I grew up in a construction family. My dad owned his own commercial construction company and later on my two brothers followed him into the trades. I was the only one who didn’t pursue the construction industry, but I remember spending my summers in high school working for my Dad and learning how to work with my hands. I have always admired how my Dad can point out buildings that he has worked on and be proud of his craftsmanship. Over the years, I have felt that same satisfaction as I have tried my hand at remodel projects in our home. There is always a feeling of accomplishment in building something out of parts and creating a finished project. Like building construction, portfolio construction utilizes a process of evaluating different parts and bringing them together to create a functioning system.
The third principle of Centered Financial’s investment strategy is to utilize an educated approach when choosing investments and manage investment behavior. We rely on research, data, historical evidence and common sense when choosing investments and once we are invested, we define risk and coach behavior to follow through on an investment plan. I will write a separate post in the future on managing behavior, but in this post, I would like to discuss how we approach portfolio construction.
Start with the Core
Index investing has become extremely popular over the last 30 years and there are some very good reasons why. When you buy an index, you are getting a large diversified basket of investments that will follow very closely to the makeup and returns of the overall market. Here are some reasons why index investing makes sense:
It is extremely low cost: Index funds typically carry very low management costs and the have minimal turnover which reduces tax and transaction drag.
The market has been successful: Over the long term, the market has produced positive average returns and most investors would be happy to capture the long-term average of the market. The image below shows the results of just being in the market over the long term.
In our portfolios we utilize an index strategy for a core position. By doing this, we obtain automatic diversification across sectors, industries, and thousands of companies. However, we don’t just stop there. Here’s why:
We don’t just focus on size: When you invest in an index, your portfolio is weighted to each investment based on company size. To say that the best performing companies are always the biggest companies doesn’t make sense, yet this is how an index values how much exposure is given to each company. Instead, we seek additional factors that can enhance expected returns.
Indexing assumes that markets are always efficient. In his annual letter to shareholders in 1985, Warren Buffett wrote: “What could be more advantageous in an intellectual contest- whether it be bridge, chess or stock selection- than to have opponents who have been taught that thinking is a waste of energy.” With this in mind, we feel that research and asset positioning can capitalize on market inefficiencies.
Add Factors
Beyond the core market position, we incorporate factors that have shown to produce positive expected returns. What we look for:
Shareholder yield: There are two ways to earn money in stocks. Appreciation of your invested capital and dividend income. We look for companies that are using their cash surplus to provide a dividend to their shareholders and have shown a history of growing dividends over time.
High Quality: These are companies that have good fundamentals when evaluating their business and financial statements. Profitability and free cash flow are important measures when seeking a high return on invested capital.
Momentum: This factor is based on the result that high recent momentum in company prices tends to persist for a sustainable period.
Size: It is important to have exposure to small and mid-size companies, not just the largest.
We utilize several factors because we know that at any given time a factor may not be producing the expected results. At different points of the economic cycle, we may find it beneficial to weight toward certain factors over others.
Invest Globally
Despite the recent political efforts to reduce globalization and become more protectionist, technology has made our world very small when it comes to business. Our large U.S. companies provide international exposure through global sales. I noticed the significance of this last summer when my wife and I visited Barcelona. We went to tour the Sagrada Familia, a historic Spanish cathedral, and I noticed KFC and McDonald’s as the popular food establishments for tourists across the street from the monument. While American companies are a stalwart investment position, we expand our investment opportunity by investing internationally. We expect international developed and emerging markets to continue to grow in world market share and be a valuable growth opportunity.
Bringing it all together
All of these pieces have to come together to function as a system. We are always evaluating the factors and where we currently stand in the economic cycle. We seek to understand how our portfolio positions match with our goals and how they correlate with each other. It is a constant process and worth the work to build portfolios that will provide for our financial goals.