The third quarter of 2018 has been an excellent one for my portfolio (PFAS) or so it would appear from the headline figures versus benchmark. The folio grew by 11.25% in the quarter (+19.75% YTD) compared to the closest benchmark, Fundsmith Equity, growing by 5.64% (+13.01% YTD) which both look impressive when compared to the FTSE All Share Total Return index which fell by 0.05% in the quarter (+1.10% YTD).

While I am pleased with these numbers, I think it is important to consider the risks that have been taken to achieve this outperformance. Most of the gain during the quarter can be attributed to my largest holding, Anglo Asian Mining (AAZ), which has risen around 50% over the period. If one were to strip out that holding, the remainder of the portfolio is around break even for the quarter, some risers, some fallers, with the two groups largely offsetting each other.

In many respects, this is how I have set my portfolio up; a diversified group of holdings that should outperform the market consistently with alpha performance provided by a small group of overweight holdings. If these overweight holdings perform well, then my alpha returns will be impressive but of course, I am ever mindful that the reverse is also true.

Not all of my larger holdings have performed well during the quarter, IQE has performed particularly poorly and Central Asia Metals (CAML) has only started to redeem itself in the last few trading sessions. Both positions are currently underwater. Fortunately, other large holdings fared better, notably Games Workshop (GAW), Bioventix (BVXP) and Victrex (VCT) in which I have top sliced some profits during the quarter, along with GlaxoSmithKline (GSK) and Fundsmith which both also help to manage the portfolio volatility.

I have no idea what the fourth quarter has in store for us. I have written recently about my unease with the macro environment and the possibility of a market sell-off, especially in the US. As for the UK, it’s not a frothy market but nonetheless, it is riddled with both Brexit and currency risk. Indeed, cash is now my third largest position, as per this article from a month ago.

In many respects, I am much more comfortable being overweight a handful of “special situation” holdings that I think will perform well, regardless of these macro factors and market risks. That does not mean they are without risk and on that basis, I thought it would be useful to run through my larger holdings and provide commentary on both my rationale for the holding/weighting and the main stock specific risks that I see.

Anglo Asian Mining (AAZ) – I am fortunate to have spotted the value being created at AAZ long before the confirmatory news was released a couple of weeks ago. Because I averaged up as the business milestones were accomplished and not least because of recent share price appreciation, I now have a significantly overweight position in this gold and copper miner, operating in Azerbaijan. My dilemma is I believe that while the re-rating has begun, there is a lot of scope for further share price appreciation.

Clearly, my position size is a risk. Shares in AAZ are usually volatile, although it would seem that liquidity is improving. The underlying commodity prices have been struggling recently and further weakness cannot be ruled out. Perhaps the most cited risk is “political”. While I accept that the company has an excellent relationship with the current Azeri government, it sits geographically in a part of the world that could see it drawn into conflicts or even a real black swan event such as regime change, for example.

Against this, the company currently yields at least 7% at the current share price and has material news flow due from mid-October through to the end of Q4 (and it goes ex-dividend on 12 October). It is a dilemma that I will be managing as we go through the quarter.

IQE – I shall not repeat the entire investment thesis for IQE but in short (see what I did there!), I believe the risk/reward is in my favour at the current share price, even though it is one of the most shorted shares on the UK market. Some positive news flow or event is required to arrest the current slide in momentum. I don’t know what the trigger will be – maybe the appointment of a new CFO, maybe raising guidance, maybe the purchase of additional capacity – but I believe my position size is at a level where I can live with the downside risk. This said, I certainly have a capitulation point with IQE – a point at which I will admit defeat, sell up and move on.

So probably the greatest risk with IQE (at the current price) is that I haven’t got the stomach to see it through. There is always execution risk, a chance that earnings might need to be downgraded (I believe this unlikely but I would never rule it out) or the prospect of increased competition that erodes the company’s first mover advantage.

Central Asia Metals (CAML) – The main risk with this established miner has to be the underlying base metals prices. If these recover, CAML is likely to be an early beneficiary as it is a low cost producer, paying a decent dividend. Beyond that, it is a mining operation and things can go wrong. And of course, there is also some political risk.

Bioventix (BVXP), Games Workshop (GAW), Victrex (VCT) – I have put these three holdings together to save repeating myself thrice over. They are all quality companies, with a strong moat. But they are all on relatively high valuations and will perhaps be hit harder than most if there is a market sell-off. If that happens, these would be the three companies that I would want to buy more of before the market realises that their businesses are largely unaffected by a weakened business environment.

In anticipation of this risk, I have top sliced all three holdings during the past month, following a decent run for all three. Any significant share price falls are likely to present a buying opportunity. Against this, there is always the possibility of a profit warning that might need to be navigated – in each case, my action would depend on the details behind the profit warning.

GlaxoSmithKline (GSK) – This holding ticks a lot of boxes for me – low volatility, decent yield, reasonable valuation and a transformative strategy with an improving balance sheet. In terms of short-term share price movement, currency risk or negative news flow (e.g. a drug failure) are probably to the fore. It is also a sufficiently complex business and covered by many professional analysts and therefore, the greatest risk is possibly that others will see something negative happening before I do and I will be left holding the baby.

Fundsmith Equity – This is another low volatility holding in which I am happy to maintain an overweight position. It is a large cap fund, globally diversified and has an excellent track record. The main risk is probably a market sell-off, especially in the US. While its holdings are likely to recover due to the fund’s quality orientation and focus on cashflows, it is an open-ended fund and customer withdrawals in times of market duress could be an issue, in extremis.

Somero (SOM) – I almost put SOM in the same group as BVXP, GAW and VCT in terms of quality but there are a couple of differences. I believe SOM is more cyclical than the other three and therefore, a key risk is a slowdown in the US economy and to a lesser extent, UK/Europe. They could also suffer in the event of trade wars escalating, although only 5% of revenues are from China. Against this, I believe the valuation is too low for a company of this quality, especially given a strong sales pipeline and a dividend yield in excess of 5% at the current share price. Too cheap – it is a quality share at a value price, in my view.

Cash – At it is now a top ten holding, I should mention cash in terms of risk/reward. I generally prefer to be fully invested but as I have written in recent weeks, I am nervous of a market sell-off. I could be wrong but cash gives me the benefit of sleeping better at night knowing that if it does happen, I will have sufficient liquidity to pick up some bargains. The downside of holding too much cash is that the money is not compounding and therefore, it presents an opportunity cost and is a direct drag on dividend income. Hopefully, this will be a short-term position – either the market sells-off and/or the US/China kiss and make up and/or Brexit is all very amicable. I know which one of those three I think is more likely.

If I could write the script for the fourth quarter, I would be hoping for a weaker pound against the dollar (Brexit) but a dollar that itself weakens against other currencies, especially gold. I’d hope that this trade war nonsense gets resolved, base metals prices recover and that there is a short sharp market sell-off that enables me to pick up some bargains in time for a Santa rally. Oh yes, and I’d also like a couple of juicy takeovers at 100%+ premium.

Alas, I am not writing the script, merely trying to navigate it. I will just have to content myself with a strategy that gives me a fighting chance of outperforming while being sufficiently agile to react to market events and company news flow.

In closing, I will mention that the Natural Yield of the portfolio has now risen above 4% which was my target at the start of the year. I am almost more pleased with this than the actual portfolio performance during the quarter – almost! As someone who now lives entirely from investment returns, the predictable cashflow from dividends provides a degree of comfort, especially when those dividends reach the level where they cover one’s living expenses. I am very pleased to have reached that particular milestone and hopefully, this will provide the foundation for me to continue compounding returns – forever!

Happy investing,
Simon (@BrilliantLeader)

Disclosure – At the time of writing, I own shares in AAZ, IQE, CAML, BVXP, GAW, VCT, GSK, SOM and Fundsmith which were all mentioned in this article.