Portfolio construction – risk and rewards
                       Eggs and Baskets
                           Wayne Mc Curr...
The classic investor cycle
                             MAXIMUM
                               RISK                   This...
Navigating choppy waters:
The economic cycle

            PEAK         SLOWDOWN          BOTTOM        RECOVERY
         M...
And


          This all looks very good –
          until you live each day in a
                  down market



       ...
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...
Example 1
Bidvest and Anglo American


           Both gave you the same
            return over 14 years




            ...
Anglo American
Return history


                 This is the number to look at
Bidvest
Return history


                 This is the number to look at
Now construct a portfolio
50% Anglo and 50% Bidvest




                            Anglo was 40 and Bidvest was 28 – so i...
And look at the risk now

                                      This is the number to look at




                        ...
Example 2
Harmony 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 portfolio
50% Standard Bank and 50% Harmony




                    Harmony was 69 and Standard was 26 – s...
And this is the answer for Harmony and
Standard Bank

                    This is the number to look at
                  ...
Portfolio Construction
Rationale


“…the art of successful portfolio management is not only to be able to
    identify opportunities, but also to...
Rationale


  Balances risk and return
  • Risk allocated according to opportunity + conviction



  • Most people don’t d...
Diversification benefits
Correlation in portfolio construction


             Cash       Bonds      ILB’s   Property   Res...
Portfolio construction in practice
Challenge in composing a portfolio


  For a good orchestral performance you require:
  • Clarity:
      · Emphasise the m...
What makes a good portfolio?


  Clarity
  • Expressing investment view
     · Top Down + Bottom Up – Ideas and themes
   ...
Portfolio construction aims


  Clarity
  • Expressing investment view
                                Repeatability
     ...
Summary

       “You cannot manage outcomes, you can only manage risks.”
                                                 ...
Equity Process
Equity investment philosophy
Concept of normalised value

         Shares trading above fair value will
         drift to ...
Three Pillars of Conviction
Stock selection


   Value / Cheapness
    • Analysis & Evaluation

   Quality / Risk Consider...
Pillar 1
Value


  Fundamental valuation of companies - normalised,
  through-the-cycle considerations
  Rank companies ba...
Pillar 2
Quality / risk factors


   Rate all stocks based on quantitative / qualitative risk
   criteria
    • Balance sh...
Pillar 2
Quality / risk factors



       Quality Ranking

        extremely high quality /
 5        extremely low risk

...
Quality ranking for financials

                              Barriers to                                                 ...
Overall ranking
Resource shares

                                                            Financial                    ...
Pillar 3
View / theme


  Identify phase of the investment cycle
   • Growth, output gap, inflation, interest rate cycle

...
Pillar 3
View / theme


             View / themes

  Growth bottomed, but still no inflation threat,
rates to stay low – ...
Themes affecting SA equity shares over
the near term …
                                                                   ...
Themes affecting SA equity shares over
the near term (2)…
                                                                ...
Thank you
Wayne Mc Currie
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Moneyweb Investment Seminars - Wayne McCurrie

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Portfolio construction - risk and rewards. Eggs and baskets. (October 2010)

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Moneyweb Investment Seminars - Wayne McCurrie

  1. 1. Portfolio construction – risk and rewards Eggs and Baskets Wayne Mc Currie
  2. 2. The classic investor cycle MAXIMUM RISK This is the best thing I have ever What a good done !! choice I made !! FUND INFLOWS This is a really Euphoria good investment Don’t worry the market is consolidating Doubt Look at last years good return THINGS Excitement Anxiety Temporary setback I am a long term CAN’T investor Denial Maybe I panicked! Revival GET I ever Why did Fear buy this ? Optimistic BETTER Optimistic MAXIMUM I really got bad Depression Doubt advice REWARD Was it right to Panic sell ?? I will not do this Market Cycle THINGS CAN’T again !! Capitulate Despondent Desperate I must get out. GET WORSE Cash is King FUND OUTFLOWS
  3. 3. Navigating choppy waters: The economic cycle PEAK SLOWDOWN BOTTOM RECOVERY MAXIMUM RISK Good news Start of Inflation Inflation Strong down turn moderating falling growth Inflation Interest rates Interest Inflation low rising at peak rates down Interest rates Interest Economy in Growth low rates rising trouble inproving Things can’t Things can’t Get any Get any better worse MAXIMUM REWARD
  4. 4. And This all looks very good – until you live each day in a down market Equity does increase Over time but with VOLATILITY Average return of ±12% 4
  5. 5. BUT the monthly losses can be huge!!
  6. 6. And you can lose money over five years
  7. 7. 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
  8. 8. Example 1 Bidvest and Anglo American Both gave you the same return over 14 years Bidvest Anglo American But look at the volatility !!
  9. 9. Anglo American Return history This is the number to look at
  10. 10. Bidvest Return history This is the number to look at
  11. 11. Now construct a portfolio 50% 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
  12. 12. And look at the risk now This is the number to look at This is the free lunch DIVERSIFICATION 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
  13. 13. Example 2 Harmony and Standard Bank Harmony Standard Bank
  14. 14. The risk profile for Harmony This is the number to look at
  15. 15. And the risk profile for Standard Bank This is the number to look at
  16. 16. Now construct a portfolio 50% 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
  17. 17. 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 44 This is the free lunch DIVERSIFICATION
  18. 18. Portfolio Construction
  19. 19. 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 & Portfolio Top-Down views Construction
  20. 20. Rationale Balances risk and return • Risk allocated according to opportunity + conviction • Most people don’t do this… Minimise risk  Allocate risk efficiently 
  21. 21. Diversification benefits Correlation 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
  22. 22. Portfolio construction in practice
  23. 23. 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
  24. 24. 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?
  25. 25. Portfolio construction aims Clarity • Expressing investment view Repeatability Skill versus Luck Balance • Dividing risk appropriately between opportunities • Making use of diversification • Ensuring exposure to the main market drivers Stability Better risk-adjusted returns : Fewer negative surprises
  26. 26. Summary “You cannot manage outcomes, you can only manage risks.” Peter Bernstein 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 “To do good work, one must first have good tools.” Chinese Proverb
  27. 27. Equity Process
  28. 28. Equity investment philosophy Concept of normalised value Shares trading above fair value will drift to the bottom Irrational Exuberance Intrinsic Value High PE's in relation to past PE's Only good news Growth in trend earnings High earnings base in a fundamental underpin relation to trend earnings over time Share Price Momentum Investing SELL Margin of Safety LEVEL BUY Irrational Pessimism Low PE's in relation to past PE's Only bad news Low earnings base in relation to trend earnings TIME Shares trading below fair value will drift to the top
  29. 29. 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”
  30. 30. Pillar 1 Value 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
  31. 31. Pillar 2 Quality / 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
  32. 32. Pillar 2 Quality / risk factors Quality Ranking extremely high quality / 5 extremely low risk above average quality / low Include stocks that 4 risk score average or average quality / moderate above-average on the 3 risk quality / risk scoring below average quality / system 2 above average risk very low quality / very high 1 risk
  33. 33. Quality ranking for financials Barriers to SCORE Solvency/Capital Entry Management Regulatory and CONSISTENCY Balance Sheet OVERALL (Retail, (Quality and Litigation Risk CHECK WITH Strength/Optimis SCORE Investments track record) NORMALISED ation and Savings) 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
  34. 34. Overall ranking Resource shares Financial Final score out Attractiveness Competitive strength & Stewardship Strategy / Final score of of the industry advantage history mission Weighting 25% 25% 20% 20% 10% 100% 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
  35. 35. Pillar 3 View / 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
  36. 36. Pillar 3 View / theme View / themes Growth bottomed, but still no inflation threat, rates to stay low – early cyclical (e.g. FSR, NED) Balance sheet repair to suppress consumer spending - rates will fall further – bonds, property Include stocks that stand to benefit from Industrialisation of BRICS, resource supply constraints tobias bulk resource prices higher – the views / themes favor low-cost suppliers (e.g. BIL, ARI) that are identified Private sector de-leveraging lead to large government stimulus → infrastr. spending – Construction to benefit (e.g. MUR, GRF, AEG) Government policy to become more populist and labour friendly, more intervention and higher taxes are possible – lower market rating?
  37. 37. Themes affecting SA equity shares over the near term … Conviction Theme / View Stocks impacted by view level Rate cycle and consumer Prospects of lower rates remain but High WHL, TRU, FOS, IPL, BAW, spending consumer de-leveraging may keep BVT, SHP, MSM, JDG, LEW, spending muted SHF, SBK, FSR, NED, ASA China and Global EM Growth in EM from urbanisation and High BHP, AGL, KIO, EXX, ARI urbanisation and rebalancing of EM domestic SAB, BTI, SBK, CFR industrialisation economies leading to greater domestic SOL, AMS, IMP, NHM demand and wealth ACL, EHS, AEG Corporate re-investment in Manufacturing led businesses benefit Medium SBK, FSR, NED, ASA domestic economy from re-stocking cycle and cash rich Manuf.: AEG, AFE, AFX, IPL, SA corporates begin re-investing for BAW, SHF growth Growth from Sub-Sahara Strong growth out of West Africa High MTN, BAW, SHP, GRF, AEG, Africa resource exposed countries, FDI led MUR {SBK, FSR} growth to drive domestic economies Europe at risk Fiscal retrenchment and austerity High BVT, SHF, IPL, BAW, OML measures to temper economic recovery
  38. 38. Themes affecting SA equity shares over the near term (2)… Conviction Theme / View Stocks impacted by view level Healthcare development Investment in HIV ARV’s by Medium NTC, MDC, LHC, APN, AIP, government, and improvement of CLS, public sector healthcare delivery. Regulation of drugs and private … AEG, MUR, GRF, WBO hospital price lists. Easing of fears of a total Stability in global financial systems Medium ANG, GFI , HAR collapse in the global returns as fiscal austerity measures financial system result in a gradual improvement in western country fiscal positions Domestic equity markets … Equity exposure in life companies to Medium LBH, OML, SLM drive improved returns and growth in EV’s. Domestic fixed investment Underinvestment over the last 2 Low AEG, MUR, GRF, WBO, PPC decades to result in further social infrastructure investment in the long term, govt. execution could mean the next 2 years are weak
  39. 39. Thank you Wayne Mc Currie
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