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This article appeared in the September 2011 ASX Investor Update email newsletter. To subscribe to this newsletter please register with the MyASX section or visit the About MyASX page for past editions and more details.

See how this veteran investor allocates funds across different types of companies.

Photo of Ian Huntley By Ian Huntley, Morningstar

When I took on Your Money back in May 1973, having bought it for $1 from the late and great Jules Zanetti, I adopted a simple strategy learned from my uncle Jack, in between surfing with him in his 80s and betting at the SP bookmaker opposite the old Astra Pub at Bondi Beach.

He showed me his handwritten book-keeping of his equity investments and somehow taught me the way he did it with 50-60 per cent blue chips, 30-40 per cent second-liners (small and mid-cap stocks), and up to 10 per cent specs. I was a child of the '60s Poseidon boom and was lucky enough to preserve some of the winnings in my first home, a tactic I later described in the newsletter as the "squirrel principle" - to funnel spec earnings into blue chip equities, or houses, or the house next door.

Old Jack would reminisce about his specs. He got a lot of fun out of them and as I became more involved in financial journalism, I learned the crooked games some were playing. How dare these guys try to get my uncle, I thought, and other uncles too. He just smiled; probably smart enough to sell when the ducks were quacking.

The point was a good risk-management strategy. Blue chips can have the odd failure but most are well-established companies with the sense to maintain great balance sheets. As retiring Telstra CFO, John Stanhope, said of a previous Telstra and Rio Tinto director, John Ralph: "He told me that financial markets may move and shake, but financial fundamentals always remain the same: a strong balance sheet."

Over the years I listened to some sad subscribers and others bemoan that they put too much money into some shares. They were often specs, and they were carted because usually they were bought at the top of the market and not the deepest cellar, the only appropriate place to buy a spec. These people either were caught by greed or the greed of their adviser wanting commission in a high-rolling market, or like many, didn't have a clue as to the risk involved. More sadly, in the lead up to the GFC, management turned property trusts and some companies into highly geared specs, conning many an unsuspecting retiree.

A solid keel of "good" shares, those dividend-paying blue chips and somewhat more risky but still dividend-paying second-liners, means you should never lose all your money. They might fall 50-60 per cent in a major bear market, then mostly soldier on to great new heights in the next and inevitable bull market. That is assuming you have no debt against your portfolio. Specs may have more lives than a cat, but they don't necessarily soldier on.

Look after the downside first

First of all, the investor needs to understand the risk, just as a bookmaker assigns odds to the horses in a race based on their form and "anecdotal evidence." The business risk of blue chips is relatively low, second-liners somewhat higher. Specs, of course, often do not yet have a business, so their development stage is risky indeed, and speculation on glorious potential leads to high price risk.

I often find with share investments that go awry that the investor did not note the "high risk", for that is when you worry about the downside the most, whatever the potential upside.

That is the basis of all investment. The key to taking risk is to judge just what you can lose. It's about looking after the downside first, or preservation of capital. As per uncle Jack's risk weighting, you apportion your money in large licks to low-risk blue chips, the ones that provide reliable and increasing income over time to offset the softer ones. They should be bought at the right price, when the price risk is low, which is often when the press is screaming bad news and consumer confidence in equities is very low. Contrarian strategies are often the best. (Editor’s note: Contrarian investors take a different view on an index or security to the prevailing market sentiment; they might buy when others are selling, or vice versa.)

The "moat" advantage

Morningstar founder Joe Mansueto has long been keenly interested in Warren Buffett's thinking. In his early days in broking research Mansueto wrote his first report on Berkshire Hathaway, so it is not surprising that Morningstar has taken Buffett's phrase "moat" and used it as a major tool across equity research.

Mansueto said in an interview: "Buffett looks for companies that have a moat that shields them from competition and allows them to earn high rates of return. The moat is something that creates high barriers to entry for would-be competition." That is an excellent way of defining business risk.

There is a huge difference in the types of shares listed on exchanges. Some are the racetrack variety, which sometimes turn the market into a casino as per the Poseidon days or the late '90s blast. But when you learn to assess the business risk, and put away in your investment portfolio these "moat", or low business risk, companies, you are investing in good businesses that will last a long time.

Yes, higher-risk companies can offer excellent opportunities, but some people attempt to buy them at a greater, at times far greater, discount to fair value and allocate less capital to them than the lower-risk "good" shares. You have to stay on top of all investments, because things can change. A maverick CEO might suddenly load the company up with debt on poor acquisitions, or structural change may hit, as the internet thumped Fairfax.

Your "moat" companies are far less prone to slings and arrows than more lowly rated companies, always with balance sheet in mind.

The late Bernard Baruch (a famous American sharemarket speculator and presidential adviser) classified speculation as the art of spying out, going back to the Latin derivative, speculari, which means to spy out. That is really the definition of all investment, to spy out the risk, price for that risk, check the potential downside, then the upside, and buy at the right price.

Remember the twin instincts of fear and greed. Always invest in what you can readily understand, particularly the downside risk. And keep your cool. What did my uncle Jack really teach me? That the conservative tortoise would usually beat the hare.

About the author

Ian Huntley is founder of Huntleys' Your Money Weekly, part of Morningstar. Access a free newsletter trial.

From ASX

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