This article on How to Build a Good Value Investing Portfolio with Limited Capital was written by Colin Richardson. Colin is a private investor based in Alberta, Canada. He focuses on applying a quantitative strategy to eliminate behavioral biases in his personal account. Article image (Creative Commons) by Stevepb, edited by Broken Leg Investing.
Are you stuck trying to build a good value investing portfolio with limited capital? You’re not alone—everybody has to start somewhere! Whether it’s only $100, $1,000, or $10,000, don’t be deterred. Tiny portfolios actually allow you to earn far higher returns than you could if you were trying to invest millions of dollars.
There are a few different ways to build a good value investing portfolio with limited capital. All three allow you to embrace the small investor advantage, outperform Wall Street, and grow your assets. Which strategy should you follow? That depends on you and your situation. I’ll explain …
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Are There Any Better Options?
Before we start, let's identify some other ways your limited capital could be used to purchase stocks. In our opinion, these common options seem great at first, but have some serious drawbacks.
The first—and easiest—option would be to purchase an index fund. This is a great way to ensure that you mostly keep up with the overall market net of fees. With that said, it also guarantees you never outperform the overall market either. The S&P 500 has a historical real return of about 7%. If you put $1,000 in this index and compound it every year, it would take just over 10 years to double your money. That is also assuming the market goes up for the entire decade—something we can never guarantee. Some would even argue, index investors are setting themselves up for poverty in retirement. As value investors, we believe the market is beatable, and settling for an index fund doesn’t make much sense.
Probably the most common method of investing in stocks is through a mutual fund. However, this does not mean it is the best way to spend your limited capital. Unfortunately, mutual funds often come with expensive management fees. Too much of your money goes towards paying the fund manager and not investing in stocks. Not to mention, mutual funds tend to underperform index funds. It will take even longer to grow your money!
Lastly, you could give your money to a financial advisor. They will handle the entire investing process on your behalf. Sounds great right? Not so much. Most financial advisers have no interest working with your limited capital. Their commission would not be great enough to justify the effort they put it. Most are only interested in working with high networth clients. Even if you do find a financial advisor, you are still faced with costly management expenses.
If you are serious about investing, it is best to forget about index funds, mutual funds, and financial advisors. As a small investor, you owe it to yourself to leverage your biggest competitive advantage: your size. Working with a large amount of money restricts you from purchasing the small capitalization companies. When value investing, this is a huge disadvantage because it is these are companies that face mispricing most often. Also, small investors have the ability to use stock strategies (like net net investing) that are out of reach of money managers and large private investors. Your limited capital sets you up for success more than you may realize!
Three different strategies allow you to do this as well as build a good value investing portfolio with limited capital. Each has advantages and disadvantages you should be aware of. Select the method that you feel fits your personality, temperament, and investing style best.
Strategy 1: Build a good value investing portfolio with limited capital by picking and choosing from among the market’s best
The first strategy is also probably the most advanced. Don’t let that scare you, though. If done correctly, it can provide the greatest returns. Implementing a qualitative approach, you purchase only the best situations. This means your limited capital portfolio will only consist of 4-8 companies.
The most challenging part of this strategy is identifying companies with the highest likelihood of success. This is a process that should take multiple hours to complete. It is important that no minor detail is missed as it may be the difference between a successful or failing future. There are some positive indicators that will better your chances. These include stocks selling at a discount to liquidation value, low debt/equity ratio, a catalyst in the near future, or insider purchases.
The advantage to this strategy is that a large portion of your money bets on a probable situation occurring. When it does, you are set to profit and your capital grows. The disadvantage of the strategy is that if the situation does not get better—or gets worse—your large portion gets smaller. Only use this strategy if you truly feel confident in your ability to pick the best companies. And, to increase the odds of success, it’s probably best to focus on a group of stocks that already have a reputation for fantastic performance, such as the net nets over at our sister site, Net Net Hunter.
Strategy 2: Build a good value investing portfolio with limited capital by buying everything (almost)
The second strategy takes the opposite track of the first. Using your limited capital, purchase a diversified portfolio of companies and let the statistical returns associated with your strategy propel your portfolio returns. Analysts say a portfolio is diversified at around 20-30 companies. You can also diversify across industries, sectors, or countries. This is similar to an index fund, except all the companies should be selling for a discount to intrinsic value.
It will be difficult to build a diversified portfolio of the high-potential companies used in the first strategy. You will likely have to lower your standards or limit your criteria. This will mean you may purchase some bad situations. That's okay though, as the good picks will more than make up for the losers on average. Rather than one-shot-one-kill, this approach is all about playing the averages.
A good tool to help with this strategy is a stock screener. For example, Net Net Hunter provides a screener that will find all companies trading for less than net current asset value. You can then purchase the 20 companies with the most significant discount. Quickly, you can build a good value investing portfolio with limited capital.
The advantage to this strategy is obviously the diversification and time savings. You won’t need to spend countless hours analysing companies and their situations. If you have a busy lifestyle, this will save you a lot of time. The strategy’s disadvantage is due to your limited capital. If you only have $500 and want 25 companies, you will only have $20 to spend per company. Not only will this limit the stocks you can afford, but it will decrease your profit when a company does succeed. This is a trade-off you have to be willing to accept.
Strategy 3: Build a good value investing portfolio with limited capital by… adding more capital!
The last strategy requires some long-term commitment. You will need to create a budget and start setting aside money to be invested. Every month, you will deposit the same amount into your brokerage account and use it to purchase 1-3 stocks. If you can commit to $1,000, then it would allow you to invest $500 in two companies every month. After a year, you will have a portfolio of 24 companies and $12,000 invested.
This is a mix between the first and second strategy. Every month, you can find the best situation and eventually build a good value investing portfolio with limited capital. You will not be forced to bet on situations that are not guaranteed. Maybe you see a company with the potential for a catalyst but aren’t completely confident. You can hold off until next month and re-evaluate the situation then.
You can also rely on an investment service, which helps enormously. Every month, for example, Broken Leg Investing issues three deep value stock recommendations to paying subscribers. If you are considering this approach, a subscription to The Broken Leg Investment Letter will take the hard work of finding and researching opportunities out of the investment process for for you. It also helps you understand how to build a diversified portfolio. All you have to do is check your email each month and send the order to your broker. It doesn’t get much easier then that!
The biggest advantage of buying a couple stocks a month is that you are not forced to commit to a portfolio of companies all at once. Throughout the year, you may identify a strong company, and you would have the capital to invest in it. The disadvantage is the commitment this path takes. You will really need to budget your income to ensure the same amount is deposited each month. You don’t want to start investing less money because this will knock your portfolio balance off and could be dangerous. If you are willing to commit to the lifestyle this strategy demands, it may be the best out of the three.
More to consider if you’re managing a tiny amount of money
Here are some other tips that will help build a good value investing portfolio with limited capital.
- Use the power of compounding to your advantage. This means when a company returns positive, don’t use the profit to celebrate your success with friends. Use your money to reinvest in another opportunity. Over time, this will grow your capital even faster.
- As mentioned in regards to purchasing mutual funds, it is important to limit fees and expenses. Unfortunately, whenever you’re purchasing stocks, commissions come with the territory. The one-time fee when buying or selling is something we can’t avoid but can control. Be sure your broker’s commission fees are lower compared to competitors. If not, consider negotiating a lower price or switching to a new broker. Do whatever you can to ensure the maximum amount of your money is being used to purchase stocks.
- When investing with small amounts, it is important to always use limit orders. Imagine using a market order right before the stock price shoots up. You would be forced to spend more money then you were originally expecting. This mishap could affect your entire portfolio strategy.
- Lastly, note that some company’s stocks have a minimum purchase requirement—meaning you must spend a set amount of money on each order. This would be a challenge if you only have $500 to spend on each company but the minimum purchase is $1,000. You would be forced to pass on the company, even if it is the best opportunity. An investor could dedicate countless hours researching a company, only to find out they can’t afford the minimum purchase. This would be a waste of time and discouraging to their efforts. Always verify first!
A Final Word from Warren
The great value investor—Warren Buffett— once said, “You have a huge advantage over me if you are working with very little money.” In fact, he made his career-best returns when he was a small investor. Use that as your motivation as you build a good value investing portfolio with limited capital. All it takes is a little dedication and some extra time to strategize.
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