Portfolio construction involves balancing risk and return through diversification. The document discusses constructing portfolios using a combination of stocks to reduce overall risk compared to holding individual stocks. It provides examples showing how a portfolio with 50% allocation to two stocks achieves lower risk than either stock individually due to diversification. The document emphasizes diversifying across industries and stocks with low correlations to benefit from diversification and achieve more stable returns.

1. Portfolio construction – risk and rewards
Eggs and Baskets
Wayne Mc Currie

2. The classic investor cycle
MAXIMUM
RISK This is the best
thing I have ever
What a good done !!
choice I made !!
FUND INFLOWS
This is a really Euphoria
good investment Don’t worry the market
is consolidating
Doubt
Look at last years
good return
THINGS
Excitement Anxiety
Temporary setback
I am a long term
CAN’T
investor
Denial Maybe I panicked!
Revival
GET I ever
Why did
Fear
buy this ? Optimistic
BETTER
Optimistic MAXIMUM
I really got bad Depression Doubt
advice
REWARD
Was it right to
Panic sell ??
I will not do this
Market Cycle THINGS CAN’T again !!
Capitulate
Despondent
Desperate
I must get out.
GET WORSE
Cash is King FUND OUTFLOWS

3. Navigating choppy waters:
The economic cycle
PEAK SLOWDOWN BOTTOM RECOVERY
MAXIMUM
RISK
Good news Start of Inflation Inflation
Strong down turn moderating falling
growth Inflation Interest rates Interest
Inflation low rising at peak rates down
Interest rates Interest Economy in Growth
low rates rising trouble inproving
Things can’t Things can’t
Get any Get any
better worse
MAXIMUM
REWARD

4. And
This all looks very good –
until you live each day in a
down market
Equity does increase
Over time but
with
VOLATILITY
Average return of ±12%
4

5. BUT the monthly losses can be huge!!

6. And you can lose money over five years

7. What is diversification and how does
it work?
Diversification is simply put:
• DO NOT put all your eggs in one basket
• DO NOT buy all “The Same Theme” shares
• TRY and offset some risks
• RISK DIVERSIFICATION is the only FREE LUNCH
in investments

8. Example 1
Bidvest and Anglo American
Both gave you the same
return over 14 years
Bidvest
Anglo American
But look at the volatility !!

9. Anglo American
Return history
This is the number to look at

10. Bidvest
Return history
This is the number to look at

11. Now construct a portfolio
50% Anglo and 50% Bidvest
Anglo was 40 and Bidvest was 28 – so in
a 50/50 portfolio – you would expect the
new number to be (40+28)/2 = 34

12. And look at the risk now
This is the number to look at
This is the free lunch
DIVERSIFICATION
Anglo was 40 and Bidvest was 28 – so in a 50/50 portfolio – you
would expect the new number to be (40+28)/2 = 34
BUT YOU GET 27

13. Example 2
Harmony and Standard Bank
Harmony
Standard Bank

14. The risk profile for Harmony
This is the number to look at

15. And the risk profile for Standard Bank
This is the number to look at

16. Now construct a portfolio
50% Standard Bank and 50% Harmony
Harmony was 69 and Standard was 26 – so in a 50/50 portfolio
– you would expect the new number to be (69+26)/2 = 47
Harmony was 69 and Standard was 26
You get almost three times as many sleepless nights investing in
Harmony as investing in Standard bank

17. And this is the answer for Harmony and
Standard Bank
This is the number to look at
Harmony was 69 and Standard was 26 – so in a 50/50
portfolio – you would expect the new number to be
(69+26)/2 = 47
BUT YOU GET 44
This is the free lunch
DIVERSIFICATION

18. Portfolio Construction

19. Rationale
“…the art of successful portfolio management is not only to be able to
identify opportunities, but also to balance them against the risks
that they create in the context of the overall portfolio.”
Robert Litterman, Goldman Sachs
Bottom-up & Portfolio
Top-Down views Construction

20. Rationale
Balances risk and return
• Risk allocated according to opportunity + conviction
• Most people don’t do this…
Minimise risk 
Allocate risk efficiently 

21. Diversification benefits
Correlation in portfolio construction
Cash Bonds ILB’s Property Resi Findi
Cash 0.04 0.01 -0.06 -0.09 -0.14
Bonds 0.04 -0.10 0.37 0.05 0.23
ILB’s 0.01 -0.10 -0.05 -0.03 -0.04
Property -0.06 0.37 -0.05 0.26 0.55
Resi -0.09 0.05 -0.03 0.26 0.59
Findi -0.14 0.23 -0.04 0.55 0.59

22. Portfolio construction in practice

23. Challenge in composing a portfolio
For a good orchestral performance you require:
• Clarity:
· Emphasise the melody
· Allow for interpretation / expression
• Balance:
· Can’t have some instruments drowning out others

24. What makes a good portfolio?
Clarity
• Expressing investment view
· Top Down + Bottom Up – Ideas and themes
· Shares you like and shares you don’t like
• Note: View = Highest expected return
Balance
• Dividing risk appropriately between opportunities
• Making use of diversification
• Ensuring exposure to the main market drivers
Why is this important for investors?

25. Portfolio construction aims
Clarity
• Expressing investment view
Repeatability
Skill versus Luck
Balance
• Dividing risk appropriately between opportunities
• Making use of diversification
• Ensuring exposure to the main market drivers
Stability
Better risk-adjusted returns : Fewer negative surprises

26. Summary
“You cannot manage outcomes, you can only manage risks.”
Peter Bernstein
Portfolio Construction
• Clarifies view of where to take risk (opportunity + conviction)
Repeatability
• Balances risk and return in the portfolio
Stability
• Enhances the investment process
Better decision-making
“To do good work, one must first have good tools.”
Chinese Proverb

27. Equity Process

28. Equity investment philosophy
Concept of normalised value
Shares trading above fair value will
drift to the bottom
Irrational Exuberance
Intrinsic Value High PE's in relation to past PE's
Only good news
Growth in trend earnings High earnings base in
a fundamental underpin relation to trend earnings
over time
Share Price
Momentum
Investing
SELL
Margin of
Safety
LEVEL
BUY
Irrational Pessimism
Low PE's in relation to past PE's
Only bad news
Low earnings base in relation to trend earnings
TIME
Shares trading below fair
value will drift to the top

29. Three Pillars of Conviction
Stock selection
Value / Cheapness
• Analysis & Evaluation
Quality / Risk Considerations
• Look and Listen
View / Theme Consistency
• Set your views
All 3 are required to identify “Leaders” & “Laggards”

30. Pillar 1
Value
Fundamental valuation of companies - normalised,
through-the-cycle considerations
Rank companies based on these normalised valuations
Discuss different scenarios, both value implications and
probability of them playing out
The cheaper the stock, the higher the value conviction

31. Pillar 2
Quality / risk factors
Rate all stocks based on quantitative / qualitative risk
criteria
• Balance sheet strength (cash & debt)
• Quality of management
• Barriers to entry, strength of competition
• Life cycle phase of the industry / company
• Threat of government regulation, interference
• Litigation risk
• Resource availability, buyer strength
• etc

32. Pillar 2
Quality / risk factors
Quality Ranking
extremely high quality /
5 extremely low risk
above average quality / low Include stocks that
4 risk
score average or
average quality / moderate above-average on the
3 risk quality / risk scoring
below average quality /
system
2 above average risk
very low quality / very high
1 risk

33. Quality ranking for financials
Barriers to SCORE
Solvency/Capital
Entry Management Regulatory and CONSISTENCY
Balance Sheet OVERALL
(Retail, (Quality and Litigation Risk CHECK WITH
Strength/Optimis SCORE
Investments track record) NORMALISED
ation
and Savings) EXIT RATING
SBK 3.5 3.5 4.0 2.8 3.5 0.95
SLM 4.0 3.5 4.0 3.0 3.5 0.90
LBH 4.0 3.0 2.8 3.0 3.2 0.85
MergeCO 3.5 4.0 3.0 3.0 3.2 0.85
INP 4.0 2.5 3.5 3.0 3.2 0.88
RMH 3.5 3.0 3.0 3.0 3.1 0.92
OML 3.5 2.5 2.5 3.0 3.0 0.75
FSR 3.0 3.0 2.5 3.0 3.0 0.92
NED 2.8 3.0 3.0 2.5 2.9 0.87
ASA 3.0 3.0 2.0 2.8 2.8 0.86
ABL 2.8 2.5 2.5 3.0 2.8 0.72

34. Overall ranking
Resource shares
Financial Final score out
Attractiveness Competitive strength & Stewardship Strategy / Final score of
of the industry advantage history mission
Weighting 25% 25% 20% 20% 10% 100% 5 Ranking
Billiton 15.0% 22.5% 20.0% 17.5% 10.0% 85.0% 4.3 1
Kumba 15.0% 20.0% 17.5% 12.5% 10.0% 75.0% 3.8 2
Impala 17.5% 20.0% 20.0% 10.0% 7.5% 75.0% 3.8 2
Sasol 20.0% 20.0% 17.5% 7.5% 5.0% 70.0% 3.5 4
African Rainbow Minerals 15.0% 17.5% 15.0% 12.5% 7.5% 67.5% 3.4 5
Northam 17.5% 15.0% 17.5% 10.0% 7.5% 67.5% 3.4 5
Anglo American 15.0% 17.5% 15.0% 12.5% 5.0% 65.0% 3.3 7
Anglo Platinum 17.5% 17.5% 15.0% 10.0% 5.0% 65.0% 3.3 7
Mondi 7.5% 20.0% 12.5% 15.0% 7.5% 62.5% 3.1 9
Mvelaphanda 17.5% 15.0% 15.0% 7.5% 7.5% 62.5% 3.1 10
Exxaro 15.0% 15.0% 12.5% 12.5% 5.0% 60.0% 3.0 11
Hiveld Steel & Vanadium 10.0% 17.5% 15.0% 5.0% 7.5% 55.0% 2.8 12
Sappi 7.5% 17.5% 7.5% 15.0% 7.5% 55.0% 2.8 13
Anglo Gold Ashanti 10.0% 10.0% 10.0% 10.0% 7.5% 47.5% 2.4 14
Arcelor Mittal 10.0% 12.5% 12.5% 5.0% 5.0% 45.0% 2.3 15
Goldfields 10.0% 7.5% 7.5% 7.5% 2.5% 35.0% 1.8 16
Harmony 10.0% 5.0% 5.0% 7.5% 5.0% 32.5% 1.6 17

35. Pillar 3
View / theme
Identify phase of the investment cycle
• Growth, output gap, inflation, interest rate cycle
• Identify best/worst themes/styles/sectors/stocks for the phase
Bottom-up and top-down themes / views
• Jointly identify stocks best / worst placed for each view
View conviction
• Determine our level of conviction for each view / theme

36. Pillar 3
View / theme
View / themes
Growth bottomed, but still no inflation threat,
rates to stay low – early cyclical (e.g. FSR, NED)
Balance sheet repair to suppress consumer
spending - rates will fall further – bonds, property Include stocks that
stand to benefit from
Industrialisation of BRICS, resource supply
constraints tobias bulk resource prices higher –
the views / themes
favor low-cost suppliers (e.g. BIL, ARI) that are identified
Private sector de-leveraging lead to large
government stimulus → infrastr. spending –
Construction to benefit (e.g. MUR, GRF, AEG)
Government policy to become more populist and
labour friendly, more intervention and higher
taxes are possible – lower market rating?

37. Themes affecting SA equity shares over
the near term …
Conviction
Theme / View Stocks impacted by view
level
Rate cycle and consumer Prospects of lower rates remain but High WHL, TRU, FOS, IPL, BAW,
spending consumer de-leveraging may keep BVT, SHP, MSM, JDG, LEW,
spending muted SHF, SBK, FSR, NED, ASA
China and Global EM Growth in EM from urbanisation and High BHP, AGL, KIO, EXX, ARI
urbanisation and rebalancing of EM domestic SAB, BTI, SBK, CFR
industrialisation economies leading to greater domestic SOL, AMS, IMP, NHM
demand and wealth ACL, EHS, AEG
Corporate re-investment in Manufacturing led businesses benefit Medium SBK, FSR, NED, ASA
domestic economy from re-stocking cycle and cash rich Manuf.: AEG, AFE, AFX, IPL,
SA corporates begin re-investing for BAW, SHF
growth
Growth from Sub-Sahara Strong growth out of West Africa High MTN, BAW, SHP, GRF, AEG,
Africa resource exposed countries, FDI led MUR {SBK, FSR}
growth to drive domestic economies
Europe at risk Fiscal retrenchment and austerity High BVT, SHF, IPL, BAW, OML
measures to temper economic
recovery

38. Themes affecting SA equity shares over
the near term (2)…
Conviction
Theme / View Stocks impacted by view
level
Healthcare development Investment in HIV ARV’s by Medium NTC, MDC, LHC, APN, AIP,
government, and improvement of CLS,
public sector healthcare delivery.
Regulation of drugs and private … AEG, MUR, GRF, WBO
hospital price lists.
Easing of fears of a total Stability in global financial systems Medium ANG, GFI , HAR
collapse in the global returns as fiscal austerity measures
financial system result in a gradual improvement in
western country fiscal positions
Domestic equity markets … Equity exposure in life companies to Medium LBH, OML, SLM
drive improved returns and growth in
EV’s.
Domestic fixed investment Underinvestment over the last 2 Low AEG, MUR, GRF, WBO, PPC
decades to result in further social
infrastructure investment in the long
term, govt. execution could mean the
next 2 years are weak

39. Thank you
Wayne Mc Currie