part0021

In the previous chapter, I mentioned the New Year’s portfolio I recommended to readers of the Financial Mail on Sunday . I tried to put the shares in order of attractiveness, but I warned readers that ‘...this is always difficult as some may surprise us’. Here is the portfolio based on buying prices on the preceding Friday, which was the last day of trading in 1995:

And here are results for the six months ended 30 June 1996 based on selling prices on the last day of trading:

Dividends were ignored and the selling prices used were the lowest that could have been obtained. The closing price of Business Post, for example, was 438-445p; there was modest demand for the shares on Friday 28 June, so instead of 438p it would probably have been possible to sell at 439p or 440p. Brokers’ commissions and stamp duty would have cost about another 1.5% in total and the price of the eight shares rose the day after my recommendations by an average of 3.5%. Therefore, net of all costs and after allowing for the effect of press comment, the final profit would have been 22.4%. During the six-month period, the FT-SE actuaries All-Share index rose by only 3.0% and the FT-SE SmallCap by 12.4%, in spite of being flattered in the usual way by using middle-market to middle-market prices and by excluding dealing costs. In this case, the All-Share was the more appropriate index to measure performance against as the eight shares were found by sieving the whole market.

There are some lessons to be learned from the performance of this portfolio:

As time goes on, I get more and more convinced that the right method of investment is to put fairly large sums into enterprises which one thinks one knows something about and in the management of which one thoroughly believes. It is a mistake to think one limits one’s risk by spreading too much between enterprises about which one knows little and has no reason for special confidence.

Warren Buffett also believes that concentrating upon a few shares may well decrease risk, if it raises the intensity with which investors think about a business and the level of comfort they need to feel before buying into the share in question. It is a mystery to Buffett why investors elect to put money into their twentieth choice rather than adding to their top choice. With the now massive funds under his control, he continues to practise what he preaches.

It is, of course, all very well for investors of the calibre of Keynes and Buffett to advise concentrating a portfolio on just a few stocks. Almost all of the time, they would know exactly what they were doing and they would be capable of thoroughly analysing a stock and obtaining the necessary level of confidence before committing a relatively large part of their portfolio to it. Most investors are aware that they do not have the ability of Keynes and Buffett and therefore, quite rightly, lack their confidence.

I suggest that ten to twelve shares is about the right number for the portfolio of a private investor with up to about £50,000 to invest. For £500,000, about fifteen shares would be more appropriate and for £1m up to twenty or perhaps a little more. This does not mean that with a portfolio of, say, twelve shares exactly 8.5% of the total fund should be invested in each share. The percentages should be weighted towards those shares which provide the investor with the highest degree of comfort. Perhaps an outstanding favourite share would merit 12.5-15% of the money to be invested. About 8.5% might then be invested in a few of the shares and the balance of the portfolio could contain some comparatively negligible shareholdings. Quite often I find that I decide to buy a share and can only obtain a few before it bounds ahead. When this happens I usually keep the holding for a while in the hope that the shares will come back to allow me to buy some more. If, however, they go on rising, I usually decide to sell, as I do not like my portfolio to be cluttered with too many small and irrelevant holdings.

All of the above ideas are, of course, based on allocating percentages of a portfolio on a cost basis. In practice, this soon becomes irrelevant. Based on market value, a really successful investment can quickly become 20-25% of a portfolio and this brings us to the most difficult question of all – when to sell?

Warren Buffett is credited with being the kind of investor who ignores the market and likes to hold shares for ever. Investors studying his very successful methods should distinguish between his company’s core holdings (quasi-partnerships) and more general investments. Of course, if a company is doing well and its shares are going from strength to strength, it pays to run the profits. The oldest and best axiom in investment is to run profits and cut losses – that way profits are likely to be large and losses are bound to be small.

In the 1987 report of Berkshire Hathaway, Warren Buffett spells out his approach to selling marketable investments. He first makes it clear that he judges his holdings not by their market prices, but their operating results. As Benjamin Graham said, ‘In the short run, the market is a voting machine, but in the long run, it is a weighing machine.’ His point was that eventually the market will recognise superior operating results (and increased value) but he did not worry unduly if this took a few years to happen. Buffett is completely confident of his ability to judge the value of a company and confident that, in the end, the market will recognise that he is right. He goes on to explain that his monitoring of operating results is to ensure that ‘The company’s intrinsic value is increasing at a satisfactory rate.’ The implication is that if this is not the case he sells, as indeed he did with his company’s first British investment, Guinness.

Warren Buffett draws attention to two other reasons that would prompt him to make a sale:

Buffett further qualifies his approach by saying that he does not sell holdings simply because they have risen in price or because they have been held for a long time. He scorns the Wall Street axiom ‘You can’t go broke taking a profit’ and is happy to remain a holder indefinitely provided the return on capital is satisfactory, management is both competent and honest and the market does not overvalue the business. As you can see, these are heavy provisos.

Another reason put forward by Buffett for holding on to exceptional growth shares with competent and honest management is that they are very hard to find and that dealing in shares costs money as well as sometimes crystallising a capital gains tax liability. When a share, that is not held in a PEP or personal pension plan, has had a really good run in the market, the potential capital gains tax liability can be many times the original cost. Provided you continue to hold the shares, the Government, in effect, makes you an interest-free loan of the tax that will eventually have to be paid. This loan helps to increase very substantially the capital appreciation on the investment as there are no interest charges and your investment is geared without the usual worry of how the loan will be repaid.

In The Zulu Principle , I suggested that the main reason to sell a share was if the story had changed. By this I meant any change in the key factors that had attracted you to the shares in the first place. If, for example, the company’s profits were faltering, a major new competitor had entered the arena and begun a price war, or the company had lost a major source of business, the shares should be sold immediately.

In normal market conditions, with an exceptional growth share that is continuing to do its thing and produce excellent year on year results, it pays to retain your holding even if the PEG rises to a slightly uncomfortable level. A PEG of 1.2 (in relation to a market average of 1.5) is as high as I would personally allow, as the margin of safety would have shrunk to a level that would make me feel ill at ease. However, I could well understand some investors deciding to hold on to their favourite investment, even if the PEG rose to the market average. Above that, I would recommend selling and bidding a reluctant au revoir to the shares. If you keep an eye on them, there will almost certainly be another opportunity to buy at a much more favourable price. Meanwhile, your money can be better used in a share that is due for an upward status change, not a downward one.

The most difficult problem arises when a share suddenly begins to perform badly in the market for no apparent reason. After a substantial rise, great growth shares often encounter profit-taking so, from one month to another, their relative strength might be poor. If the trend persists and they show poor relative strength over the previous three months, that is definitely a cause of concern.

If one of your shares performs badly for several weeks, you should ask your broker for an explanation. There may be a market story that accounts for the poor performance. For example, a key executive might be planning to leave the company, there could be news of an impending major lawsuit or of fresh competition entering the market. The other obvious source for this kind of information is press cuttings and a final option is to telephone the company and ask one of the directors or the company secretary if he or she knows of any reason for the shares’ poor relative performance.

If you can find an explanation, the key question then is whether or not the underlying story (what persuaded you to buy the shares in the first place) has changed. Re-examine the share, in light of all the available facts, including the current brokers’ consensus forecast, and ask yourself if you would still buy the shares today. If the answer is yes, grit your teeth and hold on.

Some people believe in averaging, which means buying shares on (hopefully) short-term weakness to reduce the average cost of their investment. I recommend you to resist this temptation. I prefer to buy more of a share that is rising – reinforcing success seems to me to be a better approach than compounding failure.

Some investors will find that they cannot stand the worry of a share continuing to fall, particularly when no explanation can be found. Many commentators recommend stop-loss system and if this is going to make you sleep better, by all means use one. You can, for example, set a stop-loss at 20% below your purchase price or a trailing stop-loss of, say, 20-25% below the highest price registered by the shares. The trailing stop-loss means that if the share does very well in the early stages, you make sure of locking in some profit.

My preference is to hang in there, until I can find the reason for the fall. A low PEG provides a margin of safety and buying shares in a systematic way is very different from speculating in, for example, bio-tech and concept stocks, which often have no earnings and no commercial products. With these kinds of shares a trailing stop-loss is mandatory. I do not recommend buying them though – why gamble when you have a formula that works?

Some sizeable private investors may feel that PEPs are not worth the trouble as to them the annual allowances appear to be derisory. They are not taking into account the cumulative effect of the tax-free growth PEPs offer investors. Over the years the annual allowances, together with capital gains, can accumulate to a very sizeable tax-free pool of money – a kind of tax haven in your own back yard.

Shares held in PEPs form an integral part of an overall portfolio but, as they operate tax-free, the arguments for running profits in them are less acute. The general principle of running profits does, of course, continue to apply, but the pregnant tax liability is no longer a consideration.

Near to the end of the tax year, it clearly pays to review your portfolio and absorb your permitted annual tax-exempt capital gains allowance (£6,000 in 1996), even if this is simply achieved by bed-and-breakfasting some of your shares.

I recommend keeping a file on each investment. It should contain the last couple of annual and interim reports, copies of any other announcements, press cuttings and any brokers’ circulars that you have managed to obtain. It is also a useful reminder to set out in writing, in a few words, exactly why you invested in the company in the first place. To remind you of the exact circumstances, it may also help to add to the file a photocopy of the REFS company entry at the time.

In addition to company files, it is advisable to record investments in an investment ledger. When noting the prices of any shares purchased, also make a note of the level of the FT-SE. Actuaries All-Share index on the day of the transaction. This will give you a useful measure against which to gauge the performance of individual shares and of your portfolio as a whole. If you can spare the time, try to compare performance once a week, if not, once a fortnight or at the very least, once a month.

2. Do not bet the bank on one share. Up to 15% is about the right maximum investment based on cost.

3. Use PEPs to the fullest possible extent and ensure that you absorb your annual capital gains tax allowance (£6,000 in 1996) every year, even if you simply do this by bed-and-breakfasting.

4. Run profits and cut losses.

5. Sell shares when the story has changed (e.g. the company’s intrinsic value is no longer increasing at the required rate), the market awards the company too high a PEG (say 80% of the market average) or funds are required for a better, more undervalued investment. Bear in mind that a very substantial pregnant capital gains tax liability can make it advisable to stretch the PEG selling limit to the market average, but not beyond it.

6. Record investments in a ledger and regularly measure performance against the FT-SE actuaries All-Share index. If, over a period of say three or more years, you find that you are not beating the market, you should consider delegating the management of your portfolio to a professional fund manager via unit trusts or the like.