The Motley Fool's Sonia Rehill trawls through her inbox for more of your investing queries in this week's Ask a Foolish Question podcast. Sonia is joined by David Kuo once again. Listen for a special appearance by Nate Weisshaar, too, when the two analysts ponder the problem of an unwieldy portfolio.
Elsewhere on the menu this week, we look at how to achieve the perfect diversification with just one investment, what a P/E ratio is exactly, how to find out about convertible shares, and the mystery of a disappearing company. If there is a question about investing that you would like answered, please email Sonia at firstname.lastname@example.org.
You can download or listen to this podcast here.
EDITOR'S NOTE: What follows is a lightly edited transcript of episode five of the Ask a Foolish Question podcast.
Sonia Rehill: Welcome to Ask a Foolish Question, The Motley Fool's podcast dedicated to help answer all your investing questions. I'm Sonia Rehill, and with me is David Kuo, to educate, amuse, and enrich us all. Hello, David.
David Kuo: Hello, Sonia! Right, how do you like this new shirt I'm wearing today?
Sonia: It's lovely, David, but you've got a mark on it.
David: It's not a mark, Sonia -- that is lunch. I'm having that later on.
Sonia: Were you dribbling?
David: Right, are we going to start with the first question, Sonia?
Sonia: We are indeed, so you know how this works?
David: I do know how this works.
Sonia: Are you ready?
David: I am ready.
Sonia: We have lots of good questions in our investing mailbag this week, David, but we have a fantastic question about portfolio management that everyone can take part in.
David: Ooh -- I can't wait for that one.
Sonia: More about that later -- let's start with our first question, from Simon. He wants to know, what is a P/E ratio, and how do we interpret it?
David: OK, the P/E ratio is just a very simple way of measuring how expensive a share is. If we think of the E as being profit; in other words, what we're saying is, how much profit does this company make, and if we then compare the market value of that company by dividing the market value by the profit, we end up with the P/E ratio. So let's take, for example, a company that makes a profit of 1 million pounds, and it is on the market at the moment for 15 million pounds. We would then say that this company has a P/E ratio of 15 divided by one, which is equal to 15. Now, is this expensive, or is it cheap? Well, if you have a look at the market as a whole, the market is, here in the U.K., is worth around a P/E of about 11 to 12, so therefore a P/E of 15 is a little bit more expensive than the market. But, whenever we look at P/E ratios, we shouldn't look at it in isolation; we should really be looking at the profit that the company makes today, and whether or not it is going to make more profits tomorrow. Now, if we just simply say that the company is making 1 million pound profit this year, a million pounds next year, a million pounds the year after -- in other words, there is no change in the company's profitability, then it would take us 15 years, if we were to buy the shares, to get our money back. Now, some people might say, that is quite expensive. If we then take a look at this company, and it makes 1 million pounds profit this year, 2 million pounds the year after, 4 million pounds the year after that, 8 million pounds the year after that, then we could say that, well, if it makes 1 million pounds, 2 million pounds, 4 million pounds, and 8 million pounds, then we would get our money back in four years, because if you add them, up, 1 + 2 + 4 + 8 = 15. So then we would say, this company is not really that expensive, because the profits are growing quite quickly, so all we can say is that the P/E ratio is a very shorthand way of looking at how expensive a company is, but to understand the P/E ratio, we then have to look at the profitability of the company, and how much profit it is making in future years.
Sonia: OK. My next question is from Keith. He wants to know, where can you get information about convertible shares and prices, with the terms and conditions of exercising?
David: Let me start by explaining what convertible shares are. These are shares that you can buy which convert into ordinary shares at any time, and at a fixed price. They usually pay in interest, but not always. Unfortunately, Keith, there is no one-stop shop; in other words, there is no one place where you can go to get all the information at one time, so what you need to do is to try and have a look to see first of all, whether or not a company does offer convertible shares. Now, I'll give you an example of how you can go about doing that. If you go to the fool.co.uk website, at the very top there is a search function there. If you type in, for example, a company called Balfour Beatty (LSE: BBY.L ) , type that into the search function, then what you will find is, on the right-hand side, will pop up two price quotes. One is for the Balfour Beatty share price, the other one is for the Balfour Beatty convertible share price, so that will tell you that Balfour Beatty not only has ordinary shares, but also convertible shares, and they will both have completely different prices. If you then click on the convertible share price, it will tell you what that share has been doing over time. Then what you will need to do is to go to the Balfour Beatty website, and read up on those convertible shares -- when do they convert? At what price do they convert? So you have to look at the underlying conditions with regards to the convertible shares. So unfortunately, Keith, I can't really help you with a one-stop shop, but you will have to look at each company that you may be interested in to see first of all whether or not they have convertible shares, and after you've found out that they have got convertible shares, what the terms and conditions with those shares are.
Sonia: Sounds like it's pretty long-winded?
David: It is unfortunately quite long-winded, but convertible shares tend to be a little bit more sophisticated, so therefore it isn't really for the ordinary shareholder.
Sonia: My next question is about diversification. Levin, from Munich, is searching for the ultimate diversification in one thing, and asks: how can he invest in as many different assets as anyhow possible by just one investment? For example, the Russell 2000 is a nice index, because it consists of 2,000 small-cap companies, but it is restricted to the US. He also suggests funds of funds, but he doesn't only want to invest in shares and equities, but also in metals, real estates, commodities etc, and of course he doesn't only want to invest in Europe, but all other countries of the world. What should he do, David?
David: Good grief! -- Levin, you don't ask for much, do you? OK, as far as I'm concerned, one of the best indexes to follow is the FTSE All-Shares index, simply because the FTSE All-Share index not only includes U.K. shares; in other words, companies that make their profits from the U.K., but companies that make their profits all over the world. In addition to that, the All-Share index not only contains large caps, but small caps as well, so you're getting a great diversification there geographically; you're also getting a lot of diversification in terms of the sizes of companies that you're invested in. On top of that, you also have lots of different companies within the FTSE All-Share index, so you will have your oil companies, you'll have your miners, you'll have your retailers. You'll have your boring banks, you will have your utility companies; you'll even have your real estate investment trusts. So there's all kinds of things grouped into one index called the FTSE All-Share index. Now, you can track the FTSE All-Share index through an ETF, or if you were to buy a fund. Personally I would go down the ETF route, and just say that, if I'm interested in this, I will drip my money into the FTSE All-Share index, and then you will get geographic, you will get company diversification, and you will also get sector diversification, so you will get all the things in one index.
Sonia: OK. Michael asks a quick question about his shares in Screen plc, which he purchased in 2001. He has the share certificate, and wonders if they are still valid, as Screen plc was acquired by the Petards Group.
David: OK, I have some bad news for you, Michael, because I've done some digging with regards to Screen plc. The company, as you quite rightly said, has changed its name to Petards Group, and the new ticker for Screen plc is PEG. Now, what happened in the case of Petards Group was, in 2011, the company consolidated its shares. So for every 10,000 shares you had in Petards Group, you will now get 100 new shares; in other words, there was a 100 to one consolidation. Now, according to the company's own report, it reckons it has over 14,000 shareholders, of which 13,500 had shareholdings of less than 10,000 shares. Unfortunately, those 10,000 shares that you would have had would only be worth 35 pounds. As far as the company is concerned, what they also said was, if you were to sell these shares, because of all the dealing costs, they wouldn't be really worth anything at all, so unfortunately, Michael, your Screen plc shares, unless you had over 10,000, they're not really worth anything right now, but what I do suggest you do is to contact the registrar of the company , tell them how many shares you have, and then they will just confirm that, because of the dilution of the shares or the consolidation of the shares, they are not really worth a great deal right now. I'm sorry, Michael.
Sonia: Oh, no! So, moving on, Ollie has a question about property versus pension. Is it too big a risk to own rental property instead of a pension? He has a couple of rental properties bordering on negative equity, but generating a healthy income. He is in his early thirties and has no pension -- this concerns him. Due to the amount of debt on these two properties, he sinks all his profits and any spare cash into paying off the mortgages. Continuing in this way, it will take him 15 to 20 years to pay them off, at which point he'll be left with those properties mortgage-free-but no pension. Is this too big a risk, putting all his eggs into one basket?
Sonia: OK, would you like to elaborate, David?
David: I would love to elaborate, Sonia. Yes -- I think whenever you put all your investments into one asset class, it is too big a risk to put all your eggs into one basket. So what I do suggest, Ollie, is, if you have got some spare cash, to try and diversify as quickly as possible. I am a little bit concerned about your negative equity, because while at the moment you seem to be doing OK, your big problem, I think, will be when you decide to go and get a remortgage for your property. When you have to renew your mortgage, your lender will be saying to you, how much equity do you have in this particular property? And they may not look upon it as favorably as they did previously, when you are in negative equity. So you are doing the right thing with regards to throwing any spare cash you have into paying off the mortgage, because that will help to avoid you getting into negative equity when the time comes for remortgaging, but at the same time, I would really advise you to try and also diversify as quickly as possible into other asset classes, and since you already have property, look very seriously at cash, look also very seriously at shares, because what you want is as wide a portfolio as possible.
Sonia: Also he's in his early thirties, so he has got lots of time to build up quite a good pension, I would think.
David: He has got a lot of time to build up his pension, but as I say, my big concern about Ollie is the negative equity that he is in. There was a time when lenders wouldn't really think twice about giving you a remortgage, simply because they had so much money to spare, but when you are in negative equity, and the banks are very reluctant to lend, then I think this could be very problematic.
Sonia: OK. Now for my final question, the one that you have all been waiting for, about portfolio management.
David: Finally, Sonia -- finally we're getting to the most interesting question of the day.
Sonia: A listener emailed us a breakdown of her portfolio of 16 shares, with a total value of around 190,000 pounds. She thinks she is sitting on a loss of around 150,000 pounds, and would like to know what we think. I'll post this portfolio on fool.co.uk/podcast, if anyone would like to see it. Now, there's lots of views about how to manage a portfolio of shares, and rarely will two analysts be able to agree on how to do it, so just to show you how difficult it can be, I have invited Nate Weisshaar, senior analyst on The Motley Fool Share Advisor service, to join David in reviewing this portfolio. Welcome, Nate.
David: Yes -- can I just interject here, Sonia, and just say that there is a right way and the Weisshaar way. Mine is the right way; Weisshaar's is the wrong way.
Sonia: Can you let Nate say hello first?
David: I can let Nate say hello. I thought I'd just jump in with that, before he starts.
Sonia: Welcome, Nate.
Nate Weisshaar: After that wonderful introduction, hello everybody.
David: Hello, Nate -- how are you?
Nate: I've been better!
Sonia: So before we look at this portfolio, Nate, please can you describe your style of investing?
Nate: I'm pretty much a generalist. I do like to find growth in the shares that I invest in, but I won't shy away from a good dividend yield, and my portfolio has a decent mix. You'll find a couple of companies yielding 4 to 5% in my portfolio, but I've also got some shares that are a bit more of the, on the risky end, with an eye toward long-term, strong growth.
Sonia: That's great. David, how would you describe your style?
David: Well, I'm strictly dividend -- I'm strictly a yield investor. If a company doesn't pay a yield, it doesn't deserve a place in my portfolio -- it's as simple as that. I don't believe in this speculation of whether or not a company is going to be producing higher profits tomorrow -- I need to see tangible things, I need to see those dividends, so I can then discount those dividends back again, so ultimately I am a dividend investor.
Sonia: OK. Nate, you've seen the portfolio -- what do you make of it?
Nate: Well, if this person has expertise in the mining or energy fields, it's a wonderful portfolio, but it's very concentrated. You have exposures to banks; miners, mostly gold miners; and oil companies. That covers three of the 10 general industries in the market. So in order for this portfolio to be appropriate, the person should either have a specific outcome they're expecting -- gold prices going through the roof, oil prices going through the roof, or they should have some personal expertise in the fields in which they're investing, because despite being spread across 16 shares, it is a, in my view, a pretty concentrated portfolio, because you're exposed to very specific industries and very specific segments of those industries.
Sonia: What about the actual allocation?
Nate: Well, there's some heavy allocation in Barclays (NYSE: BCS ) , which dominates the portfolio, and then Heritage Oil (LSE: HOIL.L ) , which is the second largest exposure. So with those two taking up nearly 40% of the portfolio, the rest just kind of go along with that theme, as I said. With all of the companies, they are all tied, or several of them are tied to three specific investment themes. So allocation-wise, for a general investor who isn't going to spend a lot of time looking at their portfolio, I would call this far too concentrated, for allocation.
Sonia: And high risk?
Nate: Oh, yes! Some of those oil plays are pretty binomial -- they'll either hit or they will miss, and so far several of them have been missing.
Sonia: So she thinks she is sitting on a loss of around 150,000 pounds -- how would you redress that? If it's possible to.
Nate: You can't look at your portfolio and say how much you're down. To make good investment decisions, you have to always be looking forward, so where you bought the shares is irrelevant, once you've purchased them. What becomes relevant, every time you look at your portfolio, is where you think those companies are going to go in the future. If you still think your purchase of Heritage Oil was a good one, and you think the company's prospects are still strong, then the fact that you're down right now is irrelevant -- you think it's still a good investment. However, if your point of view has changed, and you think the company's prospects have evaporated, then the fact that you're down 10, 20, 30% is irrelevant, because you can always go to zero, so it's better to cut your losses if you think the prospects for the company have changed.
Sonia: OK, David -- what do you make of this?
David: Well, personally, when I look at this portfolio, I find that six companies in this portfolio do not pay a dividend. So the dividend side of me would say, let's cut those six companies, because I'm not getting anything from this investment. But having said that, I do agree with Nate in the sense that you mustn't look at what you paid for a share if you want to carry on holding the share, and I'm going to give the listener the benefit of the doubt here, because when I look at this portfolio, the first thing that strikes me is, what is the objective of this investor? I don't understand what this investor is hoping to gain from the portfolio. If it is income, it is not succeeding; if it is growth, I don't think it's succeeding there either. But if the purpose of this portfolio is to create an eclectic mix of shares, then yes -- I would say it kind of makes sense. The only problem, of course, is the asset allocation side. So, what I've done with this portfolio is to say, let's allow all the shares to remain in the portfolio, but with two very important criteria, the first one being that no shares should have more than 20% allocation in total within this portfolio, and they shouldn't have less than 5%, and by doing that I end up with what I hope is a cleaner portfolio, so no share is less than 5%, no share is more than 20%, and then from that I put it into a spreadsheet, pressed the button, and it comes up with an allocation which hopefully you'll be able to see on the podcast web page, and then you can compare my model portfolio with what this person started off with. Again, I pay no attention whatsoever to what was paid for these shares, because I'm only interested in what is likely to go forward. What I have to say is that this is simply my solution; it is not the solution, because ultimately Nate will have his solution, and listeners will look at this and have their own solution, so there is no one-size-fit-all solution for this particular problem. It really depends on a number of things.
Sonia: Do you have anything to add, Nate?
David: Apart from the fact that you're wrong, Nate.
Nate: I think, given the guidelines you've set out, that's a decent approach to reallocating the portfolio. However, I think the guideline of keeping all the shares in the portfolio is a bit strict. I personally would reevaluate the shares, and look at the companies that you think have the best opportunities going forward, and the ones that you're no longer optimistic about, or have no idea what they do, they should be gone. They should be cut out of the portfolio.
Sonia: Despite the losses?
Nate: Despite the losses. You have to look at your objectives. If this is a portfolio you want to buy and set aside, then if you don't know what the companies are doing, they don't belong in that portfolio. That should be a rule all the time. But if you're looking at companies that could have significant events that alter their value, a miner whose mine no longer produces, or an oil explorer who comes up dry on all their test wells, if you're not paying attention to this, you will have ugly surprises when you go back to look at your portfolio. So I would say, if you don't know what these companies are doing, and how you think their prospects stand, they need to be cut out, and you need to put in companies that you understand, and from David's income standpoint, there are several good yielding companies across the remaining seven industries. They'll give you some diversification and allow you to maintain income. Just looking at the largest players in some of the other main industries, consumer staples -- you can gain decent income from Unilever or Reckitt Benckiser; health care -- GlaxoSmithKline; telecoms -- Vodafone, but those are just big names that pop to mind. There's no rule that says you have to stick to the large caps, but again it takes a little more effort if you're going to find the smaller companies that you think are appropriate for your portfolio. But I think the guideline of maintaining all shares in this portfolio as it stands, unless there's a specific goal, to play rising gold prices and rising oil prices is an artificial rule that is not necessary, and probably detrimental to the long-term performance, or long-term peace of mind, for this investor.
David: Can I also add that this happens to many private investors, and even some professional investors. What you do is, you start off with good intentions, you buy a few companies, and then you pick up the newspaper, you hear a tip, and you think, oh -- maybe I should put a bit of money into that, and before you know what's happened, your portfolio gets very unwieldy, it gets very, very complicated, and then you don't know where you should start or where you should end, because it just happens. I remember reading a book by a hedge fund manager called Michael Steinhardt. The book is called No Bull, and it happened to him as well. He just started buying little bits and pieces of investments which he thought made good sense at the time, and then after about ten years or so, you suddenly look back and you think, why did I buy that in the first place? I don't know, but let's just leave it in there anyway, in case it actually does something. His solution to the problem is actually very radical. What he did was, he said, I'll sell everything, and then I'll start afresh. I'll start with a clean sheet of paper, and think about the companies that I want to put in there. So maybe, in some cases, I don't know if you agree with this, Nate, but in some cases, like this portfolio, the best thing might be to liquidate the whole lot, and then start off with 150,000 pounds of cash, and think, how am I going to allocate the money to various shares in this portfolio -- what do you think about that?
Nate: I think it is radical, but I don't disagree with it at all. I think that a lot of investors do find themselves just, if they haven't looked necessarily at their whole portfolio in a while, they'll open it up and see shares that they're not quite sure where they came from, or why they're there.
David: It just seemed like a good idea at the time to buy it, yes.
Nate: That's always the excuse, so yes, it is radical, as is the idea of not looking at your losses. So those are two radical ideas we've introduced here that most investors probably wouldn't be comfortable with, but I think they're good steps for successful investing going forward. You need to always be willing to re-evaluate your previous decisions, and see if you still agree with them. If not, they need to be booted up. A full-fledged purge of the portfolio is an extreme version of that, but I wouldn't call it wrong in any sense. But moving forward, any investor should at least somewhere write a note as to why they bought a share. That way, when you come back, and you look at your portfolio and say, whoa -- Heritage Oil, what's that? Then you can have a note somewhere that says, oh -- that's why I bought it. Is this still valid? And then you can re-evaluate the company at that point, and say, OK -- I still think this is a hold; regardless of the loss, I'm still holding onto these guys; or, if you read the note and it makes no sense to you at all, if the world has changed to the point where that company's prospects are no longer bright, then that note will help you realize that that's time to cut bait, and painful as it may be, take the loss and put the money somewhere more effective.
David: I'm glad we agree on something, Nate.
Nate: Every once in a while!
Sonia: So I think there's a lesson here in reviewing your portfolio. How often do you guys review your own portfolios?
Nate: I review my portfolio at least annually, just for tax reasons. I think quarterly is probably a little too frequently, but I would say at least annually.
Sonia: OK, and you, David?
David: I review mine annually as well, but what I do do is, the companies that I'm interested in, I do follow the prospects of that company, so that when the RNS statements come out, when the quarterly trading updates come out, I do read them, and think, is the thesis for this company still the same as when I bought it? -- so going back to Nate's advice about keeping a journal of the companies that you're interested in. I of course read the annual statements, I of course read the quarterly updates, and then I try and find out whether or not I'm still comfortable holding onto this company. If I am, and the share price has fallen, then that is completely irrelevant, but if the reason why I bought the company was for the dividend yield, and the company has cut the dividend, then I would change my idea about that company.
Sonia: Well, thank you, guys. Is there anything more that you would like to add about this portfolio?
Nate: I would just like to apologize for offering up the wrong answer to David.
Sonia: I'm glad you did -- one of you has got to be wrong. But actually...
David: No, we could both be wrong -- that is the whole point. We could both be wrong.
David: Or we could both be right.
Sonia: Exactly, well ... I'd say the biggest takeaway for our listeners is that there is no right or wrong way to invest, but you do need to figure out your own investing style, and know why you're investing in a particular company. As Peter Lynch once said, "Never invest in any idea you can't illustrate with a crayon."
David: Where's your crayon, Nate?
Nate: It's just a nub these days.
Sonia: Now, if you would like to tell us what you would do with this portfolio, you can comment on fool.co.uk/podcast, and if you have a burning investing question you'd like us to cover next time, please email me at email@example.com. You can also find out more about diversification and sectors that our analysts are watching by downloading a free special report called "Top Sectors for 2012."
Thanks for listening, and until next time, happy investing.