Investment Education Series
INVESTMENT PORTFOLIO STRUCTURING
In previous editions of INVESTMENT ONE “investment watch” series, we highlighted the processes of investing
and the benefit of having professionals help you plan and manage your wealth. In this edition of the series, we
present a foundational study for investors seeking to understand the principles of using portfolio structuring
tools. To ensure that you position your investment to minimize risk and maximize returns, you need to deploy
well-structured investment portfolio management process under the guidance of your financial adviser.
Investment Portfolio
An investment portfolio is a collection of assets owned by an individual or by an institution. Most investment
portfolios are assembled to cater for income needs, development projects, retirement( among others); and are
made up mainly of securities, such as stocks, bonds, mutual funds, money market funds and exchange traded
funds. An investor's portfolio can include real estate and commodities such as gold bars.
Effective investment portfolio structuring in the capital market employs three major tools for minimizing risk and
maximizing investment returns which include Asset Allocation, Market Timing and Security Selection.
Asset Allocation
According to Investopedia; there is no simple formula that can find the right asset allocation for every individual.
However, the consensus among most financial professionals is that asset allocation is one of the most important
decisions that investors make. In other words, your selection of individual securities is secondary to the way you
allocate your investment in stocks, bonds, and cash and equivalents, which will be the principal determinants of
your investment results.
Asset allocation strategy must aim to balance risk and reward by apportioning a portfolio's assets according to
an individual's goals, age, risk tolerance and investment horizon. Note that the three main asset classes equities, fixed-income, and cash and equivalents - have different levels of risk and return, so each will behave
differently over time, thereby requiring bespoke asset allocation plan for each individual or institution.
Asset Allocation Strategies
Establishing an appropriate asset mix is a dynamic process and it plays a key role in determining your portfolio's
overall risk and return. Strategic asset allocation is a method that establishes and adheres to what is a "base
policy mix." This is a proportional combination of assets based on expected rates of return for each asset class.
For example, if stocks have historically returned 10% per year and bonds have returned 5% per year, a mix of
50% stocks and 50% bonds would be expected to return 7.5% per year.
The following are strategies of establishing asset allocation:
Constant – Weighing Asset Allocation
Strategic asset allocation generally implies a buy-and-hold strategy, even as the shift in the values of assets
cause a drift from the initially established policy mix. For this reason, you may choose to adopt a constantweighting approach to asset allocation. With this approach, you continually rebalance your portfolio. For
example, if one asset were declining in value, you would purchase more of that asset, and if that asset value
should increase, you would sell it.
Insured Asset Allocation
With an insured asset allocation strategy, you establish a base portfolio value under which the portfolio should
not be allowed to drop. As long as the portfolio achieves a return above its base, you exercise active
management to try to increase the portfolio value as much as possible. If, however, the portfolio should ever
drop to the base value, you invest in risk-free assets so that the base value becomes fixed
Dynamic Asset Allocation
Another active asset allocation strategy is dynamic asset allocation, with which you constantly adjust the mix of
assets as markets rise and fall and the economy strengthens and weakens. With this strategy you sell assets
that are declining and purchase assets that are increasing, making dynamic asset allocation the polar
opposite of a constant-weighting strategy.
Integrated Asset Allocation
With integrated asset allocation you consider both your economic expectations and your risk in establishing
an asset mix. While all of the above-mentioned strategies take into account expectations for future market
returns, not all of the strategies account for investment risk tolerance. Integrated asset allocation, on the other
hand, includes aspects of all strategies, accounting not only for expectations but also actual changes in capital
markets and your risk tolerance. Integrated asset allocation is a broader asset allocation strategy, albeit
allowing only either dynamic or constant-weighting allocation.
Market Timing
Some experts say that accurately identifying the best time to enter or exit the market is next to impossible.
However every market has cycles that repeat itself over time
The following are phases of typical business cycles that investors must take cognizance of to ensure they are
well guided in their investment decisions:
Recession
This slow period in the economy is characterized by falling production, peaking inflation and weakened
consumer confidence. Although it never seems like it at the time, recessions are usually a good time to buy
cyclical stocks (such as automobile companies, paper companies and other heavy manufacturers). Their
earnings may be flat, and their stock prices may be floundering, but they are among the first stocks to take off
when the economy turns around.
Recovery
Hope begins to emerge. Recoveries are marked by stimulatory economic policies, falling inflation and
increasing consumer confidence. They are a good time to buy stocks, long-term bonds, commodities, oil and
gas, and even precious metals to hedge against a possible up-tick in inflation.
Early Upswing
Once the recovery period passes, consumer confidence is up and the economy is gaining some momentum.
The early upswing is probably the healthiest period of the cycle because economic growth can continue
without any signs of overheating or sharply higher inflation. Unemployment falls, but inflation may pick up.
Higher operating levels allow many businesses to cut unit costs and increase margins and profits. The stock
market should remain strong, while commodities will continue to rise modestly.
Late Upswing
It’s hard to distinguish between the early upswing and the late upswing. But you need to look for subtle signs. The
economic boom is in full swing. Manufacturing capacity utilization is at or near a peak. Stocks are rallying, and
unemployment is falling. Real estate prices and rents move up strongly, prompting a construction boom. Inflation
picks up as wages increase in the wake of labour shortages. With interest rates rising, bonds become less
attractive.
Economic Slowdown
Once the economy has gone through its recovery and upswing cycles, it’s time for a nap. Economic activity starts
to slip. Short term interest rates move up sharply, peaking as confidence drops. The slowdown is exacerbated by
the inventory correction as companies, suddenly fearing recession, try to reduce their inventory levels.
Manufacturing capacity utilization begins to drop while wages continue to rise, resulting in increasing inflation. In the
markets, bond yields top out and start to fall. The stock market may fall, perhaps significantly, with interest sensitive
stocks such as utilities faring the best.
Principles guiding efficient stock selection
Giving the current low price valuation of many stocks in the Nigerian market, investors are buying up as much
equities as they can afford; often without applying their time and effort to ask and seek answers to basic questions
about the short and long term prospect of these equities. The reality of investment remains that investing in not an
act of gambling and choosing to follow the crowd may leave many an investor with burnt hands.
Securities Selection
Stock selection is the process or art of finding and selecting good stocks ( and avoiding bad ones) based on
certain criteria, with the aim of maximizing the total return on investment (appreciation plus any dividends received)
for the targeted holding period, limit risk (according to an individual's risks tolerance levels)and maintain an
appropriate degrees of portfolio diversification.
What is the price of the entire company?
Before making an investment decision, it is important you look at more than just the current share price of the entire
company. The "cost" of acquiring the entire corporation is called market capitalization (or market cap for short). The
market cap is the price of all outstanding shares of common stock multiplied by the quoted price per share at any
given moment in time. A business with one million shares outstanding and a stock price of N50 per share would
have a market cap of N50 million.
This market capitalization test can help keep an investor from overpaying for a stock. Make it an investment rule to
avoid generally large well-known companies in favor of small-cap stocks that still contain significant upside
potential.
How does the broader economy affect things?
Some stocks are highly cyclical--in other words, the company's performance is heavily dependent on the state of
the economy. And cyclical stocks aren't always the bargain they appear to be. For example, when the economy is
on a downswing, the stocks of paper companies may begin to look cheap. But there's a good reason for that: In
tough economic times many businesses cut back on their advertising, newspapers and magazines get thinner, and
paper companies therefore sell less paper. Of course, the opposite effect usually occur coming out of a recession.
Earnings growth rate
In investments, earnings growth refers to the annual rate of growth of earnings, or the amount of profit a company
produces during a specific period, usually defined as a quarter (three calendar months) or year. Earnings typically
refer to after-tax net income. When the dividend pay-out ratio is same, the dividend growth rate is equal to the
earnings growth rate.
Speaking of growth, it's important to realize that, a company can subtly manipulates revenue by booking sales
revenue long before the cash actually comes in the door. Investors should be alert to companies whose sales
revenue is increasing at a far faster rate than those of its competitors. They must be wary also of companies whose
sole source of sales growth appears to come from taking over other companies.
How is the company doing against competition?
Before buying a stock, it's vital to know how it is faring against the competition. The first readily accessible place for
an investor to start analysis is with sales figures. "The best clue as to whether a company is out performing its
competitors is to simply watch year-over-year revenues." Are its sales growing as fast as those of its competitors,
and have sales been holding their own over the past few years?
Debt ratio
If a company’s debt levels are excessive, it often proves extremely difficult for managers to raise sufficient cash to
finance continued expansion. Without expansion into new markets, corporate growth eventually slows down.
Companies with lower debt often have better prospects for future expansion.
Before buying any stock, you must check out the amount of debt on the balance sheet, too much debt is risky, since
a slowdown in sales or a hike in interest rates could threaten a company's ability to make interest payments. And it
greatly decreases a business margin for error.
Is the company buying back shares?
One of the most important keys to investing is that overall corporate growth is not as important as per-share growth.
A company could have the same profit, sales, and revenue for five consecutive years, but create large returns for
investors by reducing the total number of outstanding shares. A shareholder should desire a management that has
an active policy of reducing the number of outstanding shares if alternative uses of capital are not as attractive, thus
making each investor's stake in the company bigger.
Is management sweeping expenses under the carpet?
Investors should be wary of seeing one-time charges such as the early retirement of debt refinanced at a lower rate
appearing in at least three of the past five years of income statements; often the charges spell bad news for potential
investors.
Management /ownership issues
Management issues involve examining perceptions about management and perceptions by management. It includes
various qualitative judgments regarding the competence of current and prospective company management, as well
as issues related to insider buying, future strategies to increase operations and market share. Most large companies
compensate executives through a combination of cash, restricted stock and options. It is a positive sign when
members of management are also shareholders.
What is your reason for investing in the company?
Before purchasing stock in a company, you need to ask yourself why you are investing in that particular opportunity.
It is dangerous to buy a stock because people you know are buying or to buy out of love for the organization.
Investors must be certain the fundamentals of the company (current price, profits, good management, etc.) are the
only reason for investing. Anything else is based on emotions; this is detrimental and leads to speculation rather than
intelligent investing. Investment decisions have to be based on cold, hard data. Feelings of emotion must be
removed from the equation in selecting stocks. This requires patience and the willingness to walk away.
The importance of making wise investment portfolio structuring decision is critical to the success of every investor’s
aspiration to grow and protect wealth. For efficient investment portfolio structuring, we advise you to consult an
investment adviser that can partner with you to achieve your investment goals.
DISCLAIMER: The views expressed in this report are provided for information purposes only and are not to be considered as an offer or solicitation of an offer to buy or sell
any financial instrument. The material herein is obtained from a variety of sources and we make no representation as to its accuracy or completeness. This material has been
issued by INVESTMENT ONE, which is regulated by the Securities and Exchange Commission. Further information on any security mentioned herein may be obtained by
emailing: research@investment-one.com.