How do I build my portfolio?

Colum McKinley, CFA, Portfolio Manager, Canadian Equities, CIBC Asset Management

As you begin investing, you’re probably thinking, how do I build my portfolio? What should I choose, what ideas do I select and what ideas do I ignore?

There are many intelligent ways to analyze the financial markets and build a portfolio. Some methods produce practical, actionable ideas. Others… not so much. You may have your own way to approach this question based on what you already know. Maybe this knowledge came from what you learned through school or media, your own experience or investments you’ve seen your friends or family make. However you do it, it’s smart to have a thoughtful method to guide your selections. In investing, having a well-defined process really matters.

As this is my profession, I devote most of my work day to researching and selecting stocks. You may not be able to make that time commitment, but you might be able to take some aspects of my approach and begin to create your own unique perspective on investing. So, let’s dive in. Here is how I do what I do.

Step 1: Screen or rank stocks from your investment universe

How do I decide what’s the “best company”? I’m a value manager, so I have a particular way of looking at things. I start by analyzing the current valuation of the stock versus its long-term history. I’m simply interested in identifying stocks that are statistically cheap. Focusing on what’s the cheapest is the best way to narrow your field of focus. I believe that history has already shown which metrics are most important for each sector. 

For example, banks traditionally trade on price/earnings multiples. When ranking banks, I look for opportunities where a company is trading 1 standard deviation below its long-term average. Consistently identifying good businesses trading below their long-term average valuation is a starting point for investment success.

Step 2: Fundamental analysis

Now I have a short list and I’ll look more closely. I’ll take a deeper dive into the accounting statements and I’ll also analyze corporate strategy. Does the strategy make sense? What dangers are they ignoring by being too aggressive or what opportunities are they missing by being too conservative? I meet with management to ask them these questions. I’ll listen to what they’re saying and how they say it. Are they enthusiastic, curious about the competition or ignoring it? I’ll also tune in to what they’re not saying. Are they evasive?

I build a model that allows me to assess the company’s long-term potential and stress-test key drivers in the business. When companies face short-term operational issues, markets overreact. This creates buying opportunities. I want to assess the earnings power of the business once management’s actions have addressed the short-term problem. 

For example, consider the investment in Empire Limited, operator of the Sobey’s grocery store chain. I want to understand the earnings power of its business in Western Canada once it’s successfully integrated and not experiencing an energy-driven economic slowdown. Ultimately, I use this to value the business.

What’s it worth? That’s the key question. I organize this knowledge to create an investment thesis that clearly outlines our position. I’m looking for an investment idea that’s different than what everyone else sees, something the majority is overlooking.

The litmus test

Finally, there’s the ultimate test of whether we have a potential winner. What’s the price?

I might believe a stock is worth $50, but it’s trading at $30. Am I seeing something that others are overlooking? Or is Mr. Market seeing something that I’m overlooking? Which view is a more accurate take on this company’s value? 

At this stage, it can help to be part of a team, where some team members play “devil’s advocate” by challenging and probing your ideas, asking you to defend them.

Keeping it real

I’d also recommend a final gut check on your selections. How do you feel about using your own hard-earned money to buy this stock? 

I have my own version of this gut check, because a large part of my net worth and my family’s net worth is invested in funds that I manage. This reminds me that this process is much more than just an academic exercise. It has real-life consequences. I believe more portfolio managers should eat their own cooking.