Don't Sleep On Diversification

10/24/2016


When we talk about growth rates or valuation ratios or dividend yield, people listen. These topics inspire thoughts of strong investment returns and the excitement of selecting stocks. If you subscribe to this newsletter, you probably find these topics appealing.

Of course, when the subject of diversification comes up, we can hear the snores from Seattle to Miami. If growth and valuation are steak and potatoes and yield is ice cream, diversification plays the role of lima beans. We all know they're good for us, but we'd rather not think about them.

Don't make the mistake of dismissing diversification. Any investor can diversify a portfolio. It doesn't take a degree in finance, and the risk-reduction benefits are substantial. A portfolio comprised of two sector indexes (industrials and energy) provides a return about midway between the individual indexes' returns, but with less volatility and a higher ratio of return per unit of risk.

Diversification is not a silver bullet. Market risk — caused by such forces as inflation, interest rates, and political change — cannot be diversified away. Simply wading into the financial markets exposes you to such risk. However, much of the risk of your stock portfolio stems from problems faced by companies or industries. That's where diversification comes in.

The financial crisis of 2007 and 2008 crushed banks and other finance companies, while the decline in oil prices from mid-2014 through early 2016 wreaked havoc on the energy sector. Such disasters are going to occur. Most of us can neither predict nor fully avoid them. Instead, we try to weather the storm by owning a diversified portfolio. If the next year turns out disastrous for health-care stocks, our stocks in that sector will probably underperform. But perhaps our technology and industrial holdings will pick up the slack.

With diversification in mind, the table below lists a couple of intriguing stocks from each of the 11 market sectors, including a mix of large-cap, midcap, and small-cap stocks. If your portfolio is missing stocks from a sector or size category, consider these stocks to fill those gaps.

A DIVERSIFIED PORTFOLIO
Below we present stocks from 11 sectors, featuring companies of various sizes and a couple foreign firms. We list at least one stock in each sector, with up to four in the largest, most influential sectors. Stocks in bold black are from our sister newsletter Upside (www.UpsideStocks.com), stocks in green are from our Top 15 Utilities portfolio (www.DowTheory.com/Go/Top15). Neither the Forecasts nor Upside recommends any telecom stocks, so we included the only A-rated telecom from our Monitored List. The remaining stocks are from the Forecasts buy lists. A couple of the stocks are on both one of our buy lists and the Top 15 Utilities portfolio.
Stock-
Market
Value
($Bil.)
% Of
Revenue
From
Outside
U.S.
------------ Quadrix Scores ------------
Company (Price; Ticker)
Size
Category
Div.
($)
Yield
(%)
Trailing
P/E Ratio
Momen-
tum
Value
Quality
Overall
Industry
Consumer discretionary
Comcast
($65; CMCSa)
158.8
Large-cap
1.10
1.7
20
20
47
67
83
66
Cable & satellite
D.R. Horton
($30; DHI)
11.2
Large-cap
0.32
1.1
0
13
75
85
96
94
Homebuilding
LKQ ($33; LKQ)
10.2
Large-cap
0.00
0.0
33
20
78
62
97
80
Distributors
Mohawk Industries
($195; MHK)
14.6
Large-cap
0.00
0.0
33
17
94
72
94
95
Home furnish.
Consumer staples
CVS Health
($86; CVS)
92.9
Large-cap
1.70
2.0
0
16
86
82
85
84
Drug retail
Kroger ($31; KR)
29.7
Large-cap
0.48
1.5
0
14
45
86
91
70
Food retail
Energy
CONE Midstream
Part
. ($20; CNNX) *
1.2
Small-cap
1.02
5.1
0
13
98
85
76
100
Oil/gas storage
EQT Midstream
Part. ($78; EQM)
6.1
Midcap
3.12
4.0
0
14
86
77
98
95
Oil/gas storage
Financials
Ameris Bancorp
($36; ABCB)
1.3
Small-cap
0.40
1.1
0
17
98
66
89
98
Regional banks
J.P. Morgan Chase
($68; JPM)
248.1
Large-cap
1.92
2.8
24
12
47
82
58
86
Divers. banks
Preferred Bank
($36; PFBC)
0.5
Small-cap
0.60
1.7
0
15
95
76
86
98
Regional banks
Zions Bancorp
($32; ZION)
6.6
Midcap
0.32
1.0
0
19
94
76
70
98
Regional banks
Health care
Amgen ($161; AMGN)
121.8
Large-cap
4.00
2.5
21
15
81
68
92
89
Biotechnology
Centene ($62; CNC)
10.8
Large-cap
0.00
0.0
0
16
84
75
87
83
Managed care
ICON ($78; ICLR)
4.4
Midcap
0.00
0.0
27
18
60
66
97
89
Life sciences
LabCorp of America
($138; LH)
14.3
Large-cap
0.00
0.0
17
16
79
70
73
91
Health services
Industrials
Alaska Air ($73; ALK)
9.1
Large-cap
1.10
1.5
0
10
71
92
97
96
Airlines
FedEx ($170; FDX)
45.9
Large-cap
1.60
0.9
24
15
78
70
78
92
Airfreight
Owens Corning
($52; OC)
6.0
Midcap
0.72
1.4
31
15
87
87
91
98
Bldg. products
Southwest Airlines
($42; LUV)
27.0
Large-cap
0.40
0.9
0
11
76
95
98
93
Airlines
Materials
Berry Plastics
($46; BERY)
5.7
Midcap
0.00
0.0
5
20
97
70
78
96
Containers
Ciner Resources
($32; CINR)
0.6
Small-cap
2.27
7.1
60
10
29
85
81
80
Commodity chem.
Real Estate
AV Homes
($16; AVHI)
0.4
Small-cap
0.00
0.0
0
14
97
89
93
100
Development
Summit Hotel
Properties
($14; INN)
1.2
Small-cap
0.53
3.9
0
27
94
86
84
97
Hotel & resort
Technology
Alphabet
($827; GOOGL)
617.1
Large-cap
0.00
0.0
54
26
94
33
96
87
Internet software
Cardtronics
($50; CATM)
2.3
Midcap
0.00
0.0
69
16
87
69
92
98
Data processing
Citrix Systems
($86; CTXS)
13.5
Large-cap
0.00
0.0
39
17
91
64
89
93
App. software
Lam Research
($100; LRCX)
17.7
Large-cap
1.20
1.2
92
16
81
70
88
95
Semicond. equip.
Telecom services
AT&T ($39; T)
244.0
Large-cap
1.92
4.9
4
14
50
82
50
62
Integrated
Utilities
UGI ($45; UGI)
7.9
Midcap
0.95
2.1
0
21
52
59
71
57
Gas utilities
WGL Holdings
($61; WGL)
3.1
Midcap
1.95
3.2
0
20
82
73
50
77
Gas utilities
Notes: Quadrix scores are percentile ranks, with 100 the best.   Large-caps have stock-market values over $8 billion, small-caps less than $2 billion, and anything in between is considered a midcap.   Companies with a small amount of foreign revenue that do not break that revenue out in their financial statements will be presented as having 0%.     * Stock is also recommended in Upside.

Four ways to diversify

Diversification cuts portfolio risk not by reducing the volatility of individual securities, but by allowing the inherent differences between those securities to mitigate their individual risks. When one stock suffers, others may perform just fine. And in a down market, not every stock or sector will take the same hit. Here are some ways to diversify your equity portfolio:

Fixed income. The percentage of your portfolio you should keep in fixed income (bonds, preferred stocks, bond funds, etc.) varies based on factors including your age, wealth, risk tolerance, and when you need to access the money. Not sure how much to invest in fixed income? Our Asset Optimizer (www.DowTheory.com/Go/Asset) can help.

Sector or industry. Sectors don't move in lockstep, though some have more in common than others. Over the last 20 years, the S&P 1500's industrial and consumer-discretionary indexes were 87% correlated, which means the indexes tended to move in the same direction 87% of the time. Such high correlation suggests stocks in those two sectors tend to respond similarly to outside forces. However, the correlation between industrials and energy stocks is 62%, and the correlation between industrials and utilities is just 50%. Our Buy List and Long-Term Buy List are fairly well diversified, the Focus List is less so.

Size. While small stocks and large stocks don't usually move in different directions, their returns can differ in magnitude. For most investors, keeping 20% to 50% of your equity holdings in small-cap or midcap stocks makes sense.

Foreign exposure. We don't recommend many non-U.S. stocks. However, because U.S. and foreign stocks often follow different trends, holding 10% to 25% of your equity portfolio in foreign stocks may be prudent. To gain that foreign exposure, consider Fidelity Overseas ($41; FOSFX), a foreign large-cap fund, and iShares MSCI EAFE Small-Cap ($52; SCZ), a foreign small-cap and midcap exchange-traded fund (ETF).


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