Tuesday, March 20, 2012

Core Positions in a Portfolio, Part 1

Core positions, or core investments, are critical to the long term success of any portfolio. In difficult times, when the stock market drops 1000 points in a single day, they help maintain your sanity, conviction, and steer your portfolio through choppy waters.

For a person who is just beginning to take control of their own portfolio, deciding on which investments will make up the core of  your portfolio will be the first major decision. As a young investor, these investments should be that ones that help you begin your journey. If you are an older investor, these investments will form the backbone of your portfolio. In both cases, in the long run, the investments and businesses need to be ones that you can trust in, and believe in.

How do we construct this core then? How do we decide which investments will make it into this list?

Here are three characteristics that I believe characterize the types of investments that fit very well inside the core of a portfolio. Depending on the investor, he/she may have additional characteristics that they can feel comfortable with, but here are three of mine. They are:

- Defensive sector
- Secular trend
- Products and/or services I use

1. Defensive Sectors
Within the stock market, there are certain industries which are very defensive in nature. These industries typically are ones that do not suffer as much during a recession. Industries such as health care, consumer staples, and utilities are three that fit this description. Examples of companies within these industries are Johnson & Johnson (JNJ), Coca Cola (KO), Procter & Gamble (PG), and Southern Company (SO).

Whether the world is in a recession or not, consumers will still buy dental floss (J&J), do laundry (P&G), drink Coke, and use electricity (Southern Company). They may do each a little less often than before, but they will still do them.

We can see how this is reflected in both the operating incomes (income derived from business operations) and stock price of these companies during the 2007-2010 stock market crash (and subsequent rebound).

S&P 500 J&J Coca Cola Southern Co. P&G
2007/08 high 1576 72.76 65.59 40.60 75.18
2009 low 667 46.25 37.44 26.48 43.93
2010 high 1262 66.20 65.80 38.49 65.38
2008 Operating Income $16.0B $8.45B $3.51B $17.1B
2009 Operating Income $15.6B $8.23B $3.27B $16.1B
2010 Operating Income $16.5B $8.45B $3.8B $16.0B
*data provided by Morningstar

There are 3 things to notice here:
1. Observe how in all 4 cases, the decline of the stock price from peak to trough in percentage terms was less than that of the overall market (S&P 500)
2. Observe that in each case, the decline in operating income in percentage terms, is nowhere near the decline in stock prices
3. Observe that in 3 of the 4 cases, the operating income in 2010 is equal or higher than 2008, recovering all the losses and then some.

These 3 observations are critical because these are precisely the attributes we look for in the businesses we want to invest in at the core of our portfolio: predictability, consistency, and reduced volatility.

I like to think of it like a hockey team (must be the Canadian part of me). Every team is built around a group of core players. These core players define the direction of your team, and in this case, your portfolio. They provide you with reliable and consistent performance, and you know they'll be there for you, day in, and day out.

Out of the 5-6 stocks to form the core of your portfolio, I would recommend at least 2 should be from defensive sectors such as healthcare, consumer staples and utilities.

(to be continued in Part 2...)

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