When building an investment portfolio, it can be useful to take a page from accounting principles – specifically how accountants view inventory when valuing a company’s products.
Portfolio construction has a significant impact on the performance of an investment account. Usually, most thoughts on construction focus an asset classes. The ratio of bonds and cash to stock holdings is often sighted as a major contributing factor affecting long term rates of return. This is referred to as the asset mix of a portfolio, but let’s have a closer look at one particular asset class in this mix, the equity or stock component.
We can learn a lot about the different impacts certain stocks will have on a portfolio by looking at the earnings cycle companies are presently in.
It can be useful to take a page from accounting principles, specifically how accountants view inventory when valuing a company’s products.
Accountants categorize inventory into three broad buckets: raw materials, work in progress and finished goods. Investors can use these categories to improve the portfolio performance of the equity component.
Retail investors often make the error of selecting company shares by chasing "finished goods” stocks only, filling their portfolios with securities that have performed strongly, most recently. (this is referred to as momentum investing). These kinds of securities are often susceptible to significant declines during a market pull back or recession.
A better approach is to build a portfolio with a balance of stocks selected from all three of the inventory classes.
A portfolio should also include investments in companies that are beginning to grow their earnings. These would be considered ‘work in progress’ shares.
These are more established companies that have come through a phase of increased spending to grow revenue, but are now coming to the end of that spending, and profit margins will now begin to expand. Also included in this group of ‘work in progress’ shares would be companies where a turnaround has begun and management are now executing on their business strategy with results beginning to be demonstrated. Add a dash of recovering economy and these shares can be top performers. A good example of this would be the first half of 2010 in the U.S. markets when earnings started to reaccelerate after the 2008 financial crisis.
‘Raw materials’ shares would be companies that are experiencing a catalyst event or are coming out of a cycle bottom. Industrial companies such as rail or steel and resources companies in mining, lumber or oil and gas, have periods of recovery after cycle downturns that can produce a number of years of strongly growing earnings.
When you view stock choices from the same perspective as accountants view inventory classes, it will ensure that some of the shares in your investment portfolio will always be producing earnings growth no matter what phase of the economic cycle is presently occurring.