A big part of portfolio management is striking the right balance with respect to diversification. How many stocks should an investor hold? How many sectors should they spread them across? These are probably two of the most common issues that ordinary private investors are faced with.
The answer obviously depends a lot on precisely what your goals are, or more likely what stage you are at in your investing lifetime. A wealthy retiree with a couple of million to manage, whose primary goal will be the cash flow required to fund retirement, can be content with a diversified portfolio of high yielding blue chips. Probably a heavy tilt towards stodgy utilities and quality consumer stocks in tobacco, food and beverages (the usual dividend stocks like Coca-Cola, Phillip-Morris and AT&T). Pretty straightforward, especially combined with some fixed income and cash.
For younger investors who are in the process of building and accumulating significant positions though the questions can prove slightly more complex. Concentration risk and chasing high growth stocks are common issues because of the perception that these are the best avenues to generate wealth. They typically aren’t. The Nifty Fifty for example, which was looked at briefly in the last post, shows that diversification into high quality stocks is ultimately a very rewarding strategy in the long run.
The great thing about it was that it was, and to some extent still is, a sleep well at night solution. As the results show the odd bankruptcy that crops up every now and again, which totally wipes out a position, is more than made up by the big winners. Heck, a few hundred bucks in Walmart in the 1970’s is worth $500,000 today. On it’s own that would provide income of something like $1,000 a month in 2016 dividends. $5,000 each in McDonald’s and PepsiCo twenty years ago would today be worth $40,000 and $28,000 respectively assuming all the dividends were reinvested into more stock. They’d be throwing of about $1,800 in annual dividend income combined.
There is a flip side though to diversification, one that is nicely summed up in a word coined up in Peter Lynch’s One Up On Wall Street – diworsification. To sum up what diworsification means consider the following fact: $1 invested in Tobacco in 1900 is worth $6.3m dollars today. That’s compounded annual returns of 14.50%.
Some industries and businesses naturally generate much higher returns than others. In the United Kingdom for example £1 invested in alcohol stocks in 1900 is worth £200,000 today. That’s not to glorify sin industries like tobacco, but this is the most powerful example of what drives long-term returns.
Tobacco stocks have spent much of the last few decades at low valuations. The gradual realization of the implications of smoking on long-term health have weighed heavily on them, and there are many retail investors, as well as some institutions, who won’t hold tobacco shares. That, plus the threat of litigation and continuing poor long-term outlook, has kept valuations depressed. Yet they have remained hugely cash generative businesses that have showered their investors with dividends at high yields because of their chronic undervaluation. The net effect of cheap companies that have ridiculously strong and sustainable business economics is the kind of explosive returns that have been recorded by big tobacco.
The most successful stock of the last fifty or so years is Philip Morris (now Altria), a tobacco company. That’s despite the significant decline of the tobacco industry and smoking rates. It’s despite some of the stellar returns in tech stocks over the last few decades. Yet Philip Morris, a boring tobacco company, compounded at something like 20% over the last half century.
It’s not just tobacco that’s generated exceptional returns. Stodgy consumer industries like food and beverages have also done well. Between the early 1960’s and 2014 the returns averaged a rate that was about 13% annually. That’s turning a dollar back then into 450 dollars today.
This is the point behind diworsification versus diversification. Some industries and some stocks are just better than others, so simply practicing diversification for the sake of having exposure to all sectors isn’t necessarily a good idea. Take shipbuilding for example, it’s a terrible industry in terms of shareholder returns. It’s capex intensive and not particularly cash generative. Why should an investor stray away from much more attractive sectors like tobacco, food, beverages and healthcare to generate sub-standard returns? If the risk factor is already low, then adding additional assets to a portfolio won’t help. Not only that, but there’s a huge risk that you dilute the overall quality of it at the same time.
Let’s take a look at the sectors mentioned above: tobacco, healthcare and food & beverages. You could probably aggregate that to consumer staples and healthcare, maybe throw in consumer discretionary too. Over the last fifty years those sectors have returned 13%, 12.5% and a little over 11% annual returns respectively. A portfolio of four to five of the highest quality stocks from those sectors will provide the benefit of diversification without sacrificing quality to do so. If the positions are built at historically cheap to fair valuations, then there’s no reason why shareholder returns won’t be in the order of 10% a year from here. There’s enough of those kind of stocks out there. Take Dr Pepper Snapple Group for example.
As a company Dr Pepper gets a bit overshadowed by its much larger cousins, Coca-Cola and PepsiCo. The underlying business though is every bit as attractive for long term wealth creation. Their products have huge branding power that allows the company to generate almost 100% returns on tangible capital. That’s not just in one year, but every single year in sustainable returns. The product has been around for a hundred years already, and you’d imagine will be around for a hundred more barring some major disaster. It trades at about 20x earnings with the potential to easily add 7% a year to per-share earnings. Throw in a couple percent in dividends and there’s every chance of getting 10% annual returns without too much difficulty.
Sensible diversification needn’t sacrifice quality to spread risk. Remember, a Dr Pepper or Phillip Morris in a portfolio will more than make up for a host of losers.