How to build a winning portfolio (or basketball squad)

John Reese is founder and CEO of Validea.com and Validea Capital Management, and portfolio manager for the Omega American & International Consensus funds. Globe Investor has a distribution agreement with Validea, a premium Canadian stock screen service. Try it.

You are the general manager of a basketball team. Your job is to build a roster of players, without going over your budget. In your search, you find a variety of talented prospects – big, strong, 7-foot-tall centres; small-but-lightning-quick point guards; smooth, athletic, sharp-shooting forwards.

When it comes time to pick, one of your top advisers pulls you aside and says, "Let's just focus on centres – we'll have our starting lineup be the best five centres we can find." Another of your advisers takes a different approach, "How about we pick a whole bunch of point guards? Only point guards." Still another looks you in the eye and says, "Forwards – we should only pick forwards."

You would, of course, be nuts to follow any of those pieces of advice. Good players come in all sizes; different players do well in different situations. Picking only centres limits the pool of talent from which you can choose, and leaves you with weak spots.

Unfortunately, when it comes to picking stocks, that's just what a lot of money managers do. Many mutual funds focus only on a specific "style-box" category – large-cap value stocks, for example – filling the fund primarily or entirely with just that type of stock.

To be sure, style boxes serve a purpose, particularly for institutional investors, who often are required to put a certain portion of their portfolios into certain categories of stocks. But for individual investors, I think style-box investing eats away at returns.

Why? Because, much as with basketball players, good stocks come in different styles and sizes; focusing on one style and size limits your opportunities to find winners. Sometimes, for example, the small-cap growth area of the market may be offering the most attractive values; other times, mid-cap value plays may feature the best opportunities. Why not allow yourself to go where the best opportunities are, regardless of size or value distinctions?

Much like basketball players, the size and style of a stock often means it will perform better in certain situations than others. Sometimes large-cap value stocks go out of favour, and a portfolio that is focused only on them will get hit hard. A portfolio that includes stocks of various sizes and styles, however, has some natural hedges built in, which should smooth out returns – and make it more likely you'll stick with your picks over the long haul.

This "free-range" approach is what I do with my Validea Hot List portfolio, which looks for consensus from all of my Guru Strategies (each of which is based on the approach of a different investing great) when choosing stocks. At any given time, the portfolio could be tilted toward smaller stocks or larger stocks, growth-oriented picks or value plays.

The strategy has paid off, with the 10-stock Hot List model portfolio having more than quadrupled the TSX Composite since the portfolio's inception on Aug. 6, 2010. This year, it's up 22.4 per cent (through April 18) vs. just 1.5 per cent for the TSX. Here are a trio of very diverse stocks that are currently catching the portfolio's eye.

Bank of Montreal : This large-cap value play has been in business nearly 200 years, and serves more than 12 million customers. It gets approval from my James O'Shaughnessy-based model. When looking for value plays, Mr. O'Shaughnessy targeted large firms with strong cash flows and high dividend yields. BMO's $38-billion market cap and $18.6-billion in trailing 12-month sales make it plenty big enough; the firm also is generating $1.83 in cash flow per share and has a stellar 4.7 per cent yield.

TransGlobe Energy Corp. : I wrote about this Calgary-based oil and gas explorer, whose efforts are focused in Egypt and Yemen, back in December. Since then, the shares of this small-cap growth stock have jumped about 80 per cent. My Joel Greenblatt-inspired model likes its 14.9 per cent earnings yield and 33.5 per cent return on capital. My Momentum Investor model, meanwhile, likes its strong recent growth (earnings per share grew 223 per cent last quarter and 157 per cent the quarter before that, compared with the respective year-ago quarters); its price momentum; and its 25.1 per cent return on equity.

Saputo Inc. : With a market cap of about $9.3-billion, Canada's largest dairy processor (and largest snack-cake producer) is a smaller large-cap or a larger mid-cap, depending on how you define the categories. It gets strong interest from my Warren Buffett-based model, which looks for firms with lengthy histories of earnings growth, manageable debt and high returns on equity (which is a sign of the "durable competitive advantage" Mr. Buffett is known to seek). Saputo delivers on all fronts. Its EPS have increased in all but two years of the past decade; it has just $38-million in debt versus $490-million in annual earnings; and its 10-year average return on equity is a solid 18.1 per cent.