Last week I wrote an article "Diversifying Your Portfolio: The $50,000 Growth Strategy" looking at the best way to diversify a portfolio in a "new age" market. The concept of a new age market is something I discuss in my book, which is basically to hope for a bull market but to prepare for a flat/bear market. It is one of many ways to psychologically prepare yourself for volatility, and while many of you will fall into the $50,000 category, there are many of you who do not. Therefore, I am looking at one of my more basic diversification strategies, one that is simple and effective, but that changes based on the size of the portfolio.
One of the many principles that I teach is that there should not be a one-size fits all mentality when it comes to diversification. While the only goal of investing is to return more money than you originally invested, it's human nature that our perception and goals of investing change as we become both more experienced and as our portfolio grows larger. For example, if you are new to investing you are more likely to embrace risky behavior, such as chasing gains to make the quick 5-10% return. As you become more experienced you will "eventually" learn from these mistakes. If you don't learn, then you will more-than-likely lose your money to the more experienced investors who are disciplined and have developed patience.
One of the reasons that new investors partake in risky behavior is because they are usually managing less money. An investor with $2,500,000 views his portfolio differently from someone with $25,000. Although both are important to the individual retail investor, it is the goal of the $25,000 investor to grow his/her portfolio to become the $2,500,000 investor. In this article I am writing specifically to the $25,000 investor, who wishes to take more risk while also having the potential for more reward. I urge you to first read "Diversifying Your Portfolio: The $50,000 Growth Strategy" to familiarize yourself with the theory, strategy, and the investment paradigm that is being used.
Diversification Using "This" Strategy
First, the core of this series is that it's 100% based on a stock portfolio, with mostly dividends. As I explained in the previous piece, I want to invest in something that earns money and that can be measured with growth and performance, not something such as commodities with valuations that are only affected by fear and greed. In the past I have owned bonds, but with interest rates at record lows there is nowhere for bonds to go but lower. As a result, you can build a solid portfolio of undervalued companies and diversify based on those that are secular, cyclical, and speculative. As your portfolio grows the goals of the investor will change as well, and that is the point of this basic new age diversification series.
$25,000 Equity Portfolio
The purpose of a secular investment is to provide security in your portfolio. These are companies with growth that will remain consistent even in a down economy, but will also grow in a growing economy. As a rule of thumb, think of these as population companies, which are companies that will grow with the population. As a person with a $25,000 portfolio, it is your goal to maximize profits, but you will also need holdings that pay high yields and will provide some stability over a course of time.
For this particular portion of your portfolio you don't need a large amount of conventional diversification to be successful. Basically you want to invest in one company that pays a high dividend, that is cheap, and that will be consistent in your portfolio. The first and easiest choices would be companies such as Johnson & Johnson (NYSE:JNJ), Wal-Mart (NYSE:WMT), The Coca-Cola Company (NYSE:KO), or Procter & Gamble Co. (NYSE:PG). All are great companies, but one thing to remember is that this will be a long-term investment, with dividends that you will reinvest back into the company. So you want to find a company that is just as stable but trades equal to or less than the overall market.
If the S&P 500 trades with a P/E ratio near 15 then you don't want to own a stock as a long-term secular investment that trades with a P/E ratio near 20. That would be a huge premium! I suggest companies such as the utility company American Electric (NYSE:AEP), consumer company Kraft Foods (KRFT), or tobacco company Lorillard (NYSE:LO). These companies trade at or around 15 times earnings, have higher dividends, have a history of increasing dividends, strong institutional ownership, and will remain solid regardless of the economy. Any of these three would work well in this particular strategy.
While a secular investment grows regardless of the economy, a cyclical stock grows with an economy, or is a strength of a particular market. In my previous article, I used Seagate Technologies (NASDAQ:STX), Ford Motor Company (NYSE:F), and JPMorgan Chase (NYSE:JPM) as my top choices. With $10,000 and a riskier strategy, you want to break this section into two investments. And of those particular selections, I like Ford Motor Company the best, along with Apple (NASDAQ:AAPL).
While there are many great selections for this portion of the portfolio, Apple and Ford provide yield, value, and growth. Ford is fairly similar to General Motors (NYSE:GM) in terms of valuation, yet it's the company's recent 100% increase in dividend, a forward yield of 3%, and a presumed bottom to the European sales crash that make Ford more appealing. Apple has more cash than any other company in the market, it continues to grow by at least 20% year-over-year, has an unprecedented ecosystem in terms of efficiency, is trading at just seven times next year's earnings minus cash, and pays a yield of 2.30%. Therefore, it also is a great value investment, because remember; only the secular investment is a multi-decade investment.
These are longer term investments compared to speculative/growth holdings but less than those in the secular category. Both Apple and Ford are great companies, and should appreciate to be equal to the market's value; at that point you can sell and seek value elsewhere. The key with this portion of the portfolio is to invest in companies that do pay a dividend and that have solid undervalued businesses. You may want to add a retailer, coal or alternative energy, or a services company. The key is not to follow my individual selections, but to use the principles to find equal value.
The challenge with buying a stock for this category is finding a growth company that is also a value stock. In this economy, companies with 50-100% growth are rewarded with insane price multiples, such as a price/sales over 15 (hence LinkedIn (NYSE:LNKD) and Workday (NYSE:WDAY)), and these valuations are simply too expensive and will lead to loss once growth moderates. When a person thinks of a speculative/growth investment, they automatically assume I am referring to small cap investments that present high risk. However, this is not the case-- we are seeking fast-growing companies with unnoticed or incorrectly valued upside.
If you read the previous article then you know that speculative/growth was much less of the portfolio than it is in this portfolio. As wealth grows we are less willing to take chances with speculative investments, but at the same time, those with a $25,000 portfolio want to be smart. Therefore, the question becomes how to diversify your speculative investments while maximizing upside and limiting risk? In my opinion, the best way is to break your speculative investments into two categories, both small and large cap stocks.
The goal of adding speculation to your portfolio is to create the psychological excitement and intrigue that is needed to both stay interested in learning about the market and to also present you with the opportunity for larger gains. If done correctly, there are very few reasons that this approach will not succeed. Unlike your secular investments, these are not long-term investments. These you buy low, then wait, and sell at a higher premium. You find a good level to buy, then you place a limit order to buy the stock once it hits that price, and then finally you set another limit order to sell the stock once it hits your sell goal.
In my opinion, there is only one large cap industry worthy of the speculative investment, and that is in the financial sector, where companies are trading at deep discounts to book values. These are companies set to rebound with a revamp in housing, with some presenting potential gains of three-fold and beyond. Specifically, my favorite is the insurer American International Group, Inc. (NYSE:AIG). The stock is one of many in the financial sector that continues to trade at a 0.50 times book value. Bernstein recently called the stock "a once-in-a-generation opportunity" and I agree. The firm went on to compare the post-bailout AIG to a "demutualized" insurer such as MetLife. The bottom line is that the company has changed, is cheap, and is ready to start making acquisitions rather than "playing defense".
The final speculative investment in the $25,000 portfolio should be a high risk high reward small/mid-cap stock. It should be rapidly growing and cheap. Of course, the decision is that of the individual retail investor, but a few of my favorites are XPO Logistics (NYSE:XPO), SodaStream (NASDAQ:SODA), and Questcor Pharmaceuticals (QCOR). For the sake of argument we'll say Questcor Pharmaceuticals, seeing as how I always choose XPO Logistics. The reason Questcor is a good selection is because not only does the company pay a 3% yield but is also trading with a forward P/E ratio of under 7.50 and is expecting 50% growth in 2013. It is speculative because of recent controversy surrounding the company and because it only has one product to market. However, the company recently completed an acquisition and it appears as though the company is ready to develop its pipeline. Therefore, it becomes a great speculative investment.
The purpose of these articles is to show that there is no one-size fits all investment strategy and that goals change with wealth. This is an aggressive portfolio strategy, based on a few simple selections. However, there is a lot that goes into valuing a stock, such as knowing what price is presenting value, knowing how long to hold and when to sell, and what price is fair value for a stock. This article, and the one before it, barely scratch the surface with a very basic diversification strategy for new age investing. I wrote an entire book regarding this subject with much more detailed diversification and investments strategies for a new age of investing, where every holding serves a purpose within your portfolio. These are all areas of consideration that are ultimately very important in determining your success.
It's a fine line between diversifying for markets of the past and understanding that this is no longer your grandfather's market. You may sit in a money manager's office and see charts of 12% annualized returns over the last 30 years, but the fact of the matter is that since 2000 the markets are near flat after adjusting for inflation. If you are starting with a smaller portfolio of around $25,000 and want to make money in this market then you have to diversify for value and assume that the markets are going to trade flat. And although some may say that my $25,000 portfolio is not diversified enough or that it doesn't offer enough protection, or sectors, to be secure, I beg to differ. This portfolio is small yet still includes energy, tech, auto, financial, and healthcare investments. And more importantly, each sector is diversified into the portfolio based on valuation relative to the S&P 500; as each sector offers diversification to the broader market, all the while allowing for larger returns and the luxury of choice rather than closet indexing in a flat market.
Disclosure: I am long AAPL, SODA, XPO, F, STX, AIG, QCOR. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.