Building a UK Equity Portfolio: Part 1
Why bother picking stocks?
One of my goals in starting this Substack was to shine more light on investment opportunities in the UK given a decade of dire news. It seemed a good time to do this with attractive valuations set across a more stable economic and political backdrop.
I also wanted to do it for personal reasons. To keep my brain ticking away while avoiding full time employment, and to set up my own portfolio having worked in and around the investment industry for many years, but never been the investor myself. I was also convinced that amid the 1,000+ listed UK companies there must exist some that defy the Jurassic Park stereotype of aging banks, miners and oil companies.
Since then, I’ve meandered on the opportunity part. Austerity in Hindsight and The Slow Death of the UK Stock Market hardly painted an optimistic note; and I’m sure I will continue to be distracted by rudimentary commenting on economics, politics and local authority property portfolios.
But I do now want to re-focus on investment opportunities and I’m going to do that by telling the story of building my own UK equity portfolio.
Should you bother picking stocks?
Before getting into how I plan to do that, let’s address the question of why bother at all.
Historically I’ve invested in the stock market via low-cost index funds (also know as passive). These are investment funds that replicate the holdings, and therefore track the performance of, an index such as the S&P 500 or FTSE 100. I’ve held a mix of US, emerging markets and UK-focused index funds.
The reason for doing this is well known. Passive funds outperform active funds - very much so in equity markets, a little less so in fixed income.
Sure, in any one year some active funds outperform the index, e.g. in the first six months of 2024, 43% of all active large cap US fund managers outperformed the S&P 500, and around 85% of small cap managers outperformed the S&P SmallCap 600.1
The problem is that this outperformance is not persistent. Successful managers in one year are not the same as those in the following year, and so on and so on. And so, by the time you get to 10 years and beyond, only around 20% of small cap managers outperform.2
Active funds, in which people try and pick the best stocks, simply do not live up to their billing. Investors end up being charged higher fees for worse performance.
Why is this? Well, partly it’s because of those fees. Once you net off the higher fees paid for active managers with their bevy of analysts and research staff, your average active fund underperforms your average passive fund.
It’s also a function of structure and incentives. It seems a blindingly obvious point to make but if you’re running a portfolio investing in FTSE 100 stocks then to outperform the FTSE 100 that portfolio needs to look materially different from it. But when you’re judged on performance relative to the FTSE 100 there is a high price to pay for that deviation.
Combine that with a need for liquidity to manage daily client inflows and outflows from the fund, and historically a typical active equity strategy of the kind easily available to individuals, might hold a portfolio of 50 to 100 names. Once you get to that size much of your performance is just replicating the market – and then those higher fees versus passive kick in and you’re better off with an index fund.
Which leads me back to the original question of why bother picking stocks at all?
The honest answer is that for most people, I don’t think it’s worth the time and effort. As I’ve written before, investing really needn’t be that complex. Putting whatever amount of money works in a low-cost index fund, reinvesting the dividends, and forgetting about it for as long as possible (particularly if, and when, the market lurches down!) is the advice I’d give to most.
For others though, I do think it’s possible to outperform an index, but only if you invest a certain way – a concentrated, best ideas approach. Call it a private equity approach to public markets. A small number of holdings with high conviction.
The good news is that I think individuals have some advantages over professional managers in doing this. That’s because as an individual you can hold a highly concentrated portfolio because you don’t have to answer to external investors (whether you want to is another question); and you don’t have to worry about selling holdings to meet withdrawal requests (unless you have a lot of money and/or are investing in teeny tiny stocks).
All that means you can beat an index – as evidenced by the stream of Substack-ers with newsletters highlighting their double digit outperformance vs. said index. You can also massively underperform, but people tend not to brag about that so much.
The other reason for investing in individual stocks is that the investment process itself can be fun. Learning about companies and industries, doing your own research, taking some risk. For me there’s also something about putting your money where your mouth is. I can sit here and write about the UK; I can do it a lot more credibly if I own some UK firms.
So that’s why I plan to set up a UK equity portfolio and be honest about how it goes, for good or bad. It’s also why most of my money will remain in widely diversified funds!
Next week I’ll go into more detail on the process for picking stocks.
Thank you for the article food for thought. I do however, believe the lack of pension funds investing in the UK market is a real problem whether it be throughit be direct, trusts or EFTs
Great substack, Vicky - will follow with interest! Still can’t help but think UK markets will continue to lag US, but look forward to the individual picks. Smaller UK listed software companies seem massively underpriced vs peers, and keep getting delisted by PE. I wish I had more time to look at them properly!