Building an efficient equity portfolio of global leaders today

Sufficient risk reduction with only 30 stocks

Academic studies conducted around 1970 and again around 2010 on the relationship between the number of securities held and the risk in a portfolio concluded that a limited number of stocks is sufficient to considerably reduce unsystematic risk and that adding more than 30 stocks brings minimal additional diversification benefits. These studies having been based on data that may no longer be relevant today, UBP’s Swiss & Global Equity team has repeated such an experiment using recent performance data to confirm the theoretical validity of the original findings. The test conducted indicated that 25-30 stocks is indeed enough to “diversify away” any statistically significant unsystematic risk from an equity portfolio. Bearing in mind the fact that the random nature of the selection for those studies meant that the simulation could not be fully representative of a real portfolio, the findings were nevertheless conclusive.

Added diversification through active stock-selection

Unlike in studies, though, stocks are not randomly selected in the fund management industry: active managers can add value by avoiding large sector or country biases and by constructing portfolios with exposure to different growth drivers. This has proven to be an efficient solution to lower portfolio volatility and limit the impact of sector and style rotations.

Here are six tips from active portfolio managers for selecting 30 stocks to build a resilient and diversified global equity portfolio:

1.     Looking at cash flows rather than earnings, which are more likely to be distorted by accounting methods, will provide a close and universal approximation of a company’s underlying economics. Companies with a strong record of value-creation tend to deliver superior performances over the medium to long term and outperform companies whose stock price developments are more dependent on beating or meeting short-term earnings growth expectations.

2.     Companies with stable business models, visible historical profitability, and low financial leverage provide a base for lower volatility than the market average and higher expected risk-adjusted returns over any market cycle. Identifying them calls for disciplined screening for historically high and stable spreads between a company’s cash flow return on investment (CFROI^®; source: Credit Suisse HOLT) and its cost of capital, and a strong conviction as to its ability to continue to “beat the fade” in returns by maintaining these positive spreads over the next 5–10 years.

3.     A portfolio that is composed of such highly value-creative companies and offers reasonable diversification at both sector and country level should deliver consistent long-term performances that are not dependent on seasonality or market timing.

4.     Selecting relatively uncorrelated business models with similarly low risk profiles from almost every sector is a fundamental step towards achieving lower volatility of returns. Low inter-stock correlation drives diversification, and the comparably low risk profiles allow for similar active weights in the positions.

5.     Keeping away from sectors with more volatile value-creation profiles and elevated ESG risks which can negatively impact companies’ CFROI^®, such as energy and utilities, is another factor that reduces risk and volatility in the portfolio.

6.     In terms of countries, only being indirectly exposed to emerging markets through companies’ revenue streams can enable the portfolio to avoid risks linked to direct investments in those markets while still benefitting from the higher GDP growth in such countries.

Combining efficient diversification in terms of portfolio size with the added value of such multi-factor active management will reduce a portfolio’s volatility and increase its potential for long-term outperformance.