SINGAPORE (15 May): Oftentimes, investors focus on stock picking and attempt to pick stocks that will provide them with the best upside and returns in the shortest period of time. To the diligent investor, however, stock picking is just half of what is needed to be successful in the stock market. Before investing, investors ought to consider portfolio and asset allocation — which has become ever so important in light of the market volatility brought on by the Covid-19 pandemic.

What is portfolio and asset allocation? The textbook defines this as an investment strategy that involves allocating the portfolio’s assets based on the individual’s goals, risk tolerance, and investment horizon. Another way of looking at it is balancing the portfolio by holding stocks, fixed income assets and cash, with the understanding that these asset classes have different levels of risk and return. During a bull market (sustained increase in price in equity markets), investors usually hold more equities as the risk is much lower, because expectations that the economy will perform well are strong.

Holding fixed-income assets and cash during a bull market denotes higher opportunity costs, since this money could have been invested in stocks which generally have a higher rate of return. During a bear market (sustained decline in prices in equity markets), the opposite prevails, where more cash and demand for safe-haven, fixed-income instruments, such as highly rated government securities, would increase.

Regardless of market conditions, investors should be wary that portfolio allocation can be utilised in any type of market — and that it is subjective, depending on the individual’s capacity and willingness to take risk. There is no one-size-fits-all portfolio allocation strategy, but investors can pick and choose what is most suitable for them based on the different types of equities and asset allocation strategies, assuming a list of stock picks has already been pre-determined.

An important parameter to consider before incorporating portfolio allocation into investing is that this will best apply to fundamental and value investing, and not short-term trading.

Fundamental and value investing mostly entails an imbalance in price and value of a company for any investing action. The price of a company is determined by demand and supply, and hence could be affected by a variety of factors, mostly sentiment over the very short term. Value, on the other hand, is generally determined by expected cash flows, growth and risk of a particular company. Simply put, value and fundamental investors are looking for a mispricing in the fundamentals of the company, where the intrinsic value (true value of the company after pricing in its fundamentals) exceeds the current trading price. The larger this price-to-value gap, the more attractive and safer the investment.

The diligent investor would also consider the type of company to ascertain its investment safety. Broadly, the different types of companies include slow growth/mature companies, fast-growth companies, cyclical companies, turnaround companies and strong asset-base/cash-rich companies. Each type of company entails different risks and rewards; this should be incorporated into determining how safe an investment truly is, apart from the priceto-value gap. For example, a slow-growth, mature company with a very large price-to-value gap is generally considered a safe investment, though it is unlikely to be present in the market.

Other factors include the beta of the company, which reflects the volatility in its share price against the overall market or the stock exchange. Higher-beta stocks are usually riskier, particularly during bear markets like the one we are currently experiencing, since they tend to decline at a much rapid rate compared to the general market. Investors should also consider the key reasons for the market decline to gauge the investment safety. In this case, it would be based on how much each company is affected by Covid-19, and which sectors are affected the most through natural business impact and government intervention. Ultimately, investors should attempt to gauge whether these affect the fundamentals of the business, and to what extent, as well as whether the share prices move within expectations of the overall impact to the company.

The effects of Covid-19 in particular on companies can be gauged by looking at a couple of different business indicators and fundamentals. The key point to consider is the nature of the business, for example, the level of sensitivity to travel and tourism. Businesses that rely heavily on travel and tourism will most likely be affected adversely, but this is dependent on travel ban and lockdown measures. Another example is the potentially increased usage and demand for technology products and services, such as video teleconferencing and cybersecurity, due to work-from-home measures. Next is how discretionary the products and services are.

In a market and civil panic, essential (non-discretionary) products will see higher demand due to stockpiling (as seen in various parts of the world currently). Next is how labour-/ people-intensive the business is — the more labour-intensive the company is, the more likely it is to be affected adversely by quarantine and safe-distancing measures. Cash flows and debt are also an important factor to consider, as companies with low cash and high debt levels are more vulnerable to near-term losses which could lead to potential liquidity and solvency problems. Lastly, investors should take note that companies with high fixed-costs as a proportion of total costs will find it harder to scale down during market shocks, compared to other companies which are more flexible in managing their costs.

It is important to recognise that collectively, higher investment safety means lower expected returns, but a much-better-protected portfolio during dire times.

Some stocks are safer than others  

Based on the top 10 global stock picks, we feature three theoretical portfolios to illustrate the importance of portfolio allocation and why stock picks alone are not enough to be successful in the stock market. The three are safe, balanced, and aggressive portfolios, which allocate stocks based on investment safety.

The level of safety of each stock can be gauged through a couple of indicators, which include its price-to-value gap, stock beta, nature and elasticity of demand of the business, level of labour-intensiveness, amount of cash flow and debt, and the proportion of fixed costs to total costs. A company with a high level of safety would have a large price-to-value gap where value exceeds price, relatively low stock beta, low elasticity of demand for its goods and services, low labour-intensiveness, high levels of cash and cash flow, low and minimal debt levels, and low fixed costs as a proportion of total costs.

The table shows the individual allocation of each stock for the three portfolios. In the chart, the performance of each portfolio is compared to the prevailing benchmarks. Evidently, portfolio allocation plays a part in determining the extent of losses or profits in any type of market, as reflected by the varying portfolio performances in the chart; hence, it is an area investors ought to focus on before investing. Given the volatility of the market, the safe portfolio outperforms the rest with a small overall gain.