Building and managing a portfolio
Avoiding a dog from every village
The S&P 500 index has a concentration problem: Information technology at nearly 40 per cent of the S&P 500, rises to nearly 50 per cent once you add Alphabet, Meta, and Amazon.
In a recent article by David Rosenberg in the Canadian business newspaper Report on Business, he writes: “The S&P 500 is a leveraged bet on one CAPEX cycle with just under 40 per cent technology weight and a $700-billion annual spending program of unproven return to date.”
David Rosenberg is the Founder and President of Rosenberg Research, an economic and financial market consulting firm. From 2000 to 2009, he was the Chief Economist at Merrill Lynch. During his tenure there, he consistently ranked in the top three Wall Street economists polled by the annual Institutional Investor survey and ranked first in Canada for ten consecutive years
He also points out that the Canadian stock market, represented by the TSX Composite Index, also has a concentration problem. He writes: “The TSX is roughly 40 per cent in financials, and when you tack on energy, materials, and gold, you are talking about well over 70 per cent of the market cap in just four sectors. Health care is essentially non-existent, consumer staples are thin, and there is no mega-cap tech.”
He adds: “The TSX is a leveraged bet on commodity prices and Canadian residential credit with over 30 per cent in banks whose principal risk is deflation in residential real estate and extremely vulnerable household balance sheets.”
I imagine that investors in every country in the world with a stock market face similar concentration risks. It’s probably better to call it a lack of diversification and lack of balance problem.
The joy of index tracking ETFs
A passive investor, with 100% of their stock allocation in an S&P 500 cap weighted index tracking ETF such as VOO NYSE — Vanguard S&P 500 ETF, runs this lack of diversification and lack of balance risk risk. The risk can be somewhat reduced by putting 50% of the stock allocation in VOO and 50% in RSP NYSE — Invesco S&P 500 Equal Weight S&P 500 ETF. This latter is a fund with equal weighting in each of the 500 constituent companies. But this leaves 50% of the portfolio with the same lack of diversification and lack of balance risk and the other 50% with a lot of also-ran mediocre companies.
The same can be said for the Canadian market. A passive Canadian investor, with 100% of their stock allocation in an S&P/TSX Index ETF, runs the Canadian lack of diversification and lack of balance risk. One solution is to put 50% of the Canadian stock allocation in XIU TSX — iShares S&P/TSX 60 Index which covers the 60 largest Canadian companies and the remaining 50% in WXM TSX — CI Morningstar Canada Momentum Index ETF. WXM is a smart Beta quant-based product using research generated by Morningstar, and is designed to provide diversified exposure to Canadian issuers which have demonstrated, among other things, positive momentum in earnings and price. It currently has a market cap of $1.2B Canadian dollars. It has the benefit of largely side stepping the Canadian lack of diversification and lack of balance risk from Banks, Mines, Oil & Gas and Gold. This still leaves the 50% in the S&P/TSX 60 Index. So, it is only a partial solution.
This 25/25/25/25 approach with ETFs is what I have set up for my children who have no interest in investing in individual stocks. The same structure will be done for my wife if I predecease her.
Rosenberg’s solution
He writes: “What is ideal for not just U.S. and Canadian investors, but global market participants in general: the most ideal index to own from a risk-reward standpoint is the equal-weighted MSCI global composite.”
I don’t like this approach. It reminds me of the expression “a dog from every village” (derived from the German idiom “aus jedem Dorf ein Köter” or “aus jedem Dorf ein Hund”) translates literally to a mongrel or mixed-breed collection. Idiomatically, it means a chaotic, mismatched assortment of random elements, a hodgepodge, or a poorly assorted collection where nothing quite matches or fits together.
The best solution
For many decades I have invested all our family savings in a carefully crafted concentrated portfolio of stocks. The main feature is that the portfolio is both diversified and balanced. It is not exposed to major idiosyncratic risk. Typically, we own about fifteen stocks.
Before discussing diversification, let’s take a look at portfolio balance.
Portfolio Balance
Balance is a different idea from diversification. To simplify the discussion, I will limit the topic to finance, insurance and real estate.
Let’s use interest rates to think about this. Interest rates affect companies, but not in the same way. To give our portfolio some balance it would help to find stocks in sectors that react differently to interest rates. Often what is bad for lenders is good for borrowers. The real estate sector which includes REITs, public commercial real estate companies, home builders, building supply stocks and so on, is a good candidate. Those companies like low interest rates. When interest rates are falling, REITs are able to renew mortgages at ever lower rates and their funds from operations improve even if they haven’t raised rents or increased profitability in other ways. When rates are rising the opposite occurs, which is what has been happening recently.
In a falling interest rate environment banks’ interest rate spreads get squeezed more and more. This would be an example of an inverse correlation, or hedging, between sectors. But it doesn’t exist all the time. Real estate developers and builders tend to over build. When a recession comes along a number of players in the real estate sector go bust and the banks are left holding the bag. In that case both the borrowers and the lenders suffer. This is what is currently happening in the Canadian condo market.
To balance our simplified portfolio, we might think of broadening out into life insurance companies. That really doesn’t help as life insurance companies are also sensitive to interest rates and in the same direction as banks. When rates rise both banks and life insurance companies do better. When rates fall, both banks and life insurance companies do worse.
What our simplified example has also brought out is the idea of natural hedging between different stocks in the portfolio. That is to say, if we want to own companies in the real estate sector but are worried about interest rates going up, we can hedge that risk by a position in banking stocks. If we own bank stocks and we are concerned about interest rates going down, we can hedge that position with real estate stocks but, we must recognize that both get hurt in a recession.
You can carry out the same analysis with any number of business sectors. One can think of high prices for products from resource companies impacting manufacturers and vice versa.
The key point is that this kind of analysis can be done with a portfolio of individual stocks. It can’t really be done with a portfolio of index tracking ETFs. Themed ETFs are not fine grained enough.
Applying this thinking at company level
Let me use the example of one company. When I am thinking about adding or selling a company from our stock portfolio, I think carefully how the company fits into the portfolio. Does it overlap business sectors with other companies in the portfolio? Does it provide a natural hedge against other companies in the portfolio?
Let’s take Toromont. TIH TSX/CA. Toromont Industries Ltd. is one of the fifteen companies we own shares in. It is one of the largest Caterpillar dealers in the world. Its equipment group also has specialized equipment rental stores, as well as component remanufacturing, material handling, machine control solutions operations and a power generation unit manufacturer. Power generation has many applications including, for example, data centres which need back-up power systems.
Toromont is also one of North America’s leading companies engaged in the designing, engineering, fabrication and installation of industrial and recreational refrigeration systems.
In the recent fiscal years 2025, 2024 and 20234 Toromont has achieved a Return in Capital Employed (ROCE) in the business of 23.4%, 25.7%, and 30.4% respectively.
Toromont is exposed to the mining industry, a major buyer of Caterpillar equipment. There is no reason for me to own shares in mining companies because the sector is covered off. Or put another way, I don’t need any more materials sector exposure. The company is also exposed to the infrastructure sector; think roads and bridges built with Caterpillar equipment. Infrastructure can be counter cyclical to the economy. Toromont is also exposed to the housing sector which is cyclical. Through the power generation side it covers off for example, remote telecom sites that need power onsite. It’s refrigeration unit serves different sectors than the equipment business.
With Toromont I basically have materials and infrastructure covered off.
A portfolio of fifteen stocks
With a portfolio of fifteen stocks the investor is able to not only choose superb companies but see how they fit with all the other stocks in the portfolio. Some argue you need at least 30 stocks to achieve proper diversification. I disagree.
On questions like this I often go back to Warren Buffett. He wrote:
“…if you are a know-something investor, able to understand business economics and to find five to ten sensibly-priced companies that possess important long-term competitive advantages, conventional diversification makes no sense for you. It is apt simply to hurt your results and increase your risk. I cannot understand why an investor of that sort elects to put money into a business that is his 20th favorite rather than simply adding that money to his top choices – the businesses he understands best and that present the least risk, along with the greatest profit potential. In the words of the prophet Mae West: “Too much of a good thing can be wonderful.” (Cunningham, The Essays of Warren Buffett: Lessons for Corporate America, 1998) p79 (emphasis added)
I’m not comfortable with five to ten stocks. The individual positions are too large and expose you to catastrophic idiosyncratic risk. This is the risk that any individual company, through some catastrophe, simply blows up and becomes worthless. This is not likely in a closely watched concentrated portfolio but the risk is there. Some banks have been destroyed by rogue traders, and so on. I sell down any position that grows to 15% of the portfolio to below 10%.
Conclusion
Passive investing in index tracking ETFs can certainly carry lack of diversification and lack of balance risks. And, you can end up with a dog from every village.
A carefully crafted concentrated portfolio of common stocks can provide balance and diversification.
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To read further on this subject, readers might take a look at these posts:
Conventional diversification makes no sense for you
An all bank portfolio, ETFs and mistaken notions of diversification and balance
As well, readers can look at a number of posts tagged concentrated portfolio, diversification, balance and also try a word search on the home page for idiosyncratic.
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You can reach me by email at rodney@investingmotherlode.com
I’m also on Twitter @rodneylksmith
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