Thinking About Sector Weighting + 2nd Draft of the Model Portfolio
Deciding how, or if, you are going to be concerned about sector weighting is a very important part of how you manage your portfolio.
Sector weighting is a contentious issue. Discussing this issue can be very similar to arguing about religion. There are no right and wrong answers.
Let’s consider 4 different approaches:
little or no concern about sector weights
some concerns about sector weights
a fairly strict adherence to sector weights
an approach I call “build your own sectors”
In a perfect world we would all ignore sector weights and just pick stocks. There are a few folks that can get a way with this method. Perhaps, if you just manage money for your own family you might get away with this method. In the real world it is inevitable that your performance will be compared to some index.
Some type of diversification is necessary. I will not include a long dissertation on “modern portfolio theory” here. However, one problem with running a 20-25 stock portfolio is you must be more concerned about being diversified. It is a little easier to “spread out” in a 50 to 100 stock portfolio.
Many investment managers use a middle course. They are aware of the different sectors weights, but they are very willing to alter them. If healthcare is 15% of their benchmark index, then they might be wiling to be “double” weighted, 30%, or maybe have no healthcare at all. They can be flexible, but they generally explain their strategy in terms of sector weights.
More managers than you probably realize are very concerned about sector weights. They want to use their stock picking ability within each sector to “earn their alpha”. They want to be “sector neutral”. Another approach is one suggested by a top Goldman Sachs strategist just the other day on CNBC. He said:
“We all know that the best way to beat your benchmark is to “index” 75% of the portfolio, and use some smaller stocks with the other 25% to earn you alpha. We all know in the real world this is how it is done.”
In the real world this is a very common strategy. Many mangers will never admit it. out loud, but this is what they actually do. It is by no means “wrong”, it is just another approach.
What is wrong is the “closet index” approach of buying 100 stocks that almost completely mimics the index and charging a full 1% fee. Unfortunately, this is a common strategy.
Any of these first 3 strategies is acceptable, all that is necessary is to be consistent.
My preferred approach is different. I like stay disciplined, but be more worried about characteristics than sectors. Here is my suggested approach:
20% economically sensitive
20% market caps under $1 billion, variety of economic sensitivities
20% difficult to classify stocks, weird stocks, special situations
40% defensive, low Beta, not economically sensitive
Maybe if valuations get more reasonable, I will reduce the percentage of defensive stocks.Why this craziness? I just feel too constrained by industry definitions, but yet I want to have a disciplined approach. I want to diversified, but still have an emphasis on defensive stocks.
In all honesty, I am seldom comfortable with financial stocks. Their balance sheets are just too opaque. Maybe some specialty insurance names might be acceptable. This group is 10-15% of the indices, and I seldom have a representative.
The real problem is technology. It is 20-30% of the major indices, and I just can’t get there. I can hide in safer names like Corning and Intel, but eventually I have enough good “special situation” ideas I just cannot justify the larger names.
When I started out I really wanted to have a more “normal” portfolio, but in the end I settled for “weird”.
I know I need a discipline to avoid too many cyclical stocks. I need a budget.
However, I also want a focus on safety, too offset the higher risk special situation names.
Maybe this approach will have too much structure, but after a lot of thought, this is my choice.
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Given the slightly new approach, I will eliminate some of the bigger cap names like Corning, Intel, Omnicom, and one utility.
There are five new names in this portfolio.
—- 20% economically sensitive, cyclical
Brunswick - BC - my favorite consumer cyclical, trough earnings should be better, A+
Nordstrom - JWN - it’s just too cheap, Rack still growing, A+
RXO - RKO - truck brokerage spin-off, neat asset-lite approach, A+
Masco - MAS - marginal idea, easy to understand, B+
—- 20% smaller cap, $1 billion and less, economically diverse
Matrix Service - MTRX - my one micro-cap, refinery repair, A+
Argan - AGX - builds power plants, A+
Ruth’s Hospitality - RUTH - well run restaurant, A
Viad - VVI - unique travel idea, maybe to cyclical, A-
—- 20% special situation, weird stocks
Kirby - KEX - barge transport, A+
Red Rock Casinos - RRR - casinos for Vegas locals, A+
Vistra - VST - merchant power producer, A
Azenta - AZTA - just sold Brooks Automation, now only healthcare, B+
—- 40% safety, low beta, defensive, not economically sensitive
NovaGold - NG - leveraged to higher gold prices, A+
Royal Gold - RGLD - interesting smaller royalty deals, A+
Roche - RHHBY - heavy R&D yet to pay off, A
Royalty Pharma - RPRX - great exposure to diversified portfolio of drugs, A
Elanco Animal Health - ELAN - spin-off of Lily, hurt by avian flu, A+
Evergy - EVRG - simple to understand utility, B+
Molson Coors - TAP - we will need beer in a recession, A-
Scotts Miracle-Gro - SMG - lawn fertilizer and marijuana cap ex, A+
I am thrilled with the new look of this portfolio. There is plenty of safety, but still some cyclical exposure. There are only four B+ ideas left.
I can live without financials, technology, telecom, REITs,
I though it would take longer, but now I think I can a final model portfolio by the end of March.
In the future I plan to explain my portfolio changes more carefully, but I did call the first model portfolio a sketch. The lines are getting darker.