How to build the perfect portfolio is a widely-debated topic with many different opinions regarding the matter. Most financial advisers will tell you to invest 7% - 8% in each stock and to be diversified, which basically means to have a variety. During the next few articles we will discuss how to build the perfect portfolio without a "one system fits all" strategy. I will discuss several stocks that are both good for short, long, and everything in between. Along with percentages and how to better position yourself for success.
I have never agreed with the 7-8% holding rule within a portfolio. When I first began investing I was starting with roughly $5,000 and although investing with the 7% rule would have limited my risk it was not going to grow my portfolio at the speed that I desired. I believe that the way a portfolio is divided should depend on the size of the portfolio and not a "one system fits all." Because with a $5,000 portfolio I was 19 years old using money that I had saved while working in college and I was using it as a way to educate myself about the market. But over the years my goals have significantly changed and my willingness to take risk has declined. Therefore, I believe as your portfolio grows you goals change as well. Below is a general guideline that I have always used as my portfolio has grown through gains and additional investments. The chart will show the way that I believe is the best way to divide a portfolio by the total number of holdings to give the highest potential for gains while minimizing risks.
|Portfolio Value||Number of Stocks|
|$5,000 - $10,000||2 - 3|
|$10,000 - $20,000||4 - 6|
|$20,000 - $50,000||7-10|
|$60,000 - $100,000||11-14|
|$100,000 - $250,000||15 - 20|
|$250,000 - $500,000||20 - 30|
Dividing Your Portfolio
There is no standard or correct way to diversify or divide your portfolio. There are too many factors involved for one standard method. My goal is to maximize the reward while minimizing the risk by purchasing shares that I believe present value, or that have fallen for reasons that are not related to the company. Yet someone else who is near retirement may wish to minimize risk but most likely still desires a decent reward, therefore this person may prefer bonds. It's impossible to give a formula that will work for everyone yet I have had success with the formula above.
I currently hold 15-20 stocks at any given time and diversify the stocks based on my long-term goals. My idea of diversification is much different than the average investor, and I won't say that it will work for everyone but it has worked for me. When most people think of diversification in a portfolio they are speaking of a variety of stocks, mutual funds, bonds, emerging markets, etc. Along with having a variety of securities in all sectors or industries to limit risk. I use diversification in my portfolio to invest in stocks with different levels of potential rather than a variety of industries or sectors. I have been investing in stocks with this concept for the last two years when I was forced to change my investing strategy as my portfolio became larger.
I place investments into six categories and utilize each in my portfolio. I believe that each has a purpose and rather than concentrating on diversifying my portfolio with different industries my goal is to diversify my portfolio with the type of stocks that I choose. And like I said, this isn't for everyone but I have tried various strategies over the last few years and I am yet to find one with returns such as diversifying your portfolio with stocks that serve a different purpose. Below is a chart of the six categories of stocks that I use in my portfolio along with the percentage of my portfolio that each category represents within my portfolio. Over the next couple weeks I will better explain each category and its uses within an investor's portfolio. Regardless of what your individual investment goals are you can use this knowledge to better diversify your portfolio. I will also mention several stocks for each category that I believe are among the best that will serve the best purpose within a portfolio.
The short-term value portion of my portfolio is what I believe more investors are using as a strategy. It appears that fewer investors are investing for long-term yield or growth but rather playing the markets on a day-to-day or a week-to-week basis. And although I do not day trade, there are securities that I purchase with an expected hold time that is relatively short. I typically hold my short-term stocks for one week to one year and separate my short-term investments into two categories: Value and Growth. The growth stocks I will hold much longer; 6 months to one year. But the value stocks are usually held for less than 6 months.
I consider myself to be a value investor which is an investment paradigm that generally involves buying securities that appear undervalued by fundamental analysis. Therefore this concept is incorporated into short-term value investing, however, I also incorporate investor tendencies and market reaction into this portion of my portfolio for better short-term gains. Therefore the stocks that I own change quite often by what I feel is most undervalued with the potential to rise. I use earnings, economic indicators, and global events to better position myself to buy a stock at its lowest point so that I may return gains once the market recovers.
Short-Term Value & Earnings
I will typically separate the 20% of my portfolio that I allow for short-term value investing into two separate categories. The first category is used to purchase stocks before a company will announce earnings. I will purchase stocks that have a long history of beating or exceeding expectations that have fallen for some reason that is not related to the company. I believe there is a growing number of investors who are incorporating this style into their investment strategy to capitalize on the strong movement of a stock after earnings are announced. I have written several articles that better explain this strategy for purchasing stocks before earnings which include buying five or six stocks before earnings are announced and if the company releases an encouraging quarter holding the stock for approximately one month or possibly two. This strategy is not the most popular among "old school" investors but the truth is that the market has evolved and there are a large number of investors who return large gains from buying companies that consistently beat earnings and have a long history of a positive reaction upon its release. The second half of the 20% allowed for short-term value investments is used to purchase stocks that have fallen below what I believe is fair value. A perfect example is what occurred during the months of August and September when the markets trended significantly lower as a result of fear regarding another recession. The fear was sparked by the European financial crisis and a U.S. debt debate that caused mass fear and panic. And although many investors were selling entire portfolios some investors were loading up on additional shares or taking profits to buy back more shares with August being a playground for value investors.
Nearly every stock trended significantly lower during the months of August and September, however, the reaction was speculative with the majority of stocks that fell having no exposure to sovereign debt or any ties to the eurozone. Very few companies lowered guidance, reported bad earnings, or gave any indication that business was fading during that time. Yet most stocks fell without any rational thought as we nearly scared ourselves into another recession. Now that the markets have recovered a large percentage of stocks have regained much of the loss that was posted during the months of August and September. However there are several additional stocks that would make great short-term investments that have the potential to return large gains over the next year that are yet to regain the majority of its loss. Therefore I have listed 6 stocks that I believe fall into this category of undervalued stocks to return large gains in the near future.
6 Short-Term Value Stocks
Alcatel Lucent (ALU) lost nearly 17% of its value last Friday after announcing earnings. Since July 22 the stock has lost 55% of its value after slower than expected revenue growth and a dependency on Europe that has resulted in fearful investors. The loss on Friday was after the company announced decent earnings but lowered guidance for the 4th quarter and full year 2011. As a value play within a portfolio I believe that ALU would make a great investment. Because the company's guidance was more of a precaution as the result of a struggling European economy rather than a sign of what's to come long-term. The company showed significant weakness in Europe, therefore, guidance was lowered but it gives ALU the security of assumed weakness. I expect the stock to post drastic gains over the next year and that it's now trading at its low level. I believe the market overreacted and is failing to realize the significant progress that the company has made over the last year, along with exciting potential for the future. The company lowered its expected margins to 4% which is 1% lower than previous guidance, however, 4% is still double the company's 2010 margin of less than 2%. The company's net income increased from $25 million to $267 million year-over-year. I also find the company's partnerships in Spain and Barcelona to be encouraging, in which it's developing the 4G LTE network in some of the highest populated areas of the world. If the company's network is a success it could bring long-term sustainable revenue to ALU and result in high profits within these large underdeveloped regions of the globe. Overall, I believe the news was not quite as discouraging as the market's reaction and I believe there is much to be excited about regarding its future. And since the stock is trading with a loss of 30% over the last year I believe ALU is a stock of value especially considering the fundamentals and margins are much improved.
Sprint Nextel (S) has trended significantly higher over the last month to post a gain of 17%. However the stock is still trading with a 6 month loss of near 50% and much below its book value per share of $4.35. The company has horrible fundamentals with a debt-to-asset ratio that consistently increases along with a failure to post a profit for more than 5 years. Yet despite the company's problematic past I believe that Sprint is presenting a significant amount of value for its future. Because a large portion of identifying value is understanding a company's future potential and from Sprint's current position there are few stocks that have greater upside potential. The company hasn't been shy regarding the affect that Apple products have had on its company. And since Apple (AAPL) has controlled the communication market for the last six years it should come as no surprise that Sprint has been affected by not selling Apple products. Therefore I expect for Sprint to experience incredible success from selling the iPhone 4S and to retain its customers much longer. I also believe the company will attract new customers with its unlimited data plan and for revenue to drastically increase over the next year. However I do not believe Sprint will achieve profitability in 2012 because of high costs associated with the iPhone along with the amount of money that Sprint is using to advertise its new product. But I don't believe that investors care if Sprint achieves profitability in 2012 I think that investors will be satisfied with progress. And since Sprint has already shown progress with its most recent quarter and its initial sales of the iPhone I believe that investors will be satisfied and optimistic of the company's future and that the stock will rise far above its $3.96 one-year price target.
This portion of the portfolio is set aside for short-term value therefore Research in Motion (RIMM) could be a great short-term play with such low valuation. RIMM is trading at 52 week lows with a 65% loss and a P/E of 3.4. And with a new line of products with a better technology I believe its sales may be higher than the modest expectations. RIMM desperately needs to reinvent its company because it's no longer relevant compared to companies such as Apple (AAPL) and Google (GOOG). However the company does sell a large number of Black Berry products, has a solid balance sheet, and a stock position that presents value. Therefore RIMM will most likely return gains from its current price, however, this stock shouldn't be held for more than 6 months until operational changes are made. But with a new technology RIMM will probably post modest gains at some point in the future and return nice gains to investors that take advantage of the company's low valuation.
The auto industry is my favorite industry within the market. I choose auto stocks and companies that are affected by the auto industry for several positions within my portfolio. I believe that auto stocks are great for either short or long-term positions with solid growth and undervalued stocks. And the two companies that present the largest amount of value are General Motors (GM) and Ford Motors (F). These two stocks are much different from the others on the list: RIMM, ALU, and S have some fundamental reason for the stocks demise. However GM and F have increased sales with solid guidance yet both trend lower. Auto sales are at its highest levels since cash-for-clunkers yet sales are still at historic lows, despite being 1 million units sold ahead of expectations for 2011. Both companies have been reinvented with fuel-efficient vehicles and an emphasis on new designs. And with both companies releasing new models in the coming year that replicate last year's success I believe that sales will only rise. Therefore I believe the absolute best investment of the next year, and the next 10 years, would be stock in either of these two companies that are trading with P/E ratios between 5 and 6.7 in fast growing companies.
Level 3 Communications (LVLT) is by all definitions a speculative stock. The stock had posted gains of more than 200% during the last year but has now trended lower by 15% since announcing earnings. The company's fundamental progress has been much lower than what investors had anticipated and it's still yet to post a profit which remains a large concern. However this company should have filed for bankruptcy on several occasions during the last 10 years but award winning accounting has saved the company and allowed it to make strides in the right direction. Most believe the company has placed all its eggs in one basket with the recent purchase of Global Crossing (GLBC). And although I believe LVLT paid too much for the company it does give LVLT some distinct advantages in the competitive communications industry. Both companies have experienced a recent increase in demand, have solid assets, and combined have more than 170,000 miles of fiber through three continents which is an industry leading best. The company's executives hope this advantage along with new territories can build a larger more dominant company that will continue to grow through its larger regions. I believe the chances of growth are likely but with both company's having a high amount of debt this merger must be successful, because if not it would be difficult for LVLT for avoid default. However at $21.30 I believe the stock is presenting value and with a $31.71 one-year target I believe it would make a good short-term investment. No one knows if LVLT's purchase will bring long-term success to the company but what we do know is that the purchase brings optimism surrounding the company and I believe the optimism should be enough to trend this stock significantly higher.
This form of investing has higher risks involved, however, it also has significantly higher rewards by taking advantage of beaten down stocks presenting value. The goal of short-term value investing is to capitalize on stocks that are undervalued or that have fallen to some excessive level. Each of the stocks on this list present a level of risk but the potential reward outweighs the risk for each of these stocks, at current positions. The important point to remember with short-term value stocks is to take profits. Don't get greedy but rather take the 15-20% gain when it presents itself because these stocks are set aside for short-term investments to capitalize on stocks that have potential and have fallen to a point that is near the bottom of its range.
Disclosure: I am long GM. As with any investment, due diligence is required. The opinions in this article are not intended to be used to make a particular investment or follow a particular strategy but rather informational purposes only.