Getting Serious And Getting Real About Diversification
Dear Investor, We all know we need to diversify. It may be the single most frequently repeated item of investment wisdom. Actually, though, that may be a problem. It’s been repeated so often, it’s easy to wind up allowing the advice to go in one ear and out the other without really thinking about what implementation is really all about and why we need to do it; aside from avoiding accusations of being a bad person. Those who check the textbooks, whether on their own or as part of a finance class, will read of such concepts as volatility, standard deviation, covariance and correlation. Readers are led to expect that they’ll be able to protect against declines in Asset A by also owning Asset B, which goes up whenever Asset B goes down.
In textbook examples, such relationships occur all the time. In real life, more often than not, as Asset A declines, Asset B also declines but we hope it won’t fall as much (or, heaven forbid, more than) Asset A. But even that often winds up little more than a wing and a prayer. It’s not like you can learn anything by looking at objective data. Correlation among pairs of assets is remarkably unstable over time, so the lawyers and regulators are spot on when they tell us about past performance not determining future outcomes. And actually, the situation is worse than mere statistical crunching suggests. Due to globalization and years of easy money, correlations have been rising and are likely to continue to do so (making historical correlation data, the only kind we have, even less effective in pointing us toward the sort of diversification that can mitigate risk). So please do not give credence to anything you may see or hear that purports to demonstrate how effective well-diversified stock and-bond portfolios have fared. That’s really an area where we should expect much higher correlations in the future.
But if we can look at diversification without getting preachy and without flexing our statistical muscles, we can see a different aspect of the topic and how it really is a great way to manage risk. We’ll do so by looking at, you guessed it, low-priced stocks. Individually, you have to know how risky these are. I’ve felt it. I have to assume you have too.
Nevertheless, the overall track record of the 40-stock) Master List and the (15-stock) Model Portfolio, despite not all months being wonderful, have been pretty good overall, as you can see from the accompanying table. Are those figures representative of your personal results? If you choose a few stocks here and there and are lucky, you might be doing considerably better. If you’re not so lucky, you might be doing considerably worse.
The more stocks you choose, however, whether you buy and regularly update the entire Model Portfolio, the entire Master List, or a decent-sized group you put together however you wish from among the universe of stocks discussed here, your performance is less likely to depend on luck or hard-to-predict events and more likely to depend on the overall characteristics of the group as a whole. And considering our prolonged strength against the Russell 2000, and even the larger low-priced group that is not limited to those that pass the model I use (up only 16% since the 10/15/13 inception of this format for the newsletter), performing in line with the group as a whole has so far been a pretty good outcome. This stems from the fact that as you add positions, the overall fundamental profile of your personal low-priced portfolio is more likely to resemble the fundamental profile of the group as a whole, the fundamental profile that motivated me, and presumably, you, to get interested in low-priced stocks in the first place. And while individual companies may be very risky, the aggregate of a substantial portfolio is likely to have a less intimidating risk profile.
Let’s take an informal glance at this. Let’s consider some group-average fundamentals. This is not a precise study; some companies that didn’t report certain items fell out of the samples. But it should make for a useful back-of-the-envelope type view. We’ll start with valuation. The average Enterprise Value-to-Sales (a souped-up version of price/sales), Price-To-Book, and Price-to-Cash Flow (trailing 12 month) ratios for the current Model Portfolio are 1.5, 1.7 and 9.7. For the 40-stock Master List, the average ratios are 2.8, 2.2 and 11.3. For the S&P 500, the averages are 3.6, 5.5 and 16.0. So there’s a good chance that a well-diversified representative portfolio drawn from the stocks discussed in this and prior issues makes you a more a value investor than a wild-eyed crazy speculator/gambler.
Now let’s consider sales growth rates. For the last quarter (year-to-year) and the past 12 months respectively, these were 17.8% and 14.0% for the Model Portfolio, 23.7% and 20.1% for the Master List stocks, and 1.7% and 5.8% for the S&P 500. So the stereotype of little companies being able to grow faster seems to be playing out. But your chances of benefitting from it as an investor improve if you own a representative portfolio, rather than a stock here or there. What about earnings? I don’t need to look at the numbers to know they likely stink. An important investment theme for us is the potential for these companies to better cover, and eventually dwarf burdensome fixed costs as they grow. What we’d like to see is progress in terms of margin. We see that a bit in Gross Margin, where the average five-year and trailing 12 month figures for the Model Portfolio and Master List are 31.1% and 38.8%, and 39.6% and 46.1%. But in terms of fixed-cost coverage, operating margin (which reflects more in the way of overhead) is where the rubber meets the road. The five-year and trailing-12-moth figures for the Model Portfolio are -0.7% and 10.7%; for the Top 40, the figures are 7.8% and 16.1% This is exactly the sort of characteristic we seek in these stocks.
And it stands in stark contrast to the mature blue-chip S&P 500 companies, for which five-year and trailing-12-month average gross margins are 42.0% and 42.4%; the five-year and 12-month average blue-chip operating margins are 19.3% and 18.4%. So in contrast to the evolving companies in which we focus, the S&P 500 firms, on average, are what they are. What they are is good. But excess returns in the market come from change for the better, not staying in place; even if it’s a good place. We see this in return on equity (ROE) as well. For the S&P 500, the five-year and 12-month averages are 17.7% and 18.2%. Positive change from a weaker position is evident in the Master List, where these averages are -2.0% and 9.6%. But the Top 15 is not a big enough group to represent the Master List, at least not this month: The corresponding ROEs here are 12.2% and 8.8%.
Meanwhile, representative portfolios show some fundamental risk characteristics in line with the S&P 500. Long-term debt-to-capital ratios are 43% for the Model Portfolio, 47% for the Master List and 44% for the S&P 500. Accounting accruals as a percent of revenue, a big earnings-quality measure, are good on average for all three groups. As to the numbers, the lower the better and negative is even better. For the Model Portfolio, the Master List, and the S&P 500, these figures are -7%, -1% and -6%.
So while you can make a killing investing in individual low-priced stocks, if you can get a truly diversified and representative portfolio, there’s a higher probability you can benefit from the overall investment appeal of this group without taking on undue risk. That’s why I encourage you to spread your low-priced investments among as many names as is feasible given your your brokerage-fee arrangements, and/or to look for firms that can let you trade more economically. (Speaking for myself, I regularly own the 40 Master List stocks through an account at FolioInvesting.com.) With all the fundamental and technical indicators and metrics available to help us evaluate companies and stocks, the most important one of all may be our respective broker fee schedules.
No positions in stocks mentioned.