Rating your portfolio for the year ahead

If you had all your savings in cash today what stocks would you buy?   This is perhaps the best way to look at investment decisions.

People have the tendency to cling to losing stocks because they want to recover their initial investment back.   This is really not a healthy way to position a portfolio for the future.  Setting up for the year ahead involves selling your weakest names and looking for the best opportunities with the proceeds.

Let’s start by creating a five star ranking system for the stocks you currently own.   If you were to rank each individual investment with a star ranking (one being the least favourite and five being the best), how would your portfolio look?  To help with this exercise, rank the stocks on how you feel they will perform over the coming year (not on how they have performed).  Below is an example of how you could design your star categories.

One Star

Characteristics of this category would be stocks expected to lose money in the upcoming period.  The company doesn’t pay a dividend.  Analysts have either dropped coverage or have a predominately high sell ranking on the stock.  Stocks in this category may be in jeopardy of being removed from key indices because of declining market capitalization.  No clear direction from management on how the company will turn itself around.  Environment or conditions are not favourable for the company.  Investors should be concerned about the stocks long-term viability to remain as a going concern.  Recommendation for a one star stock is to sell immediately.

Two Stars

These stocks will have declining earnings in the upcoming period.  If the company is currently paying a dividend, it may be in jeopardy of being cut or cancelled.  Stocks in this category may have significantly declining fundamentals.  Companies in this category often have low cash levels or a high debt to equity ratio.  Recommendation for a two star stock should be to sell.

Three Stars

Stocks with earnings that are not expected to grow or decline significantly in the coming year.  In some cases these stocks may have been four and five star funds but have lost their shine.  In other cases they could have fundamentals that are improving.  People who are looking for longer- term stocks may see opportunity in this category, but likely not in the year ahead.   In other cases, this category may include stocks that have increased in value and you see very little additional opportunity in the year ahead.  Recommendation for a three star stock would be to consider mapping out a sell strategy.  Setting a limit order at a slightly higher price may be one strategy, or a stop loss order to protect profits.  We recommend you begin looking for switch ideas.

Four Stars

Analysts typically come out with a buy, hold, or sell recommendation on the stocks they cover.   In my opinion, the four star classification would be comparable to a “hold”.  Stocks in this category may have good earnings and growth; however, the valuation of the stock price may not justify this being a four or five star stock.  It is important that investors look at the market price of their stocks in this category to determine if it is amongst the best priced stocks to currently own.  Even great companies become over valued.  Recommendation would be to monitor the stock and possibly set a higher sell limit order if the stock continues to appreciate in value.

Five Stars

This category would include those stocks you feel are the best to own for the year ahead.  Be careful not to just include stocks that have done well in your portfolio in the past. Characteristics of this category are stocks that have a high overall expected rate of return for the year ahead.  This could be through both an increasing stock price and dividends.  It is typically a good sign when you are projecting that a company may increase their dividend.

Hopefully your portfolio has more four and five star positions.  The exercise helps maps out those stocks that you should sell either immediately or map out a plan to sell.  You will also be able to determine the estimated cash proceeds from those sells.

We also recommend you look at the tax benefits or consequences of selling.  Tax loss selling is something that every investor who has non-registered investments (cash or margin account) should look at this time of year.  You may be able to obtain some tax benefits by selling your under-performing positions.  When you do this analysis you should first look at whether you can reduce current year taxes, and second whether you can recover taxes paid in the previous three years (if you have net capital losses in the current year).

Whether you are dealing with current cash on hand, or proceeds from sells, the next step is to look at the best stocks to buy for the upcoming year – we will call this your wish list.  If we use the same classifications as above, then your focus should be on five star positions.  Investment advisors can discuss investment ideas that meet your investment objectives and risk tolerance.  Advisors also have various tools including access to fundamental and technical analysis screening tools, and internal and external (third-party) research.  Advisors also have the tools to map out expected income, sector analysis, risk levels, and how certain choices would be correlated to the stocks you continue to hold.

Comparing your current stocks to what you would buy today if you had 100 per cent cash is a great exercise.  The decisions on what stocks you sell can be as important as what you buy.  Creating a five star ranking system today can help you on both the buy and sell sides.