Principles: Portfolio Diversification Matters and Measurement Enables Improvement

Goal: Outline a process for choosing the player roster of equities we will monitor for trading.

From last time

Have a plan, communicate it, establish intermediate objectives and measures, track performance, rinse and repeat and continuous learning.

Strategic Context Changes

Fiscal policy may be taking a significant turn with the 25% steel and 10% aluminum tariffs and continuously playing chicken with China. IMHO, I want President Trump to hold the course and continue to add tariffs. Not doing so means Americans suffered pain with no result. Doing so will be successful because we remain the most powerful nation on earth.

This has certainly caused an uproar (downroar?) in the markets. More specifically, the 4th and 5th estates is busily making news, rather than reporting it.

Any change to the status quo causes uncertainty which always leads to volatility in the stock market. Volatility is your friend.

A tariff is a tax. Call it what you will, like the rose, by any other name, it is still a rose (and will prick your finger just the same). It is distinct from other taxes in that it is more like a consumption tax. If you do not use the products with tariff related impacts, you are not affected. Otherwise, the government coffers fill from the tax.

The real consumer impact varies from small to negligible. The price of a car may go up $500, perhaps 2%. The price of a can of soda may go up $0.03, an amount lost in the transaction. Many small businesses are whining in anticipation of lost sales. I would rather wait for that to happen before whining as I don't think the impact is great enough to slow the consumer down just yet.

Interesting that one of the bigger losers is US Steel (X), dropping over 5% in the market.

My sense is that this will be very positive for the market for the balance of 2018 and into 2019. There will definitely be turmoil, volatility and a general tempest in the teapot that is Wall Street. In the end, employment will go up, more capital investment will happen to ramp up our steel and aluminum production and our national security will improve.

And, don't be silly, national security is underpinning a lot of this. While Canada says using national security as a rationale with them is ludicrous, I would suggest that it is not. Consider that our enemies can attack us directly or attack our supply chain. Our supply chain is much more thinly defended. In Canada's case, I think some birch bark canoes, a couple WWI biplanes coupled with the last James Bond wooden hulled inboard for a navy. Winning wars can be simple if your opponent's logistics can be crippled.

Data Revisited

We briefly went over the need for relevant, timely and accurate data. It is important to recognize that the order of these attributes is important. Data must be relevant in that it enhances our ability to make decisions. While it is easy to collect or create a lot of data, keeping it simple and directly relevant to our objectives will be best.

Timely is the second element. Our decisions must be taken in a timely manner to have the best effect. Perfect data hours or days after a decision is required has no value.

Finally, accurate data is the aspiration. However, we need to balance cost of acquisition v. the value of the third decimal point in accuracy. Using bad data is of no value and incrementally improving our accuracy of relevant data provided in a timely manner will always be part of the daily work load.

Establishing Our Player Roster

Now that we know what we would like our sector distribution to look like, we need to identify the right set of equities we will invest time and energy into evaluating, tracking and trading.

We will not go into the detail of each of the sectors but instead will take the largest three, Financials, Consumer Discretionary and Technology. Through these we will expose our process which you can repeat the remaining sectors you have chosen for your portfolio.

Why Establish a Stable

There are more than 4,000 listed stocks with options, over 7,400 equities total. Somehow, we need to reduce that broad group to a focused set that will meet our requirements.

One advantage of taking this approach is that we will get very familiar with the price performance, earnings performance and general action of our stable. And, we can identify when it is time to swap out a player, much like an NFL or NBA team might.

An alternative is to do a stock scan anytime we are looking for a particular stock in a sector to fit our requirements and select one. From our perspective, this will be a relatively unknown entity, one we need to spend time observing to get a feel for its performance characteristics. Scanning and buying increases our risk as we may know little about the new equity.

With a known stable, we are less likely to be surprised by a given company's business performance or its stock performance. In investing, surprises are generally bad for the bottom line.

We do need some flexibility to take advantage of 'Special Situations', something we will discuss at the end of this installment.

Equity Selection Process

Here are the steps we'll use that are common to the process of stock selection:

• Identify an ETF or two that represent the sector;
• Look at the top holdings of the ETF - generally we will not go below the top 10 holdings as we are looking for strong, stable companies;
• In each sector, settle on 3-5 for the stable; for broad sectors with extreme variety, look at the major industries as well;
• For sectors where the target percentage is low a focused ETF may be the right choice rather than one or two stocks;
• Consider how different each of the selections might be and aim for diversity. Though in the same sector, the business model, capitalization, geographic distribution or some other factor can differentiate one from another.

It is much like an NFL team: you may have 53 players to field 11 for a game. Each stock we have in the stable will require some work on our part so there is a balance required between covering the sector and the labor required.

The reason we aim for the strong, stable companies is that we want as much predictability as we can get for the major part of the portfolio.

Keep in mind that we are illustrating the process. These are not recommended picks, just possibilities. You must do your own work in picking what might be best for your circumstances.

Financial Sector

We will use the XLF ETF.

Looking at the Industries under the Sector we can consider which may be of most benefit. Here is the subset of the Industries list that may have the most merit:

• ETFs: there are some that we might consider as a way into certain areas where we do not have a specific target. Examples include S&P 500, Russell 2000, Emerging Markets and regional banks.
• Investment Brokerage: This business model is different from others in that it depends on investment commissions and services;
• Money Center Banks: Similar to common banks but the lending and borrowing is with governments, large corporations and other regular banks;
• REITS: Owns, operates or finances income producing real estate.

XLF choices from the top holdings and differentiation (yours may differ):

• JPM: Money Center Bank
• BAC: Money Center Bank
• C: Money Center Bank
• GS: Investment Brokerage
• MS: Investment Brokerage
• AXP: Credit Services
• MA: Credit Services
• V: Credit Services
• PYPL: Credit Services. Went below the top ten for this one as it is a special case opportunity. Square (SQ) would
• MMP: REIT

Consumer Discretionary Sector

We will use the XLY for stock identification. Real soon now some of these will move to the Telecom Sector. From our perspective, this is one of the reasons to have custom sectors. Irrespective of the sector an equity is in, if it is consumer discretionary, we want it in that sector for our portfolio evaluations. If it is in Entertainment Services, let's look at it that way.

Top holdings and differentiation:

• AAPL: Consumer Goods; Electronic Equipment
• AMZN: Services; Catalog and Mail Order
• HD: Services; Home Improvement
• CMCSA: Services; Entertainment
• DIS: Services; Entertainment
• MCD: Services; Restaurants
• NFLX: Services; CATV Systems
• NKE; Consumer Goods; Apparel
• SBUX: Services; Specialty Eateries
• LOW: Services; Home Improvement
• CCL: Services; Resorts and Casinos
• VFC: Consumer Goods; Apparel
• PVH: Consumer Goods; Apparel

Technology Sector

We will use the XLK. There is a large number of stocks that we might want to include. It may be useful to put part of our Technology sector allocation into the XLK itself rather than splitting into too many smaller parts. Again, some of these will move to the newly created Telecom Sector. A choice may be made to do that or not by using custom sectors in your tracking.

• ADP: Application Software
• CRM: Application Software
• ORCL: Application Software
• AAPL: Consumer Goods; Electronic Equipment. We re-sectored this one into the Consumer Discretionary sector.
• ADBE: Business Software and Services
• MSFT: Business Software and Services
• FB: Internet Information Providers
• GOOGL: Internet Information Providers
• IBM: Information Technology Services
• ATVI: Multimedia and Graphics Software
• CSCO: Networking and Communication Devices
• AVGO: Semiconductor Broad Line
• INTC: Semiconductor, Broad Line
• AMAT: Semiconductor Equipment and Materials
• MU: Semiconductor - Memory Chips
• NVDA: Semiconductor, Specialized
• T: Telecom Services, Domestic
• VZ: Telecom Services, Domestic
• XLK: ETF

ETF Selection

We will use the SPY for the S&P index fund and the IWM for the Russell 2000 index fund.

Repeat on Other Sectors

Take the time to identify an ETF you like that represents the sector; look into the top 10 or so holdings; then look at the others for any special cases that may appeal to you; look into medium- to small-cap companies that may fit; and, finally, take some time to winnow down from your list to the group that you will focus on.

Special Cases

Special cases are very important. Within any given Sector, there will be a few companies that have 'something going on' that merits attention, inclusion in the stable, and the time spent monitoring them. These situations may be positive, e.g., M&A potential, regulatory changes, tax law changes, monetary policy changes or fiscal policy changes.

Such situations may be negative, e.g., senior executive issues, financial mismanagement, health issues at restaurants, technology disruptions like Uber or industry disruption like AMZN.

As we stay tuned in to the market we can hear of and evaluate them for our portfolio.

Some we'll track now are:

Industrials: GE. Thanks to Immelt, GE is auguring in. Clearly a broken company at this point, GE provides a near term opportunity for bearish positions. Bearish positions are hard to come by in an aggressive Bull market so grab them where you can.

Financials: PYPL. PayPal is special as a very established secure electronic payments company. They may or may not weather the storm of competitors. For the next 6-12 months, they merit tracking and investing, whether as a bull or a bear.

Consumer Discretionary: WYNN. Wynn Resorts merits inclusion given the fall from grace of the CEO which dropped the stock price significantly. Nothing changed regarding net income, EPS, etc., at least so far. This presents an opportunity to take a short term trade and take advantage of the precipitous drop in the stock. When the time is right, turning it to a long position will make sense.

Cannabis: CGC and TLRY.

For the moment, we will just establish a watch list and take the time to look into each of these stocks. Some attributes that are worth finding and tracking on each stock:

• Actual Sector
• Our Sector
• Market Capitalization
• 52 week high and low
• P/E
• Growth rate
• PEG
• Average True Range
• Monthly or weekly options
• Analyst average target price

As you can see, there will be a lot of data to collect. We'll establish a database and automate the updates to the extent possible.