What is the best way to design or construct a common stock portfolio? This is a question I am often asked and my short answer is always the same – it depends. The truth is, there is no perfect method or strategy for designing a stock portfolio that is right for every individual investor. However, there are principles of sound investing that every investor can follow and apply when designing a common stock portfolio that’s just right for them.
Furthermore, there are general categories that individual investors fall into. Some individuals are young and planning for retirement while other individuals are closer to retirement, and there are some that are already retired. Additionally, each individual investor has different levels of financial resources that specifically apply. To complicate the process even more, individual investors of all types possess unique goals, needs, objectives and risk tolerances. Therefore, the logical secret to designing a successful common stock portfolio is to design one that’s most appropriate for you.
Therefore, the objective of this series of articles is not to attempt to dictate how individuals should design their own stock portfolios. Instead, the objective of this series is to provide information regarding common stock investing strategies and options that each individual can evaluate and ultimately utilize so they can implement and construct a common stock portfolio that’s just right for them.
At the end of the day, it comes down to making the appropriate choices. The most appropriate choices include, but are not limited to, utilizing the most suitable categories of common stocks available as well as the appropriate mix. In one context the choices approach the infinite, and this can be confusing or even overwhelming. On the other hand, the options can be generally categorized, thereby simplifying the process to a more manageable level.
[drizzle]Of course, individual investors also have the option of engaging professional help or self-directing their own stock portfolios. This can be done directly by hiring outside professional managers or by investing in packaged products created by professional managers such as mutual funds or ETF’s. However, this series of articles is intended for the self-directed individual investor interested in designing and managing their own common stock portfolios.
Stock Selection: What Are the Choices?
On the US stock exchanges alone, individual investors have almost 20,000 individual stocks (companies) to choose from. No matter how diligent you could be, it would be impossible for any individual to conduct a comprehensive analysis on all of them. Therefore, individual investors need a method of separating the wheat from the chaff.
One effective way to accomplish that is to break the larger list down into broader categories based on specific characteristics and attributes. In his best-selling book “One Up On Wall Street,” renowned mutual fund manager Peter Lynch presented what he referred to as “The Six Categories.” Personally, I believe that Peter Lynch provided a succinct summary of the broad categories or types of common stocks available for investment consideration.
However, his 6 categories are very broad, and therefore, within each category there are many additional nuances that investors are best served to recognize and understand. Nevertheless, I believe that Peter Lynch provided an excellent foundation with his presentation of the 6 broad categories available to investors. To clarify this important distinction further, I turn to Peter Lynch and his own words with the following quote:
“There are almost as many ways to classify stocks as there are stockbrokers — but I found that the 6 categories cover all of the useful distinctions that any investor has to make.”
In order to provide the reader with a more comprehensive understanding of the 6 broad categories of stocks that Peter Lynch presented, I offer the following review of each category with a few sample F.A.S.T. Graphs™ to provide deeper insights. Importantly, since Peter Lynch was primarily referring to the characteristics of 6 broad types of businesses, I have taken stock prices off of the graphs. My goal was to allow the reader the opportunity to focus on the types of businesses that Peter Lynch was describing without the bias that volatile stock movements can bring.
Peter Lynch’s 6 General Categories
Below I present Peter Lynch’s 6 general categories with a short description taken directly from his best-selling book “One Up On Wall Street.” Then I present an example or two with brief commentary of my own with the objective of providing a deeper insight into each category and what each offers from an investment perspective. When appropriate, my examples will come directly from what Peter Lynch said. But most importantly, my examples are not recommendations to buy today; instead, they are just offered as examples of the types of companies Peter Lynch was referencing.
“Usually these large and aging companies are expected to grow slightly faster than the gross national product. Slow growers didn’t start out that way. They started out as fast growers and eventually pooped out, either because they had gone as far as they could, or else they got too tired to make the most of their chances. When an industry at large slows down (as they always seem to do), most of the companies within the industry lose momentum as well. Electric utilities are today’s most popular slow growers.”
Southern Company (SO): A Slow-Growing Utility
From the following graph we see a quintessential example of a slow-growing utility that Peter Lynch suggested as a popular slow grower. Long-term earnings growth has averaged only 2.5%. However, the primary attraction to investing in utilities is not for growth, instead, it is for their above-average dividend yields.
When you examine the performance of Southern Company since 1995, you see the benefit of its high dividend yield relative to the average company as represented by the S&P 500. However, you also discovered that capital appreciation, which averaged 2.8%, is highly correlated to its earnings growth achievement of 2.5%. Slow growth utilities can be excellent choices for retired investors seeking maximum income.
Campbell Soup Company (CPB)
However, not all slow growers are utility stocks. Therefore, I present Campbell Soup as a second example of a slow grower from the consumer nondurables sector. Since fiscal year 1996, Campbell Soup has grown earnings at 2.9%. The company does offer a moderately generous dividend, but its average dividend yield is lower than utilities such as Southern Company typically offer. Importantly, that previous statement implies that both companies are purchased when valuation is sound.
When you examine the performance of Campbell Soup over the timeframe covered in the above graph, you again discover a high correlation of capital appreciation of 3.8% to its earnings growth rate of 2.9%. On the other hand, due to its typical lower yields referenced above, total cumulative dividends are consistent with the average company, as represented by the S&P 500.
“Stalwarts are companies such as Coca-Cola, Bristol-Myers, Procter & Gamble, Hershey’s, Ralston Purina and Colgate-Palmolive. These multibillion-dollar hulks are not exactly agile climbers, but they are faster than slow growers.”
Stalwarts are an important category for retired investors and dividend growth investors. Many of