‘Screening-out’ to Reduce your Opportunity Set

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On a recent Twin Petes Investing Podcast I mentioned the idea of an ‘Opportunity Set’ from which to pick Stocks, and I remembered that I had written a draft blog on this subject that I had not managed to finish with all the other distractions of life. From looking at the draft, I can see that I started this back in May 2019 so it has probably matured a bit and no doubt has a bit of mould on it !!
 
Most of what you will read below these opening paragraphs was written back then - so don’t get too hung up on the timeline if I talk about events which don’t make a lot of sense. It has just struck me that back when I wrote this draft we hadn’t even heard of Covid 19 !!
 
I hope you find it a decent and worthwhile read,
 
Cheers, WD.

I was out in the Jardin de Wheelie this afternoon (it is actually Good Friday when I am starting this draft and we are having a proper heatwave for a change and I worry that by the time you are reading this we will have slipped back to freezing arctic weather !!) and I think I was reading through the latest ‘Investors Chronicle’ (why is it that they don’t have an apostrophe or whatever you call it [one of these ‘ ] just before the last ‘s’ on ‘Investors’?), when the idea for this Blog popped into my head.
 
I am not sure precisely what triggered it (I might actually have been superstitiously shoving Tomato Seeds of the ‘MoneyMaker’ variety into Pots when the thought hit me), but anyway it struck me that ‘Screening-out’ the potential universe of Stocks you look at might be beneficial; but on the other hand, I think the angle that Investors Chronicle takes is to see it as a bad thing and that we should have a very wide ‘Opportunity Set’.
 
It really is a difficult one but I think I am coming down on the side of reducing my own Opportunity Set and in recent years I have been doing exactly this. In Investors Chronicle they are often saying that we should be investing overseas especially in the US and I guess if you invest in Funds then it makes sense to have Geographic Exposure and this is arguably a wise move to take advantage of the benefits of Diversification.
 
On the flipside though, it is obvious that if your Opportunity Set is too large then you simply have too many potential Investments to put your Money into and it just gets more and more confusing and there is way too much ‘Noise’ around such a wide-ranging approach for my liking. It also lacks any degree of specialisation and focus, which from my experience I have generally found to be a good thing in most endeavours.
 
This is a bit tangential but funnily enough in the same copy of Investors Chronicle (Dated 18th to 25th April 2019) I enjoyed a quality article by Phil Oakley @philjoakley (they always are) which was looking at Tesco TSCO and whether or not it was now a good Stock to buy. At the time of reading this, TSCO has a Forward Dividend Yield of 4.2% (Note: that is from the earlier draft and may not apply at the time this blog is published) and that looks quite appealing to me but TSCO obviously has several challenges.
 
Anyway, the point of this bit is that Phil writes a lot about the advantages that the Discounters, specifically Aldi and Lidl, have over the likes of TSCO and the ‘Big Boys’ like Sainsburys SBRY and Morrisons MRW, and the key point that leaps out is all about focus. This works in many ways for Aldi and Lidl and the key elements of focus are:

• Very limited Product Range and hugely less Products in each Store.
• Smaller Store size.
• Superior Buying Power from this focus and ability to motivate Suppliers to improve the quality of their Products.
• Cheaper Rents from Out of Town Stores.
• Limited choice is something that many Customers prefer - for example, the Discounters might only stock 3 types of Washing Powder whereas the big Supermarkets have whole aisles full of various different Washing Powder Brands - this reduces the exposure each Brand gets and just confuses the Customer.
• Lower costs resulting from Distribution in terms of storage, warehousing and deliveries to Stores.
• More efficient stock replenishment in Stores with many Products just wheeled in on pallets and plonked on the Shop floor.

 
This also reminds me of that effin’ Chef who swears a lot - Gordon ’b*stard’ Ramsey. He does this TV thing where he visits cr*ppy Restaurants that are losing loads of money and you can guarantee that his formula is the same on every episode - cut down on Menu choice and get focused and good at producing Meals the Customers want to buy.
 
So what I am saying here is that “Less is more”.
 
Retrenching back Home
For myself, in recent Years I have reduced my exposure to Unit Trusts and sold things like a European Growth Fund I had for years and years and also a Japanese Smaller Companies Fund that I held for the same time. I also sold a US Select Opportunities Fund some time ago and now I have only got collective exposure to Tech via the Investment Trust PCT and Health via the Investment Trust WWH (I used to hold a Technology Unit Trust and a Health Unit Trust).
 
Much of my thinking here is that I want to take more control of my Money myself and to invest it in Companies that I like and more and more those are based in the UK. I still have exposure to Paypal PYPL which is listed on the Nasdaq but that is the only directly Overseas Stock I hold now. I am not ruling out ever buying Overseas Stocks in the future but to be honest I can find more than enough great Companies over here to invest in so I just don’t see the point in bothering to look at Overseas Companies. My problem is too many Stocks to invest in even after cutting down my own ‘Opportunity Set’ considerably.
 
And of course investing in Overseas Stocks involves Currency Risks and the need to have a Broker which enables buying such Stocks. The position I hold in PYPL is actually done via a Long Spreadbet so I avoid the Currency problems because I am betting ‘Pounds per Point’ even though the ‘Points’ are in US Dollars. Another issue I find with US Stocks is that it just seems more difficult to find Information Sources I can rely on and of course they seem to present Financial Reports in a different way (I am sure they are supposed to be standardised across the World but I am not convinced that actually happens).
 
Focus on Quality
So in terms of reducing my choice of potential Investments, retrenching to the UK in the main has been part of my approach, but another angle is that by cutting out loads of types of Stocks because they tend to make very poor Investments, has the added bonus of reducing my Opportunity Set even more - and I am definitely of the view that more focus is a big positive.
 
What I am meaning here is that if you skip over to the ‘WheelieBin’ Page and look at the criteria I have listed there in respect of what factors tend to make very bad Buys, then simply by following what I have put there you can avoid a lot of garbage and at the same time increase your focus by reducing your own Opportunity Set to Stocks that are of much higher quality and are more likely to do well, and at lower overall risk.
 
This all chimes in with the infamous Warren Buffett saying that “It is better to buy a great Company at a fair Price than to buy a fair Company at a great Price”.
 
That is the essence of the approach I am moving towards more and more. I would far rather hold 20 Stocks which are 70% likely to make me a Return of 50% in a few Years than to hold 20 Stocks that are only 20% likely to make me a Return of 200% in the same time. The simple fact is that if you chase Bumper Returns then in reality you will actually achieve much lower Returns - you are taking on too much Risk (Note, in probabilistic terms the ‘Expected‘ Return [Expected Value] would be higher on the latter example but in practice this rarely happens).
 
I gain ‘Risk’ by using Leverage via a Long Spreadbet Portfolio and this is in effect a ‘mirror’ of my Normal Share Portfolio. This extra Risk I take on is intended to add a bit more Return but without the fraught problems of moving up the Risk Curve by buying poor quality and junky Stocks like you will find in the WheelieBin. I will include a Link at the bottom of this Blog to one that talks more about all this.
 
This ‘focus’ also has a side effect in that it makes for an easier life. More and more I want to do less and less on my Portfolio and I want Stocks which I can buy at a decent Price and then just point them in the right direction and let them go off like my own personal ‘Cruise Missiles’ and to seek out their own way to the Target of making me loads of money without me having to do much. I hate work.
 
Actually, that is a lie. “I love work - I can sit and watch it for hours……” (I think that was Jerome K Jerome who said that in ‘Three blokes in a Canoe’ but I might be wrong).
 
The full list of stuff I rule out is on the WheelieBin page but the highlights of the types of Stocks I just ignore are these:

• Resources and Mining Stocks - this is a slightly weird one because I used to do a lot more in this space but these days I find many more decent Quality Stocks that are not in these areas that I would rather put my money into. I am not entirely avoiding Resources Stocks and I actually hold Diversified Oil and Gas DGOC because it seems quite special and I did look at bit at Serica Energy SQZ the other day because that looks better than the usual AIM Trash - but on the whole I am not doing much in this area. Obviously the big problem with Resources Stocks (apart from their own operational and financing issues) is that they lack any kind of Pricing Power and they are very much ‘Price Takers’ and at the mercy of Commodity Markets.
• Certain Geographies like China, Russia, Africa, Bits of Asia like Kazach, all the ‘Stans’, Israel has some iffy Companies, tinpots in South America like Venezuela, Columbia etc.
• Biotech and Drug Development Companies – need immense patience although some do payoff. Trouble is it is often a painful experience and you can suffer many dilutions of your Holdings via Placings before they eventually come good.
• Anything under £50m Market Cap - I do buy smaller stuff but it’s rare and it needs to be special. I hold EU Supply EUSP at the moment which is an absolute tiddler but I quite like it (Note: that appeared in the earlier Draft of this blog and since that EUSP got taken over at a small premium. It was nice to be proved right, but the outcome was a disappointment although I made money).
• Loss making - I might buy something if it is on the verge of Profit but as a General Rule these kinds of things rarely make you money (they make other people a lot of money - in other words, the Directors, Rampers, City PR Companies etc.)
• Stocks that have recently issued Profit Warnings - these are usually best avoided until they are properly in Recovery Mode. Profit Warnings are often followed by at least another one a few months later and sometimes you get a string of the dreaded things !!
• Stocks in Major Downtrend Channels – momentum is an extremely powerful force and Stocks in a Downtrend can keep falling long after you think they should have turned up.
• Dodgy Sectors with regards to ESG stuff (Environmental Social Governance - we have discussed this a fair bit on recent TPI Podcasts) such as Tobacco and ‘Sin’ Stocks like Gambling and Payday Lenders etc. I don’t entirely rule these kinds of things out but Regulatory concerns seem to be getting more and more focus these days and causing more grief for people with money in such Stocks.
• Stocks with high levels of Debt - these Days I probably lean more towards Stocks which have Net Cash positions and I want Cash Generative Companies.

 
In terms of my preferred size of Stocks these days, I am probably more focused on the FTSE250 and FTSE Smallcaps and the quality end of AIM. I look less and less at FTSE100 stuff and if I do hold them, it would most likely be as a Holding for the very Long Term in my ‘Income Portfolio’ (if you skip over to my ‘Portfolios’ Page you can see what stuff I am holding now).
 
In the list of stuff I avoid, I mentioned Resources Stocks but I must just add in that there are some People out there who are very good at making money from these sorts of Stocks but the key to how to do it well is very much to be focused and to specialise in these Stocks and to understand the Industry and the processes of mining etc. very well. So what I am saying is that if you really do want to invest in this area then you would be best served to forget all the other Stocks and Sectors that are out there and to just get laser-focused on Mining Stocks – that way you are far more likely to be successful I would suggest.
 
Conclusion
I often mention in my Blogs how I enjoy writing stuff that is ‘new and different’ and that gets me thinking and hopefully gets WD Readers firing their synapses with new concepts and different ways of looking at things. I want the material on my Website to be totally unique and different so that Readers know they can get new ideas here and read things that are not the usual ‘run of the mill’ ubiquitous Financial Services Industry fodder.
 
I am sure this Blog has addressed that remit a treat and I am pleased that I have managed to think up an unusual subject to consider and it definitely ties in with some adjustments I have made to how I do things in recent years.
 
It’s certainly not a new idea to be focused and to cut out Noise to make the tasks involved in Investing easier and more effective, but I guess it’s the sort of things that simply doesn’t get said enough and it is certainly something Readers might do well to consider in the context of their own Approach and Methods.
 
Regards, WD.
 
 
Related Blogs
This blog should give a very clear high-level view of my Approach:
 
https://wheeliedealer.weebly.com/educational-blogs/the-pungent-essence-of-my-approach
 
I’ve talked about Noise a bit in this blog so it makes sense to point you in the direction of this epic blog series (there are Links to the earlier parts at the bottom of this one):
 
https://wheeliedealer.weebly.com/educational-blogs/enjoy-the-silence-cut-out-the-noise-part-3-of-3