I recently read a book regarding investing in a private investor capacity.
As a private investor, we do not have the resources like institutional investor, and hence we should keep our competence cycle smaller when we starts our investment journey.
But the good thing is we could invest more flexible than how the institutional investors are doing.
There are two kind of methods: bottom up and TOP-down. Here I like to share about the bottom up approach:
1. Set up your investment policy: - your targeted return, drawdown risk (how many % of unrealised loss you can take), stock limit (how many % of one single stock in your portfolio), sector limit, country limit, investment style - value, growth or momentum, and your investment universe (stocks, bonds, cash, etc) as well as your investment benchmark (STI, Dow Jones or even absolute return remark if you like).
2. After setting up your investment policy, then you can go ahead to set up the stock screening process from the universe that you selected. For stock selection, you may have a few kind of section based on your investment style - value (relatively cheaper than peers), growth (relatively higher growth than peers), and momentum (technically stronger than peers). Another one is quality. For me, I prefer hybrid just to make sure I am not too biased into any style.
2. Value - always compare the stock with peers or own historic data - PE, PB (banks), EV/Ebitda (smaller service firms) etc.
3. Growth - revenue growth (TOP line growth), EPS growth (bottom line growth), and DPS growth (double check whether any dividend policy in place, otherwise it will lead you to the wrong side).
4. Momentum - suitable for Traders or macro investor, basically look at the technical indicator such as RSI, trading volumes, etc. The pro is that you gotta keep updating yourself with the news / information and sometimes you will be overwhelmed by the information you gathered. So it’s good that you could also set a parameter on the momentum indicators that you are more comfortable with your investment style. For me, I rely less on daily indicator but weekly or monthly indicator.
5. Quality - the largest market cap companies (in another Words the leader) in the sector or sub-sector. There are less risk investing in these companies and hence they demand higher valuation than peers. Most importantly, as more and more institutional investors perform passive investing through ETFs, those bigger companies would have higher market caps as the money flows in. That’s why when bull market starts, those companies normally rally first. Some of the quality indicators are High and consistent or growing ROE, high and consistent/growing ROIC, high and consistent cash convention cycle (less day to convert the cash).
After screening through the process, you may start performing some due diligence in the companies:
1. Management - how many % of holding of the management in the company, how Long have the TOP management served the company
2. Yellow flag - change in auditor? Change in TOP management? Change in secretary? Change in accounting standards?
3. Aggressive accounting - growing inventories? Growing receivables? Growing debts? Growing TOP lines but not growing bottom lines? Less operating cash flow every year?
4. Huge Shares selling by TOP management?
5. Check back the audited financial stAtements few yeArs back and see whether the TOP management managed to achieve what they said earlier
6. Frequent right issue even though there is enough cash in the bank?
7. I personally prefer to check on the management’s personality as they are the strong indicator on future company’s top line growth as well as bottom line growth.
If you do not have time to perform due diligences, then it is better that you diversify your portfolio to reduce the standalone risk.
Now move on to the portfolio construction part after the due diligence part.
Basically we as a private investor do not have big amount of capacity and hence we cannot have too many stocks in our portfolio. To begins with, we can start from ETF or mutual funds. We can then learn from those fund managers on how they allocate their funds based on the style - value, growth, quality, and momentum.
After that, we can construct our portfolio by setting single stock limit - could be 5, 10, 20, or even 30% based on your risk appetite / tolerance level. To reduce the standalone risk, it is wise to perform a good due diligence on the stock as well as macro (TOP down approach which I will explain it later), because most of the time a good management cannot beat the overall market as less spending in the markets means less income and profit to the single company. However, if we can construct a good portfolio and portfolio rebalancing process, we can then reduce the standalone risk and market risk.
It is advised to have less than 10 stocks in your portfolio, if your capital is not big enough. Provided you set an equal % in your portfolio, you can accept a maximum 10% drop or 20% drop if you happen to invest in one or two lousy companies that you have selected. You could still protect another 80% of your portfolio. Anyway, always remember the rules - #1 don’t loss your money (by investing in bad companies), and rule #2, remember the rule #1.
In modern portfolio theory, it is good that you can invest the companies in different sectors as different sectors have different beta (correlation) with the broad market. For example, real estate companies will have different movement with banks as one is the lenders and another one is the borrowers, so when the interest rates go up/down, both would have different reaction. Same goes to other sector like commodities and manufacturing sectors, one is supplier and another one is consumer so they would react differently when the commodities prices are up.
After you have a portfolio with stocks from different sectors, then you can start monitoring your stock portfolio by looking at macro level as well as micro level.
Macro level - GDP growth, CPI, PPI, manufacturing index, forex movement, treasury yield curve, bond yield spread, etc. Also always read about industry news for better understanding of how your company perform compared to the industry peers.
Micro level - always perform the due diligence after putting money in the company. Always do quarterly result review, follow up with the Mgmt the updates, check on the competitors / alternative products in the market etc
There are two sources of return - alpha and beta. As an active investor, we are more concerned about the alpha - how far we can beat the market, and beta less - beta is the market return and how highly correlation your portfolio with the market return.
So this is my thought about investing as a private investor.