New share added to this outperforming portfolio

I feel like the man who never found a share he didn't like, but sadly I don't have the resources to add the four companies currently in my sights to the Share Sleuth portfolio*.

The portfolio started with a notional £30,000 on 9 September 2009. Yesterday, it consisted of 27 shareholdings valued at a few pounds shy of £96,500 and £1,578 in notional cash. Since it's against the rules to add new money, and I prefer to put 1/30 of the value of the portfolio (currently about £3,200) at risk when I make a new investment, I don't even have enough money to add one of the new candidates, let alone all four.

There is an obvious solution, sell existing holdings to buy the new ones, but the allure of the new can be dangerous. We'll know a lot about the companies we're most familiar with and not all of it will be reassuring. Like movie stars, perhaps, unfamiliar companies are alluring because the warts and callouses are hidden from view.

They may be better investments, that's always possible, but if we're not careful, we'll latch on to shiny new shares, only to discover warts later. Do that too often and we aren't long-term investors at all. We're traders, and probably not very good ones.

To level the playing field I procrastinate. I read past annual reports to see how shares I like now have performed during less favourable times in their history. I normalise valuations to guard against the probability that the company's profits are out of kilter with what might be expected in a typical year. As far as possible I try to know as much about the pretenders as the portfolio members they'd replace.

Then I invoke 'The Obvious Clause'. I prefer to replace one share with another only when the replacement is obviously a better investment than the share it will replace. Since my Decision Engine ranks all the shares I follow, I can define 'obvious' numerically. A share has to score at least two and preferably three points more than the share it will replace on the Decision Engine's scale of 0 to 10.

The Decision Engine, a spreadsheet that is growing so large I hope it might develop self-awareness, ranks shares according to five criteria. Some are relatively hard, the long-term profitability of the company, for example, and its valuation. Others are soft and rely on my judgement, like how straightforward the business and its accounts are, whether the business is adaptive and resilient, and whether management act in the long-term interests of all shareholders.

In other words it's me, plus a bit of automation. I consider shares scoring between 0 and 4 to be 'sells', shares scoring 5 and 6 to be 'holds' and shares scoring 7 to 10 'buys'.

What's in, and what's out

Of the four new candidates for the portfolio, one, Portmeirion scores 8/10, Judges Scientific, Howden Joinery and Anpario score 7/10. The bottom four shares all rank 5/10. They are: Trifast, Tristel, Renishaw, and ITE. These are my shakiest holds.

According to my rules, Portmeirion, is the most obvious buy. It scores three more than bottom ranked Trifast.

I have now reduced the portfolio's holding in Trifast by 745 shares at an actual price quoted by a broker of just over 223p. The transaction raised £1,654 after deducting a £10 broker fee. I bought 349 Portmeirion shares at an actual price, quoted by a broker, of just under 918p. The total cost, after adding a £10 broker fee was £3,212, leaving the portfolio with a token amount of cash, just over 3% of its total value invested in Portmeirion and 2% invested in Trifast.

A quick word on Trifast. I feel bad about selling it. In share price terms alone, the small rump of shares left over is up over 500% since I bought them more than six years ago. As the valuation has soared beyond my expectations, I've found it increasingly difficult to believe the business will continue growing enough to justify the price. By all accounts, it's done magnificently in the year just concluded, but we'll have to wait for the results in June for confirmation.

Trifast manufactures fastenings, nuts, bolts, rivets and screws, used to hold bits of cars, refrigerators and consumer electronics together. Strategically, the company has excelled since the Credit Crunch, focusing on its biggest customers who are in turn focusing on fewer suppliers, those, like Trifast, that have a global footprint.

The company has diversified through acquisition, so it may not be as vulnerable to a downturn as it was seven or eight years ago, but its customers will reduce orders when demand for their products falls. I doubt it will need rescuing as it did before, but I doubt it can maintain current levels of return on capital indefinitely. The Decision Engine marks it down because of its high valuation and the potential for instability.

Portmeirion too would suffer in a downturn, but its valuation is less demanding and its record somewhat more stable. I think I can hold on to it through thick and thin.

Portmeirion gives me something else, a kind of focused diversification. The commitment to invest only 1/30 of the portfolio at a time and the reluctance to sell holdings completely unless the decision engine ranks them below 5, ensures I keep about 30 shares in the portfolio.

There's a good reason for that. Trifast is not alone in being a difficult hold. I've reduced the portfolio's holding in Dart, its best performer, twice, and in terms of share price alone the rump of Dart shares is up over 1,000% since I bought the shares in 2009. I once said of Games Workshop: "I wonder about what the company says, and what it doesn't say, and whether I'm mad or it's delusional."** Well, maybe I'm mad, because I held them and they're up 250% since I added them in 2009.

So far, the portfolio has done well, but had I focused only on my best ideas as the most confident investors encourage us to, I doubt it would have performed as well, and I would have been a lot more nervous about it. Goodwin, currently one of the portfolio's worst performers was one of my most confident choices.

Play by the rules

While 'know what you own' is rule number #1 in stockpicking, 'know thyself' is rule number #1 in portfolio management. The arbitrary rules I use to guide my decisions are a defence against ignorance and over-confidence. I don't think I'm a master stockpicker, I think most of my picks will do ok in the long-run and some will do very well.

Since stockmarket returns are skewed, you can only lose 100% on a share, but you can win 1,000% or even 10,000%, I should do well over the long-term. The trouble is, I don't know which picks are the multi-baggers, and which are the also-rans. It pays to spread the net quite widely.

Curiously, 'know what you own' is an aphorism adopted by Peter Lynch, an American fund manager famous for running one of the best performing investment funds of the 1980's, Fidelity Magellan.

When he took over the portfolio in 1977 his boss recommended he reduce it from 40 stocks to 25. Instead, by the time he wrote his best-selling book One Up On Wall Street in 1987, he'd increased the number of individual stocks Magellan owned to 1,400. He wrote:

"Soon enough I became known as the Will Rogers of equities, the man who never saw a stock he didn't like."

"I suppose they have a point," he also said, "Certainly I can name plenty of stocks I wish I hadn't owned."

Unlike Lynch, I don't have investors queuing up to pile more money into the Share Sleuth portfolio or an army of researchers. I must be more circumspect. But if the portfolio continues to grow, I may diversify to, say, 40 stocks and become even more like the man who never saw a stock he didn't like.

I'm not in a hurry, but targeting a higher number of shares would make it easier to add the other three candidates.

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* Share Sleuth Portfolio

** Games Workshop: In denial

Contact Richard Beddard by email: richard@beddard.net or on Twitter: @RichardBeddard

This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.