Five Star Portfolio

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24th Aug '24 by SCI20

31 comments 1679 reads

Following a post by Revs8 regarding Peter Lynch's investment philosophy, I have challenged myself to reduce my 24 holdings to only 5. All holdings are to be held for a minimum of 5 years with annual portfolio performance in excess of 20%. I have attempted to achieve sector and geographical diversification.

1. Morgan Sindall (LON:MGNS) : UK Industrials

2.Property Franchise (LON:TPFG) : UK Financials

3.Kenmare Resources (LON:KMR) : UK Basic Materials

4. Microsoft (NSQ:MSFT) : US Technology

5. Lantheus Holdings (NMQ:LNTH) : US Healthcare

I would welcome the thoughts of others on how they would build a Five Star Portfolio

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SCI20

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31 comments

Edward Croft

25th Aug '24

"If you increase the number of stocks it must increase your chances of getting a disaster as well as picking a big winner"

Yes, but there's a positive skew in the distribution of stock returns. Generally, the biggest disaster in a single year (in profitable companies) is a -50% return. Whereas the biggest winner often returns +100% or more.

You can look through the January NAPS writeups, as I've published charts like the below. 2023 was a weak year for AIM and sideways as a whole (NAPS up 2%)... so there were quite a few losers, but Warpaint more than doubled making up for the losses.

2017 was the NAPS best ever year. Two huge winners. Again, one 50% decline in Quarto.

And 2022, the worst year in a decade of running the portfolio. A 15% portfolio decline and sadly no doublers, with two breaching the -50% decline.

Ultimately, stock markets have a return distribution. It's easy for us to look at all our stocks and think "great companies, cheap, they must all go up"... but it really only works out this way in bullish years.

PS - The quote you mention may come from one of Lynch's other books, or interviews etc. As mentioned, I only have One Up On Wall Street. So it may well be correct - Lynch sometimes contradicted himself.

SCI20

25th Aug '24

Thanks to Ed and everyone who has posted so far. Whilst I am unlikely to trim my holdings to 5 the exercise was worthwhile in that it has focused my attention to finding within my current portfolio 5 quality businesses that I feel merit greater weighting.

Revs8

25th Aug '24

Strongly suggest reading “The Art of Execution” by Lee Freeman Shore. He quotes many other world class investors.

This is his summary for winners:

The Winner’s Checklist:

1. Best ideas only.
Invest in just a handful of your very best ideas. My findings show that having one or two big winners is essential for success – the 80/20 rule (the Pareto principle) is true. “Why not buy more of your best idea rather than your 60th idea?” – Bruce Berkowitz “Put all your eggs in one basket and then watch that basket.” – Mark Twain However, I advise against investing in just one great idea because, quite simply, bad luck happens. Moreover, my research shows that your chances of success are less than 50%. With such odds, going all in makes no sense.

2. Position size matters.

Invest a large amount of money in each idea, but not so much that one decision determines your fate. Act like a successful gunslinger, not an arrogant gunslinger. The arrogant gunslinger decides to load only one bullet into the chamber of his gun because he is so confident in his ability that he believes he will not need the other five bullets. As he stares down from heaven at his blood-soaked corpse ten minutes later, he realises that the reason successful gunslingers survive to become legends is because they always have fully loaded chambers. They know that, every now and then, they need more than one bullet. I often refer to the process of adding money to a losing position as firing another bullet. Not having all your capital tied up in one idea means you get multiple opportunities to achieve success. However, do not invest in too many ideas and over-diversify. Rather, be prepared to invest big – just don’t go all in on day one.

3. Be greedy when winning

Run your winners. You need to embrace the possibility of winning big. Embrace the right tail, the statistical long shots, of the distribution curve. Stop trying to make a quick 10 or 20%. Give your investments the possibility of growing into ‘ten baggers’.

4. Materially adapt when you are losing

Either add meaningfully to an existing investment or sell out. Both give you the possibility of changing the ultimate outcome. You can turn a loser into a winner. Expect to find yourself in a losing situation, have a plan to materially adapt, and stick to it. “Any general in the army knows that no plan survives contact with the enemy.” – Helmuth Karl Bernhard Graf von Moltke “Everyone has a plan until they get punched in the face.” – Mike Tyson

5. Only invest in liquid stocks Make sure any publicly listed investment is liquid enough to enable you to execute your idea. There is nothing worse than knowing what to do, wanting to do it, but being unable to do it.

Revs8

25th Aug '24

And for completeness here is the summary of mistakes:

The Loser’s Checklist:

The five losing habits of most investors

1. Invest in lots of ideas

2. Invest a small amount in each idea.

3. Take small profits. Many small profits are the ultimate sign of a losing investment strategy because you are effectively picking up pennies in front of an oncoming train

4. Stay in an investment idea and refuse to adapt when losing

5. Do not consider liquidity

If you do invest in a small number of companies then IMO number 4 is critical.

LeicesterPete

25th Aug '24

There was an interview with Lee Freeman Shore recently on the Investing Matters podcast, well worth a listen if you haven't already

SCI20

25th Aug '24

Hi Revs8. I have read The Art of Execution. It’s an excellent read but my problem is that I have too many “best ideas” .

Don`t let the tail wag the dog

25th Aug '24

I personally think 5 stocks is far too few. As Mark Douglas says in his books (Trading in the Zone), you must accept on the level of any one trade, anything can happen, after you hit the buy button. For example you may have been holding an airline stock at the beginning of 2020, the sector looked great, all your research said the price is likely to go up and then a month later Covid hits. That may be an extreme example but us humans tend to think we have weighed all the pros and cons before we make a decision, but we don’t the know the unknowns. If we don’t factor in that on any trade we can be wrong, we haven’t managed our money properly.

Trading is a probabilities game. Its about having an edge over a series of trades, but before I enter that trade I don’t know which shares I will make a lot of money on, which I will lose on and which I`ll just make a small profit or loss on. But above all trading is about surviving. If I risk too much on any trade at any one time, then I risk blowing up the account. If I have 5 trades and 1 of these gaps down on a profit warning, I will lose twice as much as if I had 10 equally sized trades.

How much should I risk on each trade to survive. Probably only 1% of my portfolio on any trade. As Ed Seykoya puts it, risking more than 2% on any trade is gambling. You can win if either you have a trading system where either the probabilities of winning over a series of trades is greater than the probability of losing. Even better if the average gains from winning trades are greater than the average losses. But if you only have 5 trades then you are in real danger of suffering when you get a cluster of losing trades. Just toss a coin a 1000 times and see how many times you get five heads or tails in a row.

These clusters happen, especially when market timing is unfavourable. You may lose on all 5 trades. Moreover if you lose 33% of your capital, you then have to make 50% to break even. Plus there is the psychological damage from a big loss.

You should be able to succeed in share trading, as the long term odds are stacked in your favour. You may be able to collect dividends as you hold a stock, the laws of compounding can significantly improve your results in the long run, but you risk losing this if you don’t preserve your capital in the 1st place.

MattH

25th Aug '24

I really enjoy these posts and the discussions underneath.
One factor I haven't seen mentioned which really changes everything, is portfolio size. Both in absolute terms and relative to earnings and other assets. If one is 30, has a £20k portfolio and earns £60k a year in a stable job, I could see them sleeping very well at night with 5 positions. If one is 60, has a £2 million and is retired with no other income, 5 positions is either very brave or stupid.

In the UK small/medium cap landscape, liquidity really matters too. Some good companies are just too small and illiquid to build very large positions in, again unless you are very brave (or reckless).
Personally 15 is my sweet spot given my portfolio size and ability to tolerate risk. This is the upper limit of how many I can really keep track of. I decide where my stop will be and manage weighting to limit my exposure to 1% risk or 6.7% portfolio size. I do let winners run though.

Edward Croft

26th Aug '24

The "1% risk" rule is a very solid heuristic. The first time I came across it I was a little baffled ("really so little risk!!!"), but if you look at the simple maths on the size of position size losses in diversified portfolios it makes sense:

20 stock portfolio. 5% position size. 1% risk is a 20% max stop loss per position.
10 stock portfolio. 10% position size. 1% risk is a 10% max stop loss per position.
5 stock portfolio. 20% position size. 1% risk is a 5% max stop loss per position.

If you look at Minervini (and his ilk of traders) ... he tends to hold 5-8 positions, and therefore promotes extremely tight stop losses (maximum 8% stop loss, equivalent to 1% risk with 8 positions).

Someone like Jim Slater, another advocate of stop losses, would tend to hold 12 positions or so, and keep losses tight at about 15% max (again around 1% risk).

So acceptable stop loss sizes are very dependent on portfolio size, given the 1% risk rule. I'd also say that highly concentrated portfolios ought not to play in small/micro caps, as it's almost impossible to keep to the 1% risk rule when holding just a few highly volatile stocks.

Paul Hill

26th Aug '24

Excellent points everyone. Really useful & thanks

Another factor perhaps to consider might be hit rate - because even the best stock pickers have at least 1 negative performer out of every three selections.

Meaning given the laws of probabilities - if you decide to decide to run a highly concentrated portfolio of just 5 holdings - then inevitably you're relying far more on idiosyncratic (ie non-diversified) risk.

Thus creating wild swings in portfolio returns & probably lots of sleepless nights to boot. Personally I prefer the slightly less volatile approach of owning 10-20 positions, whereby I only blow through my risk tolerance once or twice every decade - as opposed to annually.

Indeed more 'turbo-ed tortoise', than 'hypo hare'.

bullhead

26th Aug '24

very interesting thread when it some to increased risk through a concentration of risk through fewer stocks personally think it is important to diversify across different asset classes and geographies

So 40% of your trial portfolio would be based around housing in the uk which I personally think is to much risk in anyone area

I tend to spread my assets across a few different asset classes which are

Real assets

Property including REITs ,Gold ,Debt and trusts leasing aircraft and ships

Technology private equity and bio tech I prefer investment trusts for these

Investment trusts in emerging markets or other markets outside the area I hold stocks

When it comes to tolerance of risk everyone is different so you have to find your own level that you are comfortable with a really good book that covers this is

https://www.amazon.co.uk/Psych...

Another trap that many investors fall into is thinking they can predict the future the best book I have read about this is this one

https://www.amazon.co.uk/Foole...

After the late 90s where I learnt I was no good at picking the winners out of tech and biotech firms I decided as it was an area I wanted exposure too I have done it through investment trusts as I believed there would be big long term growth but doubted I could reliably pick the big winners

Namely and Also private equity which I did throughPolar Capital Technology Trust (LON:PCT) and HgCapital Trust (LON:HGT) there are plenty of others options in The same areas to choose from including ETFs

I am happy to hold these long term without worrying to much about the ups and downs

Though I did sell International Biotechnology Trust (LON:IBT) couple of years back but will buy back in soon so never say never

Like others I hold between 10-20 stocks including investment trusts

doctor dave

26th Aug '24

5 stocks is a terrifyingly concentrated portfolio!! Out of interest I ran a theoretical 5 stock Folio this year. It's down 1% compared to my actual portfolio (45 stocks) up 16%. At one point it was down 15% and I would really have found that hard to cope with given the FTSE was up 5%.

So I guess we all find the position where we are comfortable. I used to have 170 stocks which meant I knew nothing about any of them!! Ideally I would like 25 or so, I'm still slowly culling.

SCI20

26th Aug '24

Hi doctor dave. My post was a challenge to myself to cull my equity holdings and to illicit comments and feedback which it has. Great quality and educational feedback has been offered by many smarter investors than me. I hold a number of investment trusts and ETFs with a plan to "slow cull " my equity holdings to a more manageable number.

DavidMcCabe

26th Aug '24

Kenmare is a fascinating company, and their website is well worth a look, there was a really interesting video on how they were moving one of their major dredging/mining machines.

I do hold in a very small way as I believe there is a great investment case here, but there are some major risks which stop me building a bigger stake at present. I think having 20% of your investment in one commodity stock is best described as 'brave'!

1) It is effectively a single site, single country operation with all the risks that entails.

2) They are currently negotiating a continuation of their mining lisence with the Mozambique government, which apparently can be renewed on the same terms for another 20 years, but this does make me nervous.

3) There is a huge capital outlay on moving their biggest mining/dredging machine quite a distance up the coast, they seem to know what they are doing, but has to be a risky operation.

4) Irish withholding tax is payable on dividends and it seems to be a pain to get a rebate/exemption for UK taxpayers, although is technically possible.

BUT, I do see the attraction - huge cashflows, low cost producer, slowly growing end market.

Good luck!

David

illiswilgig

26th Aug '24

Excellent thread. Particularly appreciate the diversity of approach and discussion in contributions. Plenty to think about.

My own approach - which I am not recommending - is a concentrated portfolio. I spent a couple of decades with a much more diversified approach - and over the last few years have evolved twoards a more focused portfolio.

Currently I have a portfolio of around a dozen UK small cap companies.

This is misleading as the position sizes vary from 40% down to 0.5%. My 5 largest holdings account for 75% of the portfolio and I am fully invested. Not quite 5. But sometimes not far off. I don't trade. At all. I don't use gearing or short sell. i do regularly withdraw my living expenses. There is no fresh capital going into the portfolio.

Counter-intuitively I am much happier and more relaxed with the more focussed approach. There are probably some simple reasons for this.

[1] I have a lot more time to spend analysing and researching each company and am less distracted by sheer numbers of companies.

[2] I only hold my best ideas

[3] Position sizing varies hugely - currently from 40% down to 0.5%

[4] Most of my investments are losers. Currently my 6 largest holdings are the winners. What I do with the winners counts most. For me position sizing is more important to outcome than the number of holdings.

[5] No rules. Not for number of holdings, share price fluctuations, diversification and all that good stuff.

Ok one rule. Hard work. Learn. Improve. Think as much and as hard as I am able. Do very little.

I like all the usual numbers especially cash, cashflow, ROCE, and investment in R&D. If anything my approach to company research is similar to that described by Phil Fisher in his book Common Stocks and Uncommon Profits. I use a modified version of his 15 point company analysis. Management comes at the top of the list. I need to see honest management with integrity that I can trust. I don't need to like them. I need to be able to trust them.

Don't overpay. Even for quality. I don't know what the future will hold despite all my research. If I can get a quality company at a bargain price (and there normally has to be a reason why the market is ignoring it) then my risks are much reduced. Volatility can be my friend. Risk of permanent loss of capital is not.

I think it was the stockopedia 'making of a multibagger' that observed typically half of the gain comes from rising profits and half from rerating? This process often takes years to play in. And years to play out. I have a big pillow. Doing nothing can be boring. But I'm growing to like it.

I find that investment is a very individual business. It can be quite lonely at times. Always good to share and learn? So thank you all at Stockopedia - staff and especially this unique community - which throws up threads like this one - well done. You continue to be an inspiration to me.

cheers

Mark

Chilly Gizzmo

26th Aug '24

This was my thinking too so glad you've mentioned it here MattH. As a younger investor I'm probably more risk averse than I could otherwise be given the time advantage I have (hopefully!) in correcting and benefiting from time horizon. I hold 24 stocks and as a part-time investor working a corporate job full-time that's quite a bit of work to manage and keep up to date with. Getting down to 5 wouldn't do my blood pressure any good but trimming to a 10-15 level feels about right.

jonno

26th Aug '24

I run 3 family portfolios of 25, 14 and 12 shares respectively that I try to keep reasonably concentrated, although from time to time struggle to do so. However I would feel very uncomfortable holding just 5.

There are several duplicated shares across the portfolios, Volex (LON:VLX) and Avingtrans (LON:AVG) to name two. In terms of value the top 5 holdings, depending on the portfolio account for between 40% and 60% of the total.

To borrow from Peter Lynch and perhaps his most important single piece of advice is to invest in companies you understand. Following this advice I don't invest in:

Mining companies
Banks
Biotech
Oil and gas

Also from a personal perspective I choose not to invest in tobacco, gambling and armament/munition stocks. Each to their own as they say.

qvg

27th Aug '24

SC120, thanks for that. I am with most of the other comments, I would find it hard to sleep with a portfolio of less than 20.

But very good to see you hold Lantheus. It's currently my number 3 position. I am just listening to the Q2 call

littledavesab

31st Aug '24

Wow how is it I never knew the stock ranks e-book existed before now !

https://www.stockopedia.com/ac...

DavidMcCabe

1st Sep '24

My apologies, I made a mistake here, the move of their largest mining dredging machine is not "quite a distance up the coast" it will be mining its way to the new site, which is not that far away from the exisiting mine. I was confusing this move with a previous one.

David

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SCI20

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