Building The Perfect Portfolio: Part 1

by: Brian Nichols

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

There is no standard or correct way to diversify or divide your portfolio. There are too many factors involved for one standard method such as investment goals. 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 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's 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 diversifying my portfolio with different industries I 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.

Long-Term Yield 30%
Long-Term Value/Growth 20%
Short-Term Value 20%
Short-Term Growth 15%
Small Cap 10%
Emerging Markets 5%

Today we will be talking about the stocks that I believe should account for the largest position within an investor's portfolio: Long-Term Yield. The long-term yield stocks are intended to provide consistent growth in a company with a strong history of success. You want to purchase companies that have overcome adversity and continuously grow larger within an industry that can not be replaced. These are stocks that will be held over a period of many years that are rarely touched unless it's to acquire additional shares when value is present. I believe there are two types of long-term yield stocks: small range and high yield or high range and low yield. And of course there are exceptions to this rule but I believe long term stocks should consist of a variety of stocks that trade in different patterns with various yields. Below is a look at several stocks that provide long term security that I believe are the best over a period of many years to return large consistent gains.

The communications industry is one of the fastest growing industries across the globe. And I believe the best two companies within this industry is AT&T (NYSE:T) and Verizon (NYSE:VZ). Both AT&T and Verizon would make great long term investments with yields over 5.0 and a long track record of innovation and success. I believe that AT&T has the most upside because of its stock position. The stock has a $174.5 billion market cap, P/E under 15, and strong fundamentals. It's increased earnings by more than $8 billion since 2007 yet it's still trading $10 from its range in 2007. For the last three years the stock has traded in a tight range. However I believe it will soon trend higher and that those who purchase under $30 will be rewarded with stock gains and a strong yield for many years to come. Verizon has posted higher gains over the last year with a return of 15%, along with its great yield. Verizon and AT&T have remarkably similar fundamentals with the exception that AT&T posts an additional $20 billion per year. Yet both companies have solid balance sheets with nearly $11 billion in cash. Each stock trades roughly 50% less volatile than the market and has high institutional ownership which should control loss. In addition both companies have a strong history of increasing dividends with AT&T increasing its dividend nearly every year. I believe that both companies will remain industry leaders for several decades and will continue to reap the rewards from the demand of best selling products from companies such as Google (NASDAQ:GOOG) and Apple (NASDAQ:AAPL).

Major drug companies are both highly important and very profitable with stocks that provide several benefits to an investor's portfolio. There are a large number of drug companies that return large capital to its shareholders with high yields. And if we really looked at every drug company we would probably find 10 great companies that would return large gains to a portfolio. But since there are so many within this industry I will use the stocks that I believe have the most upside. Therefore I believe that both Pfizer (NYSE:PFE) and Eli Lilly (NYSE:LLY) would make great long-term investments within a portfolio. Both companies have a long history of innovation and success with large pipelines, a solid balance sheet, and high yields. However there has been a lot of concern surrounding LLY and its patent situation which includes several expiring patents. Yet the company has 66 drugs in its pipeline including 10 in phase III. And as I have detailed in a previous article LLY can easily extend the patents that are expiring with modifications and drug transport technologies that large drug companies practice. I believe the company will allow some of its drugs to expire since it has such a large pipeline of drugs that are more advanced than the current drugs that are already approved. In addition the stock is trading $20 from its range before the recession and since its revenue and earnings are exceptionally higher I believe the stock will trend higher over the next 10 years giving investors large returns with both stock gains and yield. Pfizer's stock is similar to LLY trading 30% lower over the last five years despite much better fundamentals. PFE has drugs in nearly all areas of treatment and has a proven record of long-term success. I am especially encouraged with the company's advanced technology in pain management and substance abuse, which are two of the fastest growing treatments in America. PFE has joined several small companies to develop drugs to treat pain that are abuse resistant with an AVERSION technology. The company has one drug approved, Oxecta, and four additional drugs in its pipeline that are similar. These drugs use common pain treatment medications such as Oxycodone and Hydrocodone and then use the AVERSION technology to prevent substance abuse. I believe this technology is the next multibillion dollar technology and that it will change the way doctors prescribe pain medication. And because of this technology and the company's strong pipeline of drugs to treat various diseases I believe PFE will be a great investment for many years to come, much like LLY.

The companies that create products that are bad for our health are just as profitable as the most innovating biotechnology companies that save lives. If you are looking for an investment that has survived through adversity when other companies would have fallen or grown stronger through bad press, or regulations that prevent advertising then you want to invest in tobacco. The tobacco industry has survived and grown larger despite lawsuits, regulations on advertising and the use of its product in public places, substantial tax increases on its products, and commercials that constantly bring to perspective the amount of people who die using the product. Yet despite these factors Philip Morris (NYSE:PM), Altria Group (NYSE:MO), Reynolds American (NYSE:RAI), and Lorillard Inc. (NYSE:LO) are trading near all time highs. Each stock has a yield of at least 4.33 and has strong movement with Lorillard returning 285% during the last five years. However Lorillard has a questionable balance sheet while the others have strong balance sheets. Each of these stocks would offer a company that can withstand adversity that continues to get stronger.

Utility companies are a safe place to invest your money as stocks with little movement and strong yields. There are several great utility companies yet my personal favorite is Duke Energy (NYSE:DUK). I like Duke over other utility companies for two reasons: It has stronger movement than other electric utility stocks with a 26% gain over the last two years and a 14% gain during the last year. And it has increased revenue over the last few years and remains consistent with earnings. Duke operates in several developing communities and I believe will continue to grow over many years and with a yield of 4.86 I believe it's hard to go wrong with this utility company, or others like it.

Historically, oil has risen in price which is good for only the large oil corporation. And since we are talking about companies with long-term consistent returns I believe that Exxon Mobil (NYSE:XOM) is a company that you can't go wrong with. Over the last 10 years XOM has been the most consistent stock in terms of size within the market. Other sectors such as technology consist of companies that change power every five years but XOM has managed to remain one of the top oil companies for decades. The stock has a modest yield of 2.35 but has large movement with a 94.5% gain over the last ten years. The company is well positioned for whatever changes are to occur over the next 30 years with a strong presence in natural gas, oil, and petroleum products. And since it remains one of the most consistent large companies within the market it would be hard to go wrong with XOM.

In my opinion the perfect long-term stock is McDonald's (NYSE:MCD). The stock has posted gains of 222% over the last ten years including a 23% gain during the last one year. It trades with a P/E under 19 and a yield of 3.00. The stock has consistently trended higher since 1980 with a three year period of loss during 1999-2002. And most would agree that the company is still in a growth phase with revenue increasing by nearly $1 billion during its most recent quarter. The company's future appears bright with success in its emerging markets and new services such as its McCafe posting record sales. I believe that MCD can maintain its growth for many years to come and that its stock will continue to trend higher much like its last decade.

There are several long-term stocks that will return large gains over a period of many years. I believe the stocks and industries mentioned above are among the best for long-term gains in a portfolio. Most of my long-term holds I bought during the recession and then I increased my position during August of this year when the market trended lower. I believe the most important factor in buying a long-term stock is the purchase price of the stock, and that investors should wait and be patient for a stock to drop after an economic event that does not relate to the company. And in this volatile market you are almost certain to find the opportunity to purchase a high-yield stock at a price below its value.

Disclosure: I am long DUK, T, MCD, LLY. 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.