Creating a Sector Neutral SG Stock Portfolio
Sometimes, we are not sure where to start when constructing a single country equity portfolio. This post explores how to create a single country equities portfolio that strives to maintain sector neutrality – however, instead of using a market-capitalization based benchmark, we will strive for an equal weighted sector exposure.
The rationale for equal weighted sector exposure
More often than not, investments tend to be less diversified than desired - this can lead to too much risk being concentrated in one sector. When funds move out of the sector during sector rotation, an undiversified portfolio with overly-high sector concentrations can lead to larger than expected losses. An example is a portfolio containing 25% Thai Beverage, 25% Singtel, 25% M1, and 25% Starhub. An unforeseen circumstance or event that is negative for the Telecommunications sector can cause large drawdowns in the investment portfolio due to the high concentration in telecommunication stocks (in this case 75%) compared to Consumer Goods’ 25% (Thai Beverage).
There are many methods to deal with this under-diversification. One of these methods includes sector neutrality, which can be approached in two ways - one of which would be to allocate equal weights to each sector, and another, allocating sector weights are matched to that of a benchmark. In this article, we will focus on exploring equal sector weightage.
Using Analyst Reports for Portfolio Construction
As a client of a few brokers, I often receive broker reports and recommendations. Here, we shall assume that the analysts authoring these reports are at the very least more competent than myself in stock picking. Therefore, I can follow their recommendations and hopefully achieve superior returns compared to what I would have gained if I were to conduct my own Fundamental Analysis – of course, this assumption may or may not be valid, but go with this on the pretext of laziness.
For this article, I will reference part of the Philips Morning Note report that I receive every day. I like that report as it usually updates me daily with breaking news as well as potential stock counters to watch, on top of the usual corporate earnings. One aspect of the report which I particularly like is the Singapore Stocks Coverage section where all their analyst recommendations are summarized. We will use this summary to construct our investment portfolio.
The Philips Morning Note report I am using was sent to me on the 30th of July 2018. Its Singapore Stock Coverage Section comprised 45 stocks from different sectors including Consumer Goods, Banking, Healthcare, Real Estate, Investment Trusts, Industrials, Materials, Oil and Gas, Utilities, Transport, and Technology and Communications. The report includes a rating – Buy, Accumulate, Neutral or Reduce, together with a target price and an upside to TP column which shows the percentage upside to the stock’s target price.
Constructing the Base Portfolio – removing stocks that can be interpreted as Overvalued
To construct the base Long-only portfolio, we first remove stocks that have negative upside to TP – this is because I interpret the recommendation as either over-valued or fairly valued. Since the market price has already met or exceeded our target prices, the stock might not be worth it from a fundamental perspective. Of course, this is on the assumption that the Target Price was derived from some fundamental metric such as a DCF valuation or Forward P/E price derivation. From the list of 45 stocks, 3 stocks had negative upside to TP, so we eliminate them.
Constructing the Base Portfolio #2 – Compiling Sector Information
After constructing the base portfolio, we analyze the sectors given in the report. For this section – I made one minor change – Sembcorp Industries was previously listed under the sector ‘Conglomerate’. I moved it to the ‘Industrials’ sector.
After that, I then compiled the number of stocks in each sector as per the report.
We end up having 11 Sectors and 42 stocks.
If we were to allocate the same amount of capital to all the stocks, our sector exposures would be very heavily weighted on Real Estate, Investment Trusts, and Consumer Goods. It would also be hard for us to extract any meaningful returns from the Oil and Gas and Utilities sectors.
To achieve equal weights, we need to allocate our capital differently, such that our portfolio looks like this:
The eventual portfolio will look something like this. I’m sorry if the words are too small!
Next, assuming a $100k Portfolio size, we can then calculate how many shares to buy for each stock. An abbreviated version of the table looks like this:
Given that Singapore lot sizes are of 100 shares each, we round the number of shares to the nearest 100, and re-estimate the rounded book value of the share purchases, under the Rounded Cost column. We also assume a round trip commission of $50 ($25 for buying, $25 for selling). This gives us the final outcome below:
Note that commissions here account for roughly 2.15% of our total cost, and is accounted for in our budget of $100k. Thus, our portfolio must generate a return in excess of 2.15% for us to breakeven.
Some food for thought
1. Analyst recommendations – some of you might have doubts on using purely analyst recommendations for their investment decisions. Of course, in an optimal scenario where time is not a constraint, one can consider using his or her own stock picks instead. Another alternative would be to compare different analyst recommendations from different research reports. For this example, I decide to keep it simple and use 1 report, but you can definitely mix, match and combine. Of course, if you decide to pick your own stocks, then the underlying assumption is that you can pick them better than the analysts can! Can you? Lol.
2. Different Analyst Ratings – The report’s ratings contained 4 types – buy, accumulate, neutral, and reduce. This means that the analysts had different conviction levels for each stock. From the report, it also appears that the different ratings are not based on the % upside to Target Price. Therefore, we have yet to account for conviction levels as per the analysts’ recommendations. One simple way would be to allocate more capital to those with higher ratings than their peers in the same sector, but that’s a story for another day.
3. Different report timings – The report’s recommendations for each are posted at different timings, with different individual stock reports updated at different times. This will therefore lead to slightly different time horizons for each individual stock. While the Report’s stock list is generally recent – with latest reports ranging from March to July, this is also something we might want to take into consideration. For example, we might only want to consider stocks whose recommendations were made up to 2 months ago i.e. June and July.
4. The qualitative, fundamental story – This method has insofar ignored the qualitative fundamentals of the individual stocks and sectors – one might actually decide to allocate more to a certain stock in a certain sector as there might be some interesting upside catalyst that might be happening. We didn’t account for this in our portfolio construction, but if we want to, we can just click the links in the Report – it conveniently leads to the relevant stock reports, which is a source of qualitative fundamental information. Other sources include the usual – sgx.com, annual reports, InvestingNote, among many others.
5. Technical analysis – We have ignored technical analysis in our choice of stocks (and I am assuming the analysts adopted a fundamental approach as well). You might be able to integrate technical analysis into this to improve market timing, but you might compromise your sector neutrality as you move in and out of the different stocks in this watchlist.
6. Choice of sector categorisation – So far, with the exception of Sembcorp Industries Limited, we did not change any sector allocations. That being said, we need to consider how different companies are classified into their respective sectors – for example, how should we classify a company that might have different businesses in more than one sector? Can we just file it under ‘conglomerate’? Should we split up its different businesses or treat it from a SOTP perspective when allocating capital?
7. Considering which stocks are more risky than others – We did not consider that some stocks are more risky than others – for example, a blue chip might be less risky and less volatile compared to a penny stock. We conveniently ignore this in our quest for sector neutrality – more on this perhaps when I have time for another post.
8. We did not consider sector rotation – Sector rotation occurs when one sector is in trend (all its stocks are going up or down). This is because we assume that I have no ability to predict how sectors will rotate. If however, you can predict this aspect, then you can allocate more capital to the sector you think is trending vs one that is lacklustre.
9. We do not consider full valuations... Because we assume that it has already been done by our analysts, and that they have selected what they feel is the most realistic assumptions in their models. Furthermore, DCF models and what not are time consuming and require a lot of information and data points. Of course, if you have Bloomberg, Reuters, Factset or any other such databases, that would definitely streamline your quest for a full in depth fundamental analysis. But I am too lazy to analyse 42 companies.
10. We only considered Singapore – In my humble opinion, a well-diversified portfolio should not only be adjusted for sectors, but countries as well. Here we are assuming that we only want to construct a Singapore-only stock portfolio. Realistically, it will be good to consider international options.
In conclusion, we have attempted a simplistic portfolio construction in an attempt to maintain diversification and ensure that we are not too over-exposed on any 1 sector and its risks. The aim here is to follow 2 rules:
1. Don’t lose money
2. Don’t forget rule number one
Therefore this post focuses on one aspect of managing one’s downside. We also take on the perspective of a retail investor – one who has limited time and data, and therefore defer to analyst reports, with further room for due diligence on the condition of more time commitment.
We also cover some caveats and food for thought regarding the limitations of what was done as well as some underlying assumptions.
I look forward to your discussion and comments! Let us keep the discussion constructive.
1. Whatever is shown here is not a recommendation to buy or sell. Do Your Own Due Diligence. You are responsible for the trades you take.
2. The data used here is adapted from PhillipCapital’s Morning Note dated 30th July 2018, which I received from them.
3. I am a retail client of PhillipCapital. Other than that, I am not affiliated to them.
4. I do own / might have owned some of the stocks in the post. However, I am not fully vested in that portfolio.