How to Build a Portfolio of Purple Chips
from "Purple Chips, Winning in the Stock Market with the Very Best of the Blue Chip Stocks", © 2012 John Schwinghamer, John Wiley & Sons
There are many books available that go into great depth on the topic of how to build a portfolio of investments. One simply has to search “portfolio management” on Amazon to find a lengthy list of books that cover the subject. In this section, I touch on the subject in so far as it concerns the implementation of the Purple Chips approach. My aim is to give some brief pointers so that you can minimize risk when assembling your portfolio. Every investor should be aware of his risk tolerance and understand that how he builds his portfolio is based on his own tolerance for risk.
In the 1990s and earlier, it was common practice to diversify by investing in stock markets across the globe. It was believed that by investing in companies that were located in different countries, one could reduce the risk of a portfolio of investments because there was little relationship in the performance of stocks from different regions of the world. In essence, the theory was that when one stock market did poorly, another located elsewhere would probably be doing better.
Nowadays this theory is no longer valid. Diversification by investing in different countries is practically impossible. The correlation between markets in different countries is getting higher and higher as the world communicates more easily and businesses reach out across the globe to trade. Based on my experience, it is difficult to diversify by simply crossing borders, so I do not consider this to be a viable strategy for reducing risk when constructing a portfolio.
Diversification, however, is a valid concept when applied to different sectors. Sector refers to the area in which a company does business. For example, the resource sector has companies that are largely influenced by the demand for commodities. Examples would be companies in forestry, oil and gas or mining. The financial sector includes banks and insurance companies. The consumer discretionary sector includes retail stores such as Wal-Mart or Best Buy. Other sectors include health care, technology, industrial goods, services and utilities, among others.
In addition to using the PEG ratio to evaluate risk, one can also control risk by adjusting the size of the investment in a stock. This is known as position size. Position size is the percentage weighting of a type of investment in a portfolio that a particular stock represents. It is commonly used to control risk and achieve diversification. Portfolio managers are taught that an average equity holding/investment in a portfolio should represent only around 5% of the total of equity holdings in the portfolio. This is because studies have shown that an average portfolio only needs to have twenty different stocks (usually in different sectors) to achieve the maximum benefit from diversification.
When constructing a portfolio, I recommend that you never place more than 15% in one sector. In the securities industry, exposure to a sector is often referred to as being over- or underweight. Analysts will often say that they are overweight or underweight (which has nothing to do with the size of their body). This is jargon for being either over- or underexposed to a sector when their own weighting is compared to the index weighting.
The other factor that I consider when building a portfolio is how much capital to allocate to a particular stock. I use a rule of thumb of 5% for most investments. If a stock does not have a dividend and is considered riskier, I control risk by investing less. Stocks are usually categorized as value stocks or growth stocks. A value stock is defined as a large company that pays a dividend and is trading at a P/E multiple that is similar to, or lower than, that of the market. A growth stock is defined as a company that pays no dividend and has a higher-than-average rate of growth. My rule of thumb is 3% for non-dividend-paying stocks (otherwise known as growth stocks).
Even though I do not recommend stop-loss orders in Purple Chips, they do merit an explanation.
A stop-loss order is an order to sell a security when it reaches a price that is lower than the current market price. It is designed to limit an investor's loss if a stock begins to fall. For example, if an investor buys Abbott Labs at $53 and places a stop-loss order at $42.40, then he will sell Abbott Labs at the market price if the stock trades at or lower than $42.40. A stop loss order for the above would be entered (written) as:
SELL (QUANTITY) ABBOTT LABS @ $42.40 ON STOP
The hardest part about managing investments is knowing when to admit that you’re wrong. A stop-loss order takes the emotion out of this decision and forces you to take a loss when your pain threshold has been reached. I must emphasize that unless the stop-loss order is actually placed in the market, it will do you no good. I can easily predict that a mental stop loss (i.e., a stop loss order which is not entered in the market but rather one in which an investor tells himself he will sell if a certain price is reached) is as good as useless. When the limit price of a stop loss is reached and the investor has not actually placed the stop in the market the outcome is predictable. Here’s what happens:
The stop loss price is reached.
The investor says to himself, “I’ll just hold on to this stock a little longer because this is probably the lowest price.”
The price goes lower. The investor says to himself, “Now it’s really a bargain. I’ll ignore the stop loss this time.”
The price then goes much lower. The investor loses shirt and pants.
When I first developed Purple Chips, I used stop-loss orders to control risk, but I discovered over time that a rigid stop policy was hazardous to my financial health. There were a few occasions when I was stopped out of a Purple Chip at a loss, only to see it go back above my initial purchase price a few months later. Moral of the story: Like cream, quality always rises to the top. Essentially, this is because stocks that fit the Purple Chips profile have a tendency to rebound and perform better than average even in a market correction.
No More Anchoring
Another advantage of the Purple Chip method is that it avoids anchoring, one of the common pitfalls that investors fall into.
Anchoring occurs when an investor becomes attracted to certain price levels for buying or selling a stock because he believes that they represent reliable extremes that will recur. Unfortunately, this process is flawed because it ignores the relationship between price and EPS.
For example, an investor who anchors on a recent “high” stock price believes that a drop in price will provide an opportunity to buy the stock at a discount. While it is true that the fickle nature of the stock market can cause some stocks to drop substantially in price for no apparent reason, stocks quite often drop due to changes in their underlying fundamentals. There are two schools of thought in the financial industry regarding the price of stocks: that stock prices are determined by fundamental information or that prices are determined by technical information, also referred to as technical analysis. “Fundamentals” is an industry term that is similar to a health chart for a patient in a hospital. In layman’s terms, fundamentals are all the factors that determine a company’s financial stability and health. These can include, but are not limited to, earnings, sales, indebtedness, inventory levels and the number of clients.
Exhibit 4.15 shows Whole Foods Market (WFM acquired by Amazon in 2017), a U.S.-based chain of supermarkets that specializes in natural and organic foods. Assume that in September 2004 an investor bought shares of WFM at $ 40 and subsequently sold them in June 2005 at $60 for a profit. Later in June 2007, the shares again traded at $40, so the investor buys again, thinking that he can repeat his previous experience. In essence, the investor believes that he has found an anchor point at $40, and presumes that the shares should again increase in value.
Exhibit 4.15: Whole Foods Market (WFM, June 2007)
In exhibit 4.16 it becomes obvious that the investor who bought at $40 was right for only a very brief period of time. When the EPS is overlaid on the chart it becomes clear that WFM stock was headed lower as earnings began to deteriorate. This proves that the price of a stock is driven by the direction of its earnings.
Exhibit 4.16: Whole Foods Market (WFM, June 2008)
In theory, if there were no moving parts in the valuation of a company, dropping an anchor on a previously-attained price might work well. However, because earnings and valuation levels change over time, anchoring can be a very risky practice. The Purple Chips model is dynamic because it establishes new buy and sell targets based on the latest developments in EPS, and on major high and low valuation points. Thus it protects investors from the pitfalls of anchoring.
No discussion about losses would be complete without the mention of a stock market crash. We invest in Purple Chips only when their valuations are relatively low, which makes them inherently low-risk investments. But there will be times when we follow all of the guidelines suggested in this book and will still be caught in an unexpected market crash. A market crash is virtually impossible to predict. It is an event that is often talked about but rarely happens.
Market crashes are anomalies that can occur when stocks become overvalued, or events occur that are so severe that investors lose faith in the stock market. A market crash is a moment of irrational behavior, a repricing of all securities that is usually temporary. On September 9, 2001 (9/11), there was a crash when America was attacked by terrorists and investors lost faith in the stock market. During a crash, all stocks are affected; there is no place to hide and the best defense is to invest in quality.
In conclusion, no plan is complete without well-defined entry and exit points. The rules for entry and exit points are absolutely essential to enforce discipline and maximize success. By becoming aware of valuation resets and trends in EPS, and by having a comprehensive investment plan, investors prepare themselves well for the surprises and challenges that the stock market inevitably poses for them.
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