The IpsoFacto Approach to Investment Advice
Why Worry About Asset Allocation
Principally because each investor ought to assess the risk they are prepared to take, but also:
- As a result of the variability of investment returns from different asset classes: over the five years to 31.12.12, equities as represented by the FTSE All Share returned just 13.6% versus a gain of 49.2% for bonds (gilts); the old mantra that equities always work over the long term is looking increasingly fragile and therefore it is worth considering all asset classes.
- Spreading investment over different asset classes (diversification) lowers the risk of being exposed to an underperforming asset class.
- In a low return and volatile world, investments need to work as hard as possible. Sensible asset allocation may help to lessen the volatility of investment returns, reducing the danger of having to sell investments at a low point in their valuation.
Equity Selection Process
We have developed an approach to selecting stocks (equities) which we have called RRR (Risk-adjusted Relative Return). As with our asset allocation methodology, this is designed to be a selection tool which is objective, numbers based and hence not susceptible to emotional bias. The approach takes its inspiration from classic Value investing as pioneered by Benjamin Graham, of whom Warren Buffett is a disciple.
In simple terms, the selection process ranks stocks by their actual adjusted operating profit divided by the EV or Enterprise Value (being the combination of market capitalisation and debt) which is usually a good proxy for the gross cash flow return to the buyer of a business. This is Relative Return. We then apply a risk metric based on the variability of earnings per share (EPS) over five years to achieve Risk-adjusted Relative Return (RRR). See also Research.
Importantly, we apply two screening factors; firstly we only select stocks where the market capitalisation is at least 55% of EV. This is to avoid stocks which are too heavily indebted. Secondly, we only select stocks which have been listed for five years. This is to ensure that the stocks have a proper five year track record.
Apart from providing an objective method of stock selection, the advantages of this approach include:
An automatic rotation of those more expensive equities that have performed well into cheaper stocks.
Our stocks will tend to be higher yielding than the market, so a good proportion of the total return will come in the form of dividends.
In order to ensure sufficient diversification within the portfolio we do not select more than three stocks from the same sector.
This is not to suggest that this process is a magical solution that will somehow guarantee good investment returns; we do believe, however, that it should help prevent buying stocks that are overvalued.