Basics of Building a Profitable Portfolio

Welcome to Module Three. In this Module, you’re going to build a strong and diversified portfolio of leading companies.

Once you’ve completed this Module you’ll not only end up with a portfolio of 12 great stocks, you’ll also learn how to search, analyze and choose winning companies from the following sectors: consumer products, finance, energy, high-tech, health care and utilities.

To get the most out of this Module, please stay with us as we go through the various lessons, and buy the stocks from the sectors we suggest. Only by doing this will you learn some of the fundamental strategies to building a diversified portfolio.

Remember, at this point we’re not trying to learn how to compare different types of companies. We’re just going to highlight a cross-section of good, representative ones within each of the major sectors. The companies we are going to choose for your virtual portfolio may not necessarily soar above their peers, but neither are they likely to flounder like smaller companies or those in niche areas of the sector.

In this section, you’ll…

• Buy two blue-chip consumer products companies for your portfolio.
• Apply both growth and value investing methodologies when buying them.
• Learn why consumer products companies are great defensive stocks to protect your portfolio.

Our goal in this lesson is to set you up with a stable, diversified basket of blue chip stocks from a range of industries. Continue to the next page to find out why we have done this.

‘Blue chips’ are large and stable companies. The term ‘blue chip’ originates from poker, where the colour blue represents the chips with the highest value.   Diversify to limit the damage any one stock can do to your portfolio.

Here’s why:

• It means we’ll diversify by buying a number of different stocks to limit the damage any one stock can do to your portfolio. We’ll learn more about diversification in Module Four.
• We’ll stick to big blue chip stocks. These are companies that have a long track record. This helps us assess whether they have what it takes to grow – and help our money grow – for the long term.
• It also means we’ll have money invested in companies operating in many different sectors. This adds to our diversification and lowers our risk and volatility.

Our basic strategy is this:

We’re going to take $60,000 of your simulated savings and invest that money evenly between 12 stocks – two stocks each from six different economic sectors. This equates to $5000 invested in each stock.

Why We Won’t Build You Your Perfect Portfolio

Once you’ve worked your way through this Module, you’ll have the foundation for a great portfolio of stocks. But much like the rest of life, no one size fits all in the investing world.

The specific stocks that make sense for you will partly depend on your interests, how much research you like to do, and the areas you may have in-depth knowledge of. Your ideal stocks will mostly be determined by your time frame, whether you are investing for long-term growth, or need some income from your investments along the way.

Once you complete this Module, you will have a diversified portfolio of stocks from some very well known companies. And because we’re doing this within a simulated investing environment, you don’t have to be concerned about whether the stocks we’ve selected are the perfect ones for you to buy. It’s all for practice, to adequately prepare you when you’re ready to invest for real.

Much like the rest of life, one size does not fit all in the investing world.

Selecting Profitable Stocks: Different Styles Mean Different Steps

As we learned in Lesson One, Module 2, there are two basic methods used when selecting winning stocks – value investing and growth investing. We’ll be applying both methods as we build your diversified portfolio. Using both styles not only adds diversity to your portfolio, it also reduces volatility.

You’re going to start building your portfolio using a growth investing approach with our first company selection. We’ll begin with a sector you’re likely very familiar with – consumer products – which includes companies that make and sell products like the Bic razor, made by Gillette Co. and Budweiser, made by the brewer Anheuser Bush.

The first pick of two companies on our purchase list for the consumer products sector is famous for refreshing consumers all around the world. That company is Coca-Cola.

Growth investing is a style that looks for companies with above-average current and projected-earnings growth.  Growth investors believe in buying stocks with superior earnings growth, with little or no concern about the share price.  Growth stocks tend to have very high earnings-growth rates but very low dividend yields.  Having said that growth investing involves a certain degree of risk and may not be suitable for beginning investors.  Firms of growth stocks all trade at high valuation levels, meaning they usually have high price-to-earnings (P/E) ratios.

Putting Some Fizz In Your Portfolio

You may like Coca-Cola so much you drink a case a day. On the other hand, carbonated beverages may not be your thing.

That doesn’t matter. We’re going to purchase Coke as the first stock in your portfolio for the following reasons:

1. Coca-Cola is a long-standing company with a proven and consistent track record for making profits.
2. Coke is the largest and most recognized soft-drink brand in the world giving Coke a significant competitive advantage. More recognition means more sales. More sales means more earnings. More earnings results in a higher share price.
3. We’re not alone in thinking Coca-Cola has a bright future. The stock’s price-to-earnings ratio (P/E) is relatively high, meaning that investors think Coke will continue to increase its earnings faster than the average consumer products company.

In the majority of cases, growth investing involves buying young companies with high earnings potential.  Because of their high prices and low yields, growth stocks tend to have less downside protection and more volatility than cheaper companies.  Growth stocks are particularly sensitive to rising interest rates, which can dampen their rapid earnings growth.  Growth stock companies need capital to finance their expansion. All earnings are reinvested into the business, so no dividends are paid.  Over the past decade many technology companies have taken the title of growth stocks.

So let’s go add some of fizz to your portfolio and purchase some Coca-Cola shares. Remember, our strategy is to purchase $5,000 of each stock we select.  Simply divide $5,000 by Coca-Cola’s latest stock price to determine the number of shares we can buy.  Once you’ve done your division using the stock price you looked up, enter the number of shares that $5,000 will buy in the “# of shares window”. Move to the “Ticker Symbol” window by hitting “tab” and enter ‘COKE’ in the ticker symbol window.

All you need to do now is to actually make the trade to complete the share purchase.  You’ve just successfully purchased around $5000 worth of Coca-Cola shares.

Now, for our second and last stock purchase within the consumer products sector. To keep our portfolio on the straight and narrow, we’re going to purchase a stock with a low P/E ratio. In other words, we’re going to adopt a value investing approach for our next stock purchase.

Growth stocks often perform best, relative to the market, when the economy is slowing down.  Value investors look for stock market bargains, buying companies whose shares appear cheap when compared to current earnings.  Value investors typically buy stocks with high dividend yields, or ones that trade at a low price-to-earnings (P/E) ratio.  In most cases, value stocks tend to outperform during bear markets and are thus considered defensive investments.

Looking for Value in Consumer Products Stocks

A company whose stock has a low P/E ratio means you can buy that stock relatively cheaply compared to other companies’ stock. But a low P/E doesn’t always mean great value. A stock may deserve a low P/E if the company has run into troubles that may keep its profits flat for a long time to come. Or it may have nowhere near the potential for growth compared to other companies it competes with.

Sticking to large and recognized companies, below are three big and well-branded consumer companies and their stock prices:

In order to find the stock that holds the best value, we need to know what each company makes in earnings per share.

To determine the companies’ P/E ratios, we just need to divide the share price by the earnings-per-share value for each respective company. The following chart shows the P/E ratios for each company as of July 10, 2001.

The winner of our value contest is McDonald’s Corporation. Repeating the steps you made to purchase your shares of Coke, purchase $5000 of McDonald’s Corporation stock to add to your portfolio.

Well done. Now you have two world-beating consumer products companies in your portfolio. Lets leave you with one other notion about consumer products companies.

When the Economy is Down, Think Defense

Some companies will continue to make a profit whatever happens to the economy. Even in a recession, everybody still needs to buy the life essential products.

In addition to things like toothpaste and band-aids (made by companies like Proctor & Gamble), they’ll also continue to buy soup (Heinz) and bread to make sandwiches (General Mills). And while they certainly aren’t the essentials of life, tobacco companies like Philip Morris and RJ Reynolds, as well as beer companies like Anheuser-Busch and Coors, are also non-cyclical.

Built-In Protection for Your Portfolio

In other words, the sales of these companies will generally be unaffected by whatever different part of the boom-and-bust cycles the economy finds itself in. Stocks that behave like this are called defensive stocks.

Defensive stocks act as a kind of body-guard for your portfolio, protecting it from a faltering economy and offsetting those stocks in your portfolio whose values will falter with it. These nice, stable stocks have an advantage beyond letting you sleep at nights.

The stability they bring to your portfolio means you can supplement them with stocks that do bounce around with the economy, such as energy stocks.

They also act as a conservative cornerstone to your portfolio, letting you then add shares from more volatile sectors such as the high-tech industry – the next sector we’re going to purchase from in Module 2.

Defensive investing typically implies a low risk/low return portfolio with a high percentage of assets in bonds, cash equivalents and stable stocks.

Key Learning Points

• Consumer products stocks are known as defensive stocks primarily because they are unaffected by the boom-and-bust cycles of the economy. This adds a level of stability to your portfolio by helping offset more volatile holdings.
• A company whose stock has a low price-to-earnings (P/E) ratio means you can buy that stock relatively cheaply compared to other companies’ stock. In other words, it has good value.
• A low P/E ratio doesn’t always mean the company’s stock is a great value. A stock may in fact deserve a low P/E if the company has financial trouble, or nowhere near the growth potential of its competitors.
• To determine a company P/E ratio, you just need to divide the company’s share price by its earnings-per-share (EPS).
• Both the share price and EPS of a company can be easily obtained using Investor Factory’s QUOTES & RESEARCH function.