflix (NASDAQ: NFLX ) 22.9% Amazon (NASDAQ: AMZN ) 20.1% Although not all of the companies have performed well over the past year, most notably Valeant Pharmaceuticals, most of them have. This high allocation in a company would classify as a ‘conviction buy’, exemplifying each investor’s confidence in these respective companies. It is what separates them from the rest of the market, allowing them the opportunity to beat the market returns. Know your strengths Every investor has their own strengths. This is down to the fact that whatever their profession is, or if they have a strong passion for something, they will generally have a deeper knowledge of it. This gives them an advantage over the general public and can give them the edge when it comes to putting their capital to work. This can be reflected in your portfolio. For example being a student has its perks. Many trends over what is popular originate from this age group. This could be said with regards to Apple, Facebook (NASDAQ: FB ) and Nike (NYSE: NKE ). What is popular with this age group has a tendency to spread to other age groups to create the norm. Looking back at Facebook, I grew up alongside the likes of Bebo, MSN Messenger and MySpace. My age group saw a shift from these social networking sites to Facebook, because we were causing the shift. Examples such as this give investors of certain age groups, professions, or hobbies that advantage in the market. This is one of the reasons why I am still so bullish on Apple. Regardless of what some financial news websites publish about Apple losing it’s ‘shine’ or ‘cool factor’, it is evident that Apple still has the backing of its supporters. It only takes a trip to any university library to see the momentous number of Apple products being used by students, who are in effect the future. For example, the Mac lineup has been of great popularity. Many students are making use of their university discounts and either upgrading from the previous model or other brand laptops. Growing up, these students will see Apple as the norm and are more likely to continue using their products. On the contrary, there are many areas where my knowledge lacks. This could come down to being young, lack of interest in the subject matter, or just plain ignorance. This is absolutely fine. It just means I don’t invest in these areas. If I invested in these areas for the sole reason of ‘achieving diversification’, I would be opening myself up to a great deal of risk. This is just not necessary. When opportunities are present, grab them by the horns The second part of investing in your strengths is investing at the right price. There are many companies I see doing well. Nike and Starbucks (NASDAQ: SBUX ) are both companies I want to own, just not at these prices. There is too much optimism built into the stocks. On the other hand, Apple is a company I understand well. I have a strong insight into how my generation sees their products and services over their competitors, and most importantly, the valuation is cheap. Valuation The company stands at a huge discount to the overall market. Apple’s trailing P/E ratio stands at just under 13 while the forward P/E is 11. This represents a 41% discount to the current ratio of the wider market, currently standing at 22. Apple is priced for a deceleration in earnings, while it is posting ever-growing earnings. The last earnings report showed EPS growth of 38% over the previous year, with guidance showing further record earnings for the near future. An earnings growth that surpasses the wider market. In addition to this, I believe Apple has in recent years been paving the way to become a future dividend champion. It is managing to consecutively increase dividend payments to shareholders year over year, while maintaining a low payout ratio. Currently, the dividends to shareholders represent only 21% of total earnings. This gives the company a great deal of room to increase payments several years from now. On top of this, Apple stated in April of this year that the share repurchase program would be increased to $140 billion. What are my risks? Having over a quarter of my capital in one stock does mean that if the share price drops significantly, this will drag down the portfolio significantly. Bill Ackman has recently been a victim of this, as Valeant has dropped like a rock after allegations of price gouging surfaced. This has led to him suffering a severe loss of capital and significant underperformance to the market. To compare this to Apple would be unfair. Apple has many factors that give it a large margin of safety to prevent this. First of all, almost a third of the entire market capitalization is made up of cash and equivalents, and this continues to grow. This allows Apple to raise cheap cash in corporate bonds to facilitate large share repurchases. Secondly, Apple’s great P/E discount to the wider market and higher growth rate provides a safety buffer, as it is already priced for no growth. The only time I will reduce this high allocation is if either of two things happen: Earnings begin to fall, or the share price rises resulting in a P/E ratio similar to the wider market. Conclusion Everyone has their strengths in investing. This means having a high allocation of your capital in one company will carry different risks depending on who owns that particular company. When you have the opportunity to own a good company trading at a cheap valuation that you have a deep understanding of, allocate more capital to this to increase your chances of outperforming the rest of the market. Thank you for reading. If you have enjoyed reading this article, or want to follow the progress of the ‘Young and Cautious’ portfolio please hit ‘follow’ at the top of the page. Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks. Scalper1 News
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