CFA - Level 4
Don’t worry the denizens of Charlottsville (CFA leadership) have not added another level to the CFA exam, but maybe they should.
I graded CFA exams for over 15 years. It was a great experience. I got to meet many interesting people from the industry and academia. Two guys of particular interest were Frank Reilly and Don Tuttle, both authors of leading texts on portfolio management. many years ago, I was asked to join them on the Curriculum Committee to choose the reading material for upcoming exams.
We can have a long debate about the value of the CFA program, but that can wait for another day.
I argued with Frank and Don that the standard investment texts lack coverage of many important practical questions.
Here are the questions that I thought should be covered more carefully in portfolio management textbooks, but will be considered on this blog:
How do you build portfolios for different types of individual investors?
The textbooks correctly cover many different types of institutional investors, but never different types of individuals. Specifically how should manage money for yourself, or close family and friends, compared to individuals that are paying you a fee. Every PM at my old bank would say to me about my recommendations, “of course I will buy that stock for myself, but never for my clients”. That comment alway troubled me deeply.
In this blog I will discuss building the portfolio for yourself, a subject not well discussed elsewhere.
How many stocks should be in a portfolio?
Academic research clearly shows that 90% of diversification is achieved at 20 stocks, yet most professionally managed portfolios are over 40 stocks. Why the discrepancy?
I argue strongly for 20-25 stocks.
What percentage of portfolio’s ideas should you generate yourself?
This is a critical question, but is almost never addressed.
It is ok to generate less than 100% yourself, but you must carefully consider how to best use outside sources.
How should a portfolio manager interact with Wall Street or even Seeking Alpha?
Textbooks seem to assume the “sell-side” does not exist. This is unrealistic.
As a value investor you should usually be acting “counter” to Wall Street, but you cannot ignore them. Find me one textbook that discusses how a PM should react to Wall Street buy recommendations, and I will hold a parade in your honor.
How should a portfolio manager allocate his time?
This is perhaps the most important question of all.
It was actually our final exam question in a Portfolio Management seminar taught by my wise friend Dr. Henry Oppenheimer over 40 years ago. I am still trying to answer that question today.
To me the answer is roughly 10% maintenance research on existing ideas, 30% searching for new ideas, 60% analyzing potential new ideas.
What investment style should I choose?
I am told growth stock investing is still legal in this country, but I am not sure why. Alright, I guess we need growth guys to mercilessly sell good stocks to create value opportunities.
To me the critical question in what “flavor” of value investing you should undertake. Many different approaches are possible.
What market cap range should I invest in?
20 years ago I would have said go as small as possible. As I aged, I saw that on more than a few occasions Wall Street could be so silly that opportunities occurred in $20+ billion market cap stocks. There is also a place for mid-dap ideas.
The decision of how small it is safe to go, is a question we will be investigating.
Should I strive to have a minimum dividend yield in my portfolio?
Over the last 15 years I have observed way too many professional and individual investors “reaching” for yield. This can often be a disaster.
I am strongly advocating a total return approach.
Should I consider highly leveraged companies?
Investing in highly leveraged companies is a very specialized business that value investors should approach with caution.
What constitutes too much leverage depends on the industry and the structure of the debt. Where value investing ends, and distressed investing begins, is tricky.
Should I consider the sector weights of my benchmark when I build a portfolio?
This answer is widely debated. In the real world way too many managers “hug” their benchmark. No textbook really discusses this issue.
In the institutional world some amount of sector concern is inevitable, but no so much in the individual world.
I prefer to think of sectors as more “offense and defense”, but other approaches are possible.
How should “macro thinking” effect my portfolio selections?
Wow, is this an important question, with no clear answer.
As a young analyst I tended to completely ignore macro issues, but as I got wiser I accepted that some amount of macro thinking was possible.
We will continuously address this question as we go forward, it will never go away. This is an issue every PM must face every day.
Should I own international stocks?
There are lots of different approaches here. To me the texts are always too optimistic about international investing without considering how difficult in can be to do the analysis.
“Ugly Americans” are just not used to multi-currency issues. I advocate a cautious approach to international investing.
How should I invest in energy and financial stocks?
Both of these groups present unique problems for the generalist. When you cannot hire more analysts, these problems need to be addressed.
Because the balance sheets of financials and energy are murkier, I tend to go with larger, more established companies, in these unique sectors. Often, I just ignore financials and energy stocks completely.
What process should I use to find new stock ideas?
I guess the texts think you should just call your Goldman Sachs institutional broker and get his best ideas.
The search for new ideas is crucial, and almost never discussed.
We will constantly be scanning the markets for new opportunities. If you don’t, you will find yourself buying other people’s ideas.
What constitutes a great new stock idea, or at least a good one?
In the old days we liked to see a stock that could double in 5 years, with at least some limited downside risk. With valuations elevated, trying to find a stock that can go up 50% in 3 years is more realistic (less for stocks with a yield).
We will discuss limiting downside risk as we go along, but it is important.
In the real world every portfolio will have marginal ideas. Those are stocks you are trying to replace with better ideas. I call them B+ names.
Of course, in the real world very few investors have 3-5 year time horizons, but that is an issue for another day.
Does every good idea go in the portfolio?
When you find a good idea be sure to first compare it to 10-20 companies in the same industry or sector. Some companies defy comparison, but most have clear alternatives. The biggest mistake made by inexperienced analsyts is not making enough comparisons.
Before adding a new stock, it is important to have a rough idea of your diversification plans. Maybe the new idea does not give you enough diversification. This can often happen in portfolios with less than 30 stocks.
Should every idea in the portfolio have a catalyst?
In the real world almost every stock discussion eventually gets to catalysts, but I have never seen the word in a textbook.
I believe catalysts are nice to have, but not necessary. Many would disagree with that statement.
Should momentum be an important part of the investment decision?
To me value investing means buying low and selling high. That means avoiding momentum.
However, some value investors want to see some momentum before they buy, but I disagree.
Defining momentum itself can be a difficult task. To me momentum is a factor to be aware of when making some portfolio decisions. This issue will be discussed as we go along.
What should be your sell discipline?
One key reason to manage a model portfolio is to answer this question.
In the real world of institutional investing, consultants consider this perhaps the most important question.
My general approach is to force ideas out of the portfolio by finding better ideas.
What should portfolio turnover be?
If you are truly a long-term investor then turnover should stay under 25% to 30% annually, and could even be much lower.
Frank and Don agreed these were important questions, patted me on the head, and published their next editions with no changes.
Practical questions seldom bother academics.
Sorry, for the long rant. Go have a beer.