Constructing a Stock Portfolio — What to Consider, What to Avoid

Obviously, $10,000 is an arbitrary number. Whether we are talking about $10,000 or $50,000, the point of this article is to examine some of the capital allocation possibilities investors have during such a treacherous macroeconomic and geopolitical environment.

The previous decade was loaded with euphoria in the capital markets. Everyone seemed like a smart investor because everyone was making money on the bulk of their investments. In contrast, the current market environment is totally unforgiving. Selecting investable securities these days requires in-depth due diligence, confidence in one’s area of expertise, and, most importantly, distinguishing between price and value.

That last point, in particular, is quite crucial. With rates on the rise, investors now require a higher equity risk premium. In other words, investors demand an excess return when they invest in the stock market over the “risk-free” rate they can get through T-Bills. This can and has led to a compression in valuation multiples, which can easily wipe out the value of the stocks you purchased with your hard-earned dollars.

Below, I list some ideas which I believe are worth allocating capital to following the ongoing market decline and some to avoid, as they still pose several risks.

Investment Ideas to Consider

High-Yield, Low-Valuation Quality Stocks

This category includes names that offer high dividend yields, trade at below-average multiples, but, most importantly, have been distinguished for their unique qualities. High yields, as long as you deem they are sustainable, can provide increased predictability and visibility for one’s future total-return prospects. Further, inexpensive valuations provide a margin of safety against steep multiple compressions.

Some noteworthy names to consider here include tobacco stocks. Earlier this month, we examined whether you should invest in tobacco companies. While we concluded that it all comes down to each investor’s preference, what is quite certain is that companies in the space, such as Philip Morris (NYSE: PM), Altria Group (NYSE: MO), and British American Tobacco (NYSE: BTI), enjoy remarkably resilient cash flows, with their products being highly inelastic and inflation-resistant.

Philip Morris’s most recent quarterly results, for instance, exemplified its business model’s qualities. The strong dollar materially hurt the company’s results due to the entirety of its cash flows being sourced in currencies other than the dollar. However, on a currency-neutral basis, earnings-per-share grew by 8.3%, illustrating the capability of tobacco giants to deliver growing profits even during the harshest economic environment.

With tobacco giants trading at reasonable valuations following a lack of institutional interest, make sure you don’t disregard their investment cases. High-yielding oil & gas midstream names also appear to be offering equally attractive risk/reward characteristics these days.

Low-Volatility ETFs 

Low/minimum-volatility ETFs aim to track various indices comprising equities that, in the aggregate, have lower volatility elements compared to the broader equity market. Securities with low-volatility characteristics tend to yield an excess return compared to the risk taken during uncertain times like the one we are currently experiencing. This is due to investors flocking to such names over riskier, higher-beta ones during times of heightened volatility.

The two largest low-volatility ETFs by AUM are iShares MSCI USA Min Vol Factor ETF (USMV) and Invesco S&P 500 Low Volatility ETF (SPLV). Their holdings include reliable companies whose trading patterns tend to be less volatile than the general market due to their quality revenues, robust profitability, and sticky shareholder bases. Examples include Johnson & Johnson (NYSE: JNJ), Waste Management (NYSE: WM), and McDonald’s (NYSE: MCD), among several other dependable names.

Indeed, while the S&P 500 is now down about 15% year-over-year, USMV and SPLV have only declined by 7.3% and 2.55% over the same period. This doesn’t sound particularly pleasant, but it’s still noteworthy outperformance that can accumulate over time if the current market conditions persist.

You can either directly invest in these ETFs or browse their individual holdings and pick the names you like based on your personal investment criteria.

Investment Ideas to Probably Avoid 

Expensive Blue-Chip Stocks

A blue-chip stock is usually one that features a large market cap and prolonged history of proven shareholder-value creation. Johnson & Johnson and McDonald’s, which I mentioned in the previous example, are two such companies, for instance.

That said, don’t make the mistake of overpaying for these names. With investors herding to blue-chip stocks since the turmoil in the capital markets began, many of them have seen their valuation multiples expand to unreasonable levels. Thus, not only do investors face the risk of a valuation compression but their future upside has already been limited following their multiple expansions.

For example, in an article I shared earlier this month, I went over why Procter & Gamble (NYSE: PG) and Colgate-Palmolive (NYSE: CL) – two well-known blue chip stocks – are likely not worth buying at their current valuations despite featuring decades of robust performance and 60+ years of growing dividends.

Fallen, Money-Losing Angels

A few years ago, losing money wasn’t an issue for a company as long as it met its growth targets. Investors were happy to overpay for these equities, and these companies could, in turn, issue shares at a premium to fund their expansion before reaching sustainable profits. For many companies, it did work out, and they eventually started generating strong profits.

Those who didn’t make it to positive bottom lines before the excess-liquidity party ended, however, have seen their shares get beaten down violently over the past year. I am talking about the likes of Unity Software (NYSE: U), Teladoc Health (NYSE: TDOC), and Cloudflare (NYSE: NET).

Do such names still have exciting long-term prospects? Maybe. However, raising capital in the current environment (low share prices) to fund their future growth can be destructive for shareholders.

To issue debt would be very expensive, too, as creditors will have wild demands these days, especially from riskier companies. Finally, their rich stock-based compensation schemes can further dilute existing investors, making these names even less appealing investments.

It’s not bad to go for high-growth equities in the current environment. Just make sure they are decently profitable and don’t print shares like the Federal Reserve is used to printing cash. Make sure you don’t overpay, as mentioned repeatedly, as well.

Disclosure