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When Diversification Hurts

Global Market Past Three Months

The bar chart above shows you what’s been happening in the global stock markets over the past three months.

Brazil has been absolutely crushed, down -22.49% while the S&P 500 Index is down a much smaller -4.26%.

Looking across the graph, most of the major indices around the world are down 7% – 11% in the past three months.

Let’s take a deeper look at the US market:

US Market Industry Sectors

Looking at the sector performance the past three months, its easy to spy what has performed and what has not. The defensive sectors have all soared higher while the sectors tied to the economy (and which have had strong earnings growth in spite of our slow-growth economy) have languished.

Let’s look at the major asset classes:

Asset Class Comparison

The bar chart above shows you how some major asset classes beyond equities have performed in the past three months.

You can see that any exposure to commodities and commodity stocks have been devastating, and they have more than offset any diversification benefits from the asset classes that performed better than the S&P 500 (high yield bonds, REIT’s, gold, etc.).

If you owned only an S&P 500 index fund during the past three months, you would have done much better than any fully diversified portfolio. If you owned the index fund and a bond fund, you would have been about break-even for the past three months.

It’s never fun when we are going through a time where the asset classes that the Prudent Investor Rule requires be included for diversification purposes hurt your portfolio performance. However, there will always be short periods of time where that happens. Over the long-term, though, things are different. Take a look:

Long Term Asset Class Returns

Over the past 13.5 years, you can see that the S&P 500 has been a significant underperformer compared to the other diversifying asset classes. The lesson here – and I say this to remind myself as much as everyone reading this blog – is to not get overly discouraged by these infrequent time periods where the only thing that works in the short-term is a beta investment in the S&P 500.

Over the long-term, the Prudent Investor Rule plays out as intended – the diversifying asset classes provide additional incremental return while lowering overall portfolio risk.

One of the problems we have today is that with an always-on internet and investment television available at the click of a remote, it seems that everyone’s investment horizon has gone from 7 to 10 years (a must if you want to own anything other than short-term fixed income) to 7 to 10 days.

Many people are making investment decisions based upon short-term phenomena instead of sticking with a long-term strategy. They hear some TV personality say to buy some company because its possible the US economy will grow 1.5% per year instead of a previously forecast 2%. A 1/2% change in GDP growth in a slow growing economy will not materially impact the fortunes of any particular company – but selling a company with strong earnings growth in favor of a utility company with little earnings growth after a market pullback is already well underway makes no sense.

For me, it is always better to raise cash when you believe the market has moved up to the top of what you think is its current range, then reinvest that cash in solid companies with strong earnings growth or macro catalysts that will push their stock prices ahead of the S&P 500 over that 7 to 10 year horizon.

A good example of the above is Caterpillar. It is growing its earnings at 41% year-over-year. It is trading at a P/E of 10.97 while its industry competitors are trading at a P/E of 12.83. Its Return on Equity is at 38.33% compared to is industry competitors at 13.75%. It yields 2.39% compared to the broader market average yield of 2.29% and it has a payout ration of 22% giving it lots of room to continue to increase its payout, which has been growing just under 10% per year.

From a valuation standpoint, the current price for CAT is $86.83.
> the Analyst Consensus Target Price is $127.68 implying a 47% return
> the Industry P/E X Forward EPS is $124.71 implying a 43% return
> the Discounted Earnings Yield value is $121.54 implying a 40% return
> the Discounted Cash Flow value is $148.95 implying a 71% return
> the Cash + Capitalized Earnings value is $125.18 implying a 44% return

The earnings growth of a company like CAT, even though it is tied to the economic cycle, justifies to me owning it over a defensive company with less potential return. Yes, it is more volatile, but if you keep your investment horizon in mind and not focus solely on the short-term – and you add to your position if the price goes down (as long as the fundamentals of there to propel the earnings growth forward) – then ultimately you will be rewarded.


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Mark