Portfolio construction – risk and rewards

Eggs and BasketsWayne Mc Currie

The classic investor cycle

Why did I everbuy this ?

I really got badadvice

Revival

Excitement

Optimistic

Euphoria

Doubt

Anxiety

Denial

Fear

Depression

Panic

CapitulateDesperate

Despondent

Doubt

Optimistic

FUND INFLOWS

FUND OUTFLOWS

I will not do thisagain !!

What a good

choice I made !!

This is a really

good investment

Look at last years good return

Don’t worry the market

is consolidating

Temporary setback

I am a long term

investor

I must get out.Cash is King

Market Cycle

Maybe I panicked!

Was it right tosell ??

This is the best

thing I have ever

done !!

MAXIMUM

RISK

MAXIMUM

REWARD

THINGS

CAN’T

GET

BETTER

THINGS CAN’T

GET WORSE

Navigating choppy waters:The economic cycle

PEAK SLOWDOWN BOTTOM RECOVERY

Good news

Strong

growth

Inflation low

Interest rates

low

Things can’t

Get any

better

Start of

down turn

Inflation

rising

Interest

rates rising

Inflation

moderating

Interest rates

at peak

Economy in

trouble

Things can’t

Get any

worse

Inflation

falling

Interest

rates down

Growth

inproving

MAXIMUM

RISK

MAXIMUM

REWARD

And

4

This all looks very good –

until you live each day in a

down market

Average return of ±12%

Equity does increase

Over time but

with

VOLATILITY

BUT the monthly losses can be huge!!

And you can lose money over five years

What is diversification and how does

it work?

Diversification is simply put:

• DO NOT put all your eggs in one basket

• DO NOT buy all “The Same Theme” shares

• TRY and offset some risks

• RISK DIVERSIFICATION is the only FREE LUNCH

in investments

Example 1Bidvest and Anglo American

Both gave you the same

return over 14 years

But look at the volatility !!

Anglo American

Bidvest

Anglo AmericanReturn history

This is the number to look at

BidvestReturn history

This is the number to look at

Now construct a portfolio50% Anglo and 50% Bidvest

Anglo was 40 and Bidvest was 28 – so in

a 50/50 portfolio – you would expect the

new number to be (40+28)/2 = 34

And look at the risk now

This is the number to look at

Anglo was 40 and Bidvest was 28 – so in a 50/50 portfolio – you

would expect the new number to be (40+28)/2 = 34

BUT YOU GET 27

This is the free lunch

DIVERSIFICATION

Example 2Harmony and Standard Bank

Harmony

Standard Bank

The risk profile for Harmony

This is the number to look at

And the risk profile for Standard Bank

This is the number to look at

Now construct a portfolio50% Standard Bank and 50% Harmony

Harmony was 69 and Standard was 26 – so in a 50/50 portfolio

– you would expect the new number to be (69+26)/2 = 47

Harmony was 69 and Standard was 26

You get almost three times as many sleepless nights investing in

Harmony as investing in Standard bank

And this is the answer for Harmony and

Standard Bank

This is the number to look at

Harmony was 69 and Standard was 26 – so in a 50/50

portfolio – you would expect the new number to be

(69+26)/2 = 47

BUT YOU GET 44This is the free lunch

DIVERSIFICATION

Portfolio Construction

Rationale

“…the art of successful portfolio management is not only to be able to

identify opportunities, but also to balance them against the risks

that they create in the context of the overall portfolio.”

Robert Litterman, Goldman Sachs

Bottom-up &

Top-Down views

Portfolio

Construction

Rationale

Balances risk and return

• Risk allocated according to opportunity + conviction

• Most people don’t do this…

Minimise risk

Allocate risk efficiently

Diversification benefitsCorrelation in portfolio construction

Cash Bonds ILB’s Property Resi Findi

Cash 0.04 0.01 -0.06 -0.09 -0.14

Bonds 0.04 -0.10 0.37 0.05 0.23

ILB’s 0.01 -0.10 -0.05 -0.03 -0.04

Property -0.06 0.37 -0.05 0.26 0.55

Resi -0.09 0.05 -0.03 0.26 0.59

Findi -0.14 0.23 -0.04 0.55 0.59

Portfolio construction in practice

Challenge in composing a portfolio

For a good orchestral performance you require:

• Clarity:

· Emphasise the melody

· Allow for interpretation / expression

• Balance:

· Can’t have some instruments drowning out others

What makes a good portfolio?

Clarity• Expressing investment view

· Top Down + Bottom Up – Ideas and themes

· Shares you like and shares you don’t like

• Note: View = Highest expected return

Balance• Dividing risk appropriately between opportunities

• Making use of diversification

• Ensuring exposure to the main market drivers

Why is this important for investors?

Portfolio construction aims

Clarity• Expressing investment view

Balance• Dividing risk appropriately between opportunities

• Making use of diversification

• Ensuring exposure to the main market drivers

Repeatability

Skill versus Luck

Stability

Better risk-adjusted returns : Fewer negative surprises

Summary

Portfolio Construction

• Clarifies view of where to take risk (opportunity + conviction)

Repeatability

• Balances risk and return in the portfolio

Stability

• Enhances the investment process

Better decision-making

“You cannot manage outcomes, you can only manage risks.”

Peter Bernstein

“To do good work, one must first have good tools.”

Chinese Proverb

Equity Process

Equity investment philosophyConcept of normalised value

LEVEL

TIME

Irrational Pessimism

Low PE's in relation to past PE'sOnly bad newsLow earnings base in relation to trend earnings

Growth in trend earningsa fundamental underpinover time

Intrinsic Value

SELL

BUY

High PE's in relation to past PE'sOnly good newsHigh earnings base inrelation to trend earnings

Irrational Exuberance

MomentumInvesting

Margin ofSafety

Share Price

Shares trading below fair

value will drift to the top

Shares trading above fair value will

drift to the bottom

Three Pillars of Conviction Stock selection

Value / Cheapness

• Analysis & Evaluation

Quality / Risk Considerations

• Look and Listen

View / Theme Consistency

• Set your views

All 3 are required to identify “Leaders” & “Laggards”

Pillar 1Value

Fundamental valuation of companies - normalised,

through-the-cycle considerations

Rank companies based on these normalised valuations

Discuss different scenarios, both value implications and

probability of them playing out

The cheaper the stock, the higher the value conviction

Pillar 2Quality / risk factors

Rate all stocks based on quantitative / qualitative risk

criteria

• Balance sheet strength (cash & debt)

• Quality of management

• Barriers to entry, strength of competition

• Life cycle phase of the industry / company

• Threat of government regulation, interference

• Litigation risk

• Resource availability, buyer strength

• etc

Pillar 2Quality / risk factors

1very low quality / very high

risk

2below average quality /

above average risk

3average quality / moderate

risk

4above average quality / low

risk

5extremely high quality /

extremely low risk

Quality Ranking

Include stocks that

score average or

above-average on the

quality / risk scoring

system

Quality ranking for financials

Solvency/Capital

Balance Sheet

Strength/Optimis

ation

Barriers to

Entry

(Retail,

Investments

and Savings)

Management

(Quality and

track record)

Regulatory and

Litigation RiskOVERALL

SCORE

SCORE

CONSISTENCY

CHECK WITH

NORMALISED

EXIT RATING

SBK 3.5 3.5 4.0 2.8 3.5 0.95

SLM 4.0 3.5 4.0 3.0 3.5 0.90

LBH 4.0 3.0 2.8 3.0 3.2 0.85

MergeCO 3.5 4.0 3.0 3.0 3.2 0.85

INP 4.0 2.5 3.5 3.0 3.2 0.88

RMH 3.5 3.0 3.0 3.0 3.1 0.92

OML 3.5 2.5 2.5 3.0 3.0 0.75

FSR 3.0 3.0 2.5 3.0 3.0 0.92

NED 2.8 3.0 3.0 2.5 2.9 0.87

ASA 3.0 3.0 2.0 2.8 2.8 0.86

ABL 2.8 2.5 2.5 3.0 2.8 0.72

Overall rankingResource shares

Weighting

Attractiveness

of the industry

25%

Competitive

advantage

25%

Financial

strength &

history

20%

Stewardship

20%

Strategy /

mission

10%

Final score

100%

Final score out

of

5 Ranking

Billiton 15.0% 22.5% 20.0% 17.5% 10.0% 85.0% 4.3 1

Kumba 15.0% 20.0% 17.5% 12.5% 10.0% 75.0% 3.8 2

Impala 17.5% 20.0% 20.0% 10.0% 7.5% 75.0% 3.8 2

Sasol 20.0% 20.0% 17.5% 7.5% 5.0% 70.0% 3.5 4

African Rainbow Minerals 15.0% 17.5% 15.0% 12.5% 7.5% 67.5% 3.4 5

Northam 17.5% 15.0% 17.5% 10.0% 7.5% 67.5% 3.4 5

Anglo American 15.0% 17.5% 15.0% 12.5% 5.0% 65.0% 3.3 7

Anglo Platinum 17.5% 17.5% 15.0% 10.0% 5.0% 65.0% 3.3 7

Mondi 7.5% 20.0% 12.5% 15.0% 7.5% 62.5% 3.1 9

Mvelaphanda 17.5% 15.0% 15.0% 7.5% 7.5% 62.5% 3.1 10

Exxaro 15.0% 15.0% 12.5% 12.5% 5.0% 60.0% 3.0 11

Hiveld Steel & Vanadium 10.0% 17.5% 15.0% 5.0% 7.5% 55.0% 2.8 12

Sappi 7.5% 17.5% 7.5% 15.0% 7.5% 55.0% 2.8 13

Anglo Gold Ashanti 10.0% 10.0% 10.0% 10.0% 7.5% 47.5% 2.4 14

Arcelor Mittal 10.0% 12.5% 12.5% 5.0% 5.0% 45.0% 2.3 15

Goldfields 10.0% 7.5% 7.5% 7.5% 2.5% 35.0% 1.8 16

Harmony 10.0% 5.0% 5.0% 7.5% 5.0% 32.5% 1.6 17

Pillar 3View / theme

Identify phase of the investment cycle

• Growth, output gap, inflation, interest rate cycle

• Identify best/worst themes/styles/sectors/stocks for the phase

Bottom-up and top-down themes / views

• Jointly identify stocks best / worst placed for each view

View conviction

• Determine our level of conviction for each view / theme

Pillar 3View / theme

Government policy to become more populist and labour friendly, more intervention and higher

taxes are possible – lower market rating?

Private sector de-leveraging lead to large government stimulus → infrastr. spending –

Construction to benefit (e.g. MUR, GRF, AEG)

Industrialisation of BRICS, resource supply constraints tobias bulk resource prices higher –

favor low-cost suppliers (e.g. BIL, ARI)

Balance sheet repair to suppress consumer spending - rates will fall further – bonds, property

Growth bottomed, but still no inflation threat, rates to stay low – early cyclical (e.g. FSR, NED)

View / themes

Include stocks that

stand to benefit from

the views / themes

that are identified

Themes affecting SA equity shares over

the near term …

Theme / ViewConviction

levelStocks impacted by view

Rate cycle and consumer

spending

Prospects of lower rates remain but

consumer de-leveraging may keep

spending muted

High WHL, TRU, FOS, IPL, BAW,

BVT, SHP, MSM, JDG, LEW,

SHF, SBK, FSR, NED, ASA

China and Global EM

urbanisation and

industrialisation

Growth in EM from urbanisation and

rebalancing of EM domestic

economies leading to greater domestic

demand and wealth

High BHP, AGL, KIO, EXX, ARI

SAB, BTI, SBK, CFR

SOL, AMS, IMP, NHM

ACL, EHS, AEG

Corporate re-investment in

domestic economy

Manufacturing led businesses benefit

from re-stocking cycle and cash rich

SA corporates begin re-investing for

growth

Medium SBK, FSR, NED, ASA

Manuf.: AEG, AFE, AFX, IPL,

BAW, SHF

Growth from Sub-Sahara

Africa

Strong growth out of West Africa

resource exposed countries, FDI led

growth to drive domestic economies

High MTN, BAW, SHP, GRF, AEG,

MUR {SBK, FSR}

Europe at risk Fiscal retrenchment and austerity

measures to temper economic

recovery

High BVT, SHF, IPL, BAW, OML

Themes affecting SA equity shares over

the near term (2)…

Theme / ViewConviction

levelStocks impacted by view

Healthcare development Investment in HIV ARV’s by

government, and improvement of

public sector healthcare delivery.

Regulation of drugs and private

hospital price lists.

Medium NTC, MDC, LHC, APN, AIP,

CLS,

… AEG, MUR, GRF, WBO

Easing of fears of a total

collapse in the global

financial system

Stability in global financial systems

returns as fiscal austerity measures

result in a gradual improvement in

western country fiscal positions

Medium ANG, GFI , HAR

Domestic equity markets … Equity exposure in life companies to

drive improved returns and growth in

EV’s.

Medium LBH, OML, SLM

Domestic fixed investment Underinvestment over the last 2

decades to result in further social

infrastructure investment in the long

term, govt. execution could mean the

next 2 years are weak

Low AEG, MUR, GRF, WBO, PPC

Thank youWayne Mc Currie