How To Build a Profitable Stock Portfolio

zaginvestor profitable stock portfolio

Building a stock portfolio is challenging enough - let alone a profitable one. If you’re interested in a simple to understand yet potentially profitable method, you'll not want to miss this!

My investment process has evolved significantly since I started investing. With over a decade of investing track record, I found that the key ingredients to build a profitable portfolio requires diligence, patience and emotional intelligence.

In this post, I'll focus on how I organise my investments and explain what is my investment framework. More importantly, I'll share how to pick the optimal stocks that will ultimately make you money!

Let’s dive in.

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    Why I prefer single stocks over index funds

    Why shouldn’t I just buy an index fund? You may ask. Optically, index fund are attractive because fees cost close to nothing, there’s little admin for you to do and you’re diversified, owning a bit of everything.

    There’s nothing wrong owning an index fund, I too got involved in my early days. However, as I build up knowledge, the risk-reward of cherry-picking single stocks became much more attractive.

    Investing in index funds make sense for the average investors. But you’re not! Investing in single stocks allows you to isolate research on industries you find attractive and in companies you like.

    How do I decide what to invest

    An investment framework allows you to streamline your thought process and focus on the key points that matter. Consequently, it help builds efficiency, discipline and consistency that every investor must have.

    The key point of a framework is less of finding the next big thing, but rather, it helps rationalise your thinking during market downturn. It’s valuable to think of framework as a tool that increases your chances of making the right decision.

    Briefly, here’s my DCMV (Drivers, Capital, Management team, Valuation) investment framework I use when analysing companies:

    • Drivers of the business: How does the company generate revenues? How are they converting revenues into profit?
    • Capital / cashflow: What level of dividend and reinvestment the company is doing to continue growing?
    • Management team: What are the business experiences and track record of the current team?
    • Valuation / profitability: How much should I be paying for the business?

    Within my portfolio, I allocate capital to three groups of stocks: dividend growth, small/micro caps and concept stocks.

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    Dividend growth stocks

    A dividend growth stock is a company that increases its dividend consistently. The power of dividend compounders is well documented and Buffett’s Coca-Cola investment in 1988 is a case-in-point. Specifically, Coca-Cola provided Buffett an annual yield on a cost basis of just under 50% vs a yield today of just under 4%.

    Dividend growers total return
    Source: RBC Quantitative Research, December 1986 – December 2019. Growers, Cutters, Payers and Non-Payers determined yearly.

    Criteria for dividend growth stocks

    Before any analysis, I first build screens to shortlist potential candidates. Here are my key criteria:

    • Track record: I look for quality companies that has consistently distribute progressive dividends over at least 10 years, say. It’s important to choose a long enough time period to exclude companies that have inconsistent dividend policies.
    • Payout ratio: this is a measure of how much a company is paying out from profits. As a rule of thumb, I look for companies that distribute around 50-70%. Based on my analysis, I found that this range is the sweet spot. Too low of a payout means that we aren’t maximising our monies at work, while a higher payout may mean inherent risk of a dividend cut.
    • Valuation: Our goal is to buy stocks at a reasonable price. The commonly used metrics are price-to-earnings ratio, price-to-book, dividend yield and return on equity. I view valuation on a relative basis. For example, a company could be considered expensive across all sectors, but cheap if compared to its peers in the same industry.

    To summarise, I screen for companies that has grow base dividends for at least 10 years, pays out 50-70% of earnings and a reasonable valuation relatively to the industry.

    Small / micro cap stocks

    Small caps stocks are stocks that have a market capitalisation of less than $2 billion (definition varies). These group of stocks appeals to me because the market pay less attention to them, hence, higher probability of finding undervalued in stocks. The nature of this means stocks tend trade at a significant bargain to its net asset value (NAV), offering a skewed risk-return profile.

    small cap vs large cap total return
    Source: Schroders - Small cap vs large cap: how valuations compare.

    How I pick my bets in small / micro cap stocks

    My strategy is to identify stocks that are trading at a discount of its liquidation value and hold it till it reaches its fair value. This is analogous to “cigar butt investing”, as Warren Buffett called it, made famous by Ben Graham. Imagine a cigar butt that has been discarded on the road side with a few more puffs left, it’s unpleasant, but it’s free!

    Price is what you pay and value is what you get. The idea is if a company were to go under tomorrow, you are protected on the downside because of the discount you’ve bought it at.

    In particular, I look for companies that are trading at 66% or less of its liquidation value or Net Current Asset Value (NCAV):

    NCAV = Current Assets - Total Liabilities

    The reason we choose 66% is to provide us with a margin of safety. This means that should the NCAV turn out to be lower than expected, we have a cushion.

    Concept stocks

    Concept stocks are stocks that are based on new ideas or visions that may not yet materialised. Many innovative companies today, Amazon, Tesla and Netflix were concept stocks when they were first introduced to the market.

    At the time of writing, Amazon has delivered an annualised return of just under 23% per annum since its IPO vs S&P which delivered ~5% per annum over the same period.

    Clearly, survivorship bias kicks in and we would have never heard of companies that didn’t make it.

    What do I look for in a concept stock

    The nature of concept stocks means there are huge uncertainty due to subjectivity. Our goal is to ascertain the viability of the idea in the next 5-10 years. These are my checklist for stocks of this variant.

    • Competition: How easy is it for a new firm to enter the market? What are the substitutes for the product and what is the level of competition currently?
    • Market opportunity: What is the addressable market and its long-term growth potential both today and in the medium term?
    • Financials: Figure out what the market expectation is of the stock (look at valuation metrics). How realistic are their targets vs expectations?
    • Management team: What are the team’s experience and knowledge of the particular sector? How is the team’s track record in delivering results?

    Where do we go from here?

    This post outlines how I think about allocating capital through my use of framework, checklists and screens. Going forward, we aim to share unique insights with a particular focus on single stocks that can help you make money over the long run.

    Finally, I encourage interested readers to seek a portfolio that align with your risk appetite as your first priority. Similarly, a pension fund mandated to meet its long-term liabilities, would not be playing roulette in a casino.

    Investing is personal and subjective, but that doesn’t mean it has to be boring. Marco Pierre White once said “Cooking should be a pleasure, if it’s a job, get a takeaway”. I could say the same about investing. “Investing should be exciting, if it’s hassle, buy an index fund”.

    Are you an avid stock investor too? What is your approach and framework?

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