The University of Miami School of Business Administration

Portfolio Construction & Stock Selection

In Peter Lynchs book One up on Wall Street, one of his chapters; The
Perfect Stock, What a Deal! provides key factors to consider when attempting to
pick ideal stocks.
Stocks that have a niche business: Investing in stocks that have a niche
business is safer than investing in other stocks as it creates a virtual monopoly, as it
not as popular among investors as more common industry stocks. World Wrestling
Entertainment Inc. is an example of this, and is in a position where they have price
power (Lynch 140).
Companies selling products people have to keep buying: Costco,
Home Depot, Yum! Brands, Humana, and Consolidated Edison are all examples of
these types of companies. Why not invest in firms that have steady business and
that has goods consumers need to restock often? These companies will more likely
survive during bad times (Lynch 142).
Understanding the business and choose the stock for a specific
reason: When a firm is built on a firm economic basis with strong company
fundamentals, it will be a company in which one should invest. The company will be
able to withstand bad times and competition due to a sustainable competitive
advantage. Costco for example, has a major competitive advantage due to its
ability to maintain a low cost structure and sell premium products at low prices.
Apple has created a brand so strong that the brand in itself is an economic moat.
Netflix has managed to create a solid economic moat through building a strong
network too (Lynch 130).
Finding stocks that seem dull or have dull names: The Priceline Group
Inc. and Consolidated Edison, Inc. are two companies that sound dull and do not

create an initial interest from most people. By investing in these type of companies
we avoid mainstream traps that are overvalued and can buy the company at a
reasonable price and profit for their ability to create good earnings (Lynch 131)
In chapter 7 of One Up on Wall Street, Peter Lynch recommends placing
stocks into one of six categories based on their growth rate, price per earnings ratio,
dividends paid, or expected growth rate. The six categories Peter Lynch uses to
classify

his

portfolio

are

slow

growers,

stalwarts,

fast

growers,

cyclicals,

turnarounds, and asset plays (Lynch 110). We selected stocks that fit into the four
categories:
Slow Growers:

These stocks consist of companies that are larger than average

and have a sluggish growth rate, but tend to pay out higher dividends. While this
benefits the investors in the short term, means that the company has less money to
fall back on making these stocks riskier over the long haul. From our portfolio
Diageo plc, Humana, and Consolidated Edison fall into this category. Diageo and
Consolidated Edison pay dividends around 4%, approximately double of what the
rest of the stocks pay out. Humana pays less in dividends, but has had a slow
growth rate over the past 10 years. These three stocks maintain a steady customer
base, but are unlikely to produce innovative products that drastically raise company
value (Lynch 111 & 112).
Stalwarts:

These stocks are usually large companies that have a consistent

growth rate over a long period of time, they are accurately priced compared to their
earnings per share, and they provide good protection in hard times because they
are unlikely to go out of business (Lynch 112-118). Costco, Apple, NIKE, and Yum
Brands fall into this category.

The Cyclicals: These are companies whose profits fluctuate regularly.

Cyclical

businesses tend to fall in the travel, commodities, or auto industries. From our
portfolio The Priceline Group is in the business travel industry which tends to be
seasonal and therefore have stock prices that change frequently (Lynch 119 122).
Fast Growers: These stocks are generally smaller companies that work in new
enterprises and have higher earnings and growth rates (Lynch 118-119). Over the
past year Netflix had a growth rate of 39% and the projected growth forecast of
17%. Netflix also works in an industry that has a large potential for future growth.
World Wrestling Entertainment Inc. has done consistently well over the years and
has an earnings growth forecast of 20%.
Portfolio Construction: Portfolio Weights:
The method behind constructing our theoretical portfolio was based on a
combination of Peter Lynchs types or corporations including Fast-Growers,
Stalwarts, Cyclicals, and Slow-Growers. Further discussion of the portfolio selection
factors is discussed in section one of this report (see Portfolio Construction Section
above).
According to Table 2.2, our selected securities demonstrate that we have a
relatively well diversified portfolio because there is a lack of highly correlated
individual securities. Furthermore, it is important to note that the security with the
highest weight was Consolidated Edison (ED) at 16.22% and had a negative
correlation with 5 out of the 12 stocks in the portfolio. On the other hand, a stocks
like Diageo and Yum had some of the lowest portfolio weights (2.78% and 5.03%)
due to their comparatively higher correlations with the other securities in the
portfolio. Furthermore, Diageo and Yum had a positive correlated with respect to

almost all of the stocks in the portfolio, which is a reasonable explanation as to why
they have comparatively lower weights. The correlations also suggest that Netflix
serves as the hedge or insurance with an overall portfolio weight of 7.79%. This is
due to the fact that Netflix is negatively correlated with 7 out of the 12 securities in
the portfolio.
Additionally, the highest correlation of securities that we observed was
between Costco and Home Depot (0.4890). However, it makes sense that these two
securities would have a disparity in their weight allocation (Costco, 14.28% and
Home Depot,7.56%) because Costco has a higher Sharpe Ratio than Home Depot
considering the fact that it offers a higher return per unit of risk.

Risk Measurement:
While neither portfolio would be considered to be extremely risky, the
optimized portfolio carries less total risk. In addition, it is better explained buy the
Capital Asset Pricing Model (CAPM), as more of the risk has been diversified away.
This is because the weights of the riskier stocks have been minimized, with a
simultaneous effort to maximize the return. The risk characteristics for the
optimized and naive portfolios are summarized in Table 4 in the Appendix.
Performance Evaluation:
The performance of the optimized portfolio and the naive portfolio can be
observed in Table 5 in the Appendix. The optimized portfolio maximized the weights
in order to get the greatest Sharpe Ratio, and outperforms the naive portfolio
significantly. Although the naive portfolio exhibits a greater Treynor Measure, the
difference is minuscule, with a value of 0.001. Furthermore, the idiosyncratic risk of
the naive portfolio is greater than that of the optimized portfolio. Thus, the naive

portfolio does not represent an ideal investment strategy, and one should opt for
the portfolio that maximizes the Sharpe Ratio in this case since the reward is
greater per unit of risk.
Back-Testing & Real-Time Performance Evaluation:
The historical sample data consisted of 10 years, dating back to August 2005.
Thus, the buy & hold portfolio was comprised of the first five years. It achieved a
mean historical return (excess) of 2.75%, outperforming the naive portfolio for the
same time period. In addition, the buy & hold portfolio presented a much more
desirable risk/reward profile than the naive portfolio. A summary of the statistics is
presented in Table 6 in the Appendix.
The real-time portfolio was rebalanced after each year, with the initial
weights based on the end of the first five-year period. Although the initial values for
the weights at the beginning of the sixth year resulted in several un-weighted
stocks, these became weighted with each re-balancing. The results for each time
period are summarized in Table 6 in the Appendix.
Among the buy & hold, naive, and real-time portfolios, the buy & hold and
real-time portfolios achieved the best results. However, the measures for risk/return
produced contradictory conclusions as to which portfolio was superior. The Sharpe
Ratio was significantly higher for the real-time portfolio, while the Treynor Measure
of the buy & hold was higher. Thus, our conclusion for which portfolio to select was
based on the diversification of our combination of risky assets, as well as the
correlation with the market benchmark. Since the correlations between each stock
were relatively low, with a majority of the values aggregating around zero both on
the positive and negative sides, coupled with a high R-squared value, we can
assume our portfolio has substantially diversified away idiosyncratic risks. In

addition, a meaningful R-squared value of 0.72 indicates that the movement of our
fund is well-represented by the market benchmark. The higher the Treynor Measure,
the greater the returns relative to its beta. Thus, we have chosen to invest in the
buy & hold portfolio.
Asset Allocation: Stock vs. Bonds:
As seen in Table 7, the overall risk aversion of our group can be classified as
very risky with an average Risk Aversion of 2 for our A value. Our risk-less asset was
chosen to be CitiGroups 3-month Treasury Bill, providing a monthly return of 1.65%.
Based on this risk aversion, we allocated 9.33% of our wealth to the risky portfolio,
with the remaining 90.67% in the risk-less asset. This combination resulted in a new
Sharpe Ratio of 0.621, which outperforms all the previous scenarios involving only
the risky assets.

Appendix
Table 1

Table 2.1

Table 2.2

Table 3

Table 4

Table 5

Table 6

Table 7

Works Cited

Lynch, Peter, and John Rothchild. One up on Wall Street: How to Use What You
Already Know to Make Money in the Market. New York: Simon and Schuster, 1989.
Print.