Thursday, March 29, 2012

Core Positions in a Portfolio, Part 2

...continued from Part 1 

Secular Trends

Now that our portfolio contains some defensive minded equities, let's take a look at the second important anchor group, businesses which benefit from secular trends.

Simply put, secular trends are long term tailwinds for businesses taking part in those trends. These tailwinds could be due to a variety of factors, such as, changes in the way we live, or a global emergence, or simply generational trends. For example, two secular trends that have already occurred and shaped the modern day society as we know it are the mass production and adoption of cars in the early 1900s, and the internet revolution of the 1990s. The first made automobiles affordable to the masses, and drastically improved the mobility of the middle class. The second altered the landscape of information exchange and continues to shape modern society in areas such as schooling, media, social, and business.

Humans are a very dynamic species. Secular trends are not anything new to society. Throughout history, there have been countless secular trends that have occurred, often concurrently. But we aren't here for a history lesson (however useful that may be :) ). What are some the secular trends currently affecting our lives? In fact, there are many

- mobile communication devices
- fracking
- global emergence of the middle class

A lot can be said about each of these secular trends that are shaping our world. Today I'll just focus on the last one.

Global Emergence of the Middle Class

A major secular trend in the world today is the emergence of the global middle class in major population centers. It is important to distinguish that this new middle class comes from some of the most populous regions in the world. If we compare the population of the emerging BRIC countries. They simply dwarf the current advanced economies.

- China: ~1350 million
- India: ~1200 million
- Russia: ~150 million
- Brazil: ~200 million

- Eurozone: <500 million (major Eurozone economies)
- United States: ~300 million
- Canada: ~30 million

While it is true that the majority of the population in BRIC countries have yet to achieve middle class, or anywhere near middle class, the sheer size of their nations means that even if 10% of their combined populations arrive in the middle class over the next 25 years (290 million), it will be nearly equal to the entire population of the USA (300 million).

As more and more of the people from emerging economies like China, India, and Brazil enter the middle class, they will want middle class things, like cars, fancy electronic gadgets, and improved diets. Their daily lives will involve more middle class events, like banking, driving, eating out. With their new-found discretionary income, their spending patterns will become more middle class like, with increasing emphasis on brand and quality premiums. They will have the ability to occasionally splurge on luxury goods or travel. All these changes create tailwinds for various types of businesses.

Improved diets bodes well for fertilizer and farm equipment businesses like Potash (POT) and Deere (DE), who supply fertilizer and tractors to farmers who will benefit not only from higher demand for their goods, but less available land as major cities sprawl into surrounding farmland. The new middle class will discover the magic of the internet, benefiting businesses like Intel (INTC) and Apple (AAPL). Having more money means having a need to keep that money safe somewhere, which means more business for our most global banks like Scotiabank (BNS) and Citigroup (C). Increased emphasis on quality brand names will drive growth for years to come for global brands like Coca Cola (KO) and Nike (NKE). All these will also cause increased global demand for raw materials, and global commerce in general. This directly benefits shippers of resources such as Canadian National Railway (CNI) and global commerce enablers such as United Parcel Service (UPS).

These are just some of the many businesses benefiting from the global emergence of the middle class. This secular trend is real, and I believe it is changing the world as we know it. I feel comfortable allocating 1-2 out of 5 equity names (20-40% of a portfolio) to an area which has a secular tailwind such as this one at its back.

Products and Services You Use

There is a well known saying, "invest in what you know". I believe for novice investors, you should allocate the remaining 20-40% (1-2 out of every 5 stocks) of your portfolio in products and services you use everyday. I think this is an excellent way to get involved in and have a personal connection with your investments.

Take a moment and consider that the average person uses thousands of products or services per day. In fact, before you even leave your home for work, you've likely interacted with no less than 10 businesses and their products (toothpaste, toothbrush, mouthwash, hair products, make up, breakfast, orange juice, dish soap, clothes, shoes, etc).  By the time you return home from work, you've likely interacted with another 5-10 businesses that provide every day services (gasoline, banking, coffee, or a donut) As a paying customer of he business, you already understand the business and know more about it than you think!

Another advantage of investing in products and services you use is you will be able to understand how strong the pricing power of the business is. Think of the many times that you noticed the Colgate toothpaste price increases, but were still hesitant to switch to the cheaper store brand toothpaste. As a customer, you have first hand knowledge of why some brands have pricing power, and others do not. You'll know exactly why customers choose one product over the other.

I believe it is advantageous for an investor to understand how the business she invests in conducts their business, markets the brand, and interacts with their customer, so what better way to learn about all of these than to be the customer! I'm not saying to go out and start buying products from all the business you invest in (because God knows what I'd do with a truck engine from Cummins (CMI) or a 787 from Boeing (BA)...). Just that it helps to understand your potential investment opportunities from the viewpoint of the customer.


So, to recap, a new investor should build core positions of their portfolio first, and three possible areas to select long term core investments from are:

- Defensive sectors
- Secular trends
- Products and/or services you use

For every 5 stocks, I would be comfortable with 2 defensives, 1-2 seculars, and 1-2 products I use. Of course, often, these categories will mix together, so you'll have to use some discretion when planning your portfolio. I hope these ideas will help you in the creation of your own balanced portfolio as well!

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