Investment professionals will almost always recommend some diversification within a portfolio. But diversification could mean virtually anything from picking many industry groups or sectors, a mix of small (or even nano caps under $5) and large cap stocks, adding companies from other countries, or having a blend of value and high growth stocks(7 oil growth stocks here).
This article will cover one novel concept for portfolio diversification using analyst upgrades and downgrades across a variety of industry groups. The goal is to increase reward for assumed risk, and to simultaneously have a hedge against a falling market (tracked by the SPY). (You might also like to read a novel method to increase reward and lower risk based on stock transparency).
Research of the Diversified Portfolio
What is the basis for the formation of the diversified fund? Some interesting research by Boni and Womack (2004) was detailed in a paper titled "Analysts, Industries, and Price Momentum." These are a few highlights of what they found:
- Attempting to chase hot industry groups based on analyst recommendations yielded little profit.
- Equal-weighted industry portfolios have a reward-to-risk ratio 6 times higher than momentum strategies (Sharpe ratio) and 100% higher return-to-risk ratios (Sharpe) than non-weighted portfolios using the suggested strategy below.
- Buy analyst upgrades and short analyst downgrades.
- The returns of this strategy were 15% per year. More notably is the reduction of risk for increased reward.
- The larger cap the stocks and the wider the analyst coverage, the more diluted this strategy becomes.
- The analyst consensus had little effect, and stock selection by picking a top industry group based on analyst consensus had minimal results.
Creating the Strategy
The simple approach is to buy the recently upgraded stocks while shorting the recently downgraded stocks. We need to ensure that we are spreading our stocks across a variety of sectors and industries to achieve some measure of industry-weighting. Of course, it is not reasonable to own hundreds of stocks for perfect industry-weighting, but even picking 10 long and 10 short picks with each buy in a different industry and each short sell in a different industry group should have some industry-weighting.
Note that Boni and Womack found that prices did pop 3% in a few days following the upgrades. However, we are not chasing tiny returns that short-term might attempt to capture. Furthermore, some data sources might be delivering the information second-hand which leads to information delay and a lack of timeliness for short-term trading.
Again, we buy a maximum of one stock per industry group.
Feb 18th Upgrades (Name, Ticker, Upgrade from, Old rec., New rec., Industry)
|Air Products||APD||Deutsche Bank||Hold||Buy||Chemicals - Major Diversified|
|Brocade||BRCD||Wunderlich||Hold||Buy||Data Storage Devices|
|eLong||LONG||Brean Murray||Hold||Buy||Personal Services|
|Newfield Expl||NFX||Canaccord Genuity||Hold||Buy||Independent Oil & Gas|
|Techtarget||TTGT||Caris & Company||Average||Buy||Internet Information Providers|
|Toreador Royalty||TRGL||RBC Capital Mkts||Sector Perform||Outperform||Independent Oil & Gas|
|VASCO Data Security||VDSI||Dougherty & Company||Neutral||Buy||Security Software & Services|
|Zimmer Hldgs||ZMH||Robert W. Baird||Neutral||Outperform||Medical Appliances & Equipment|
Feb 16th Upgrades
|Airgas||ARG||BB&T Capital Mkts||Hold||Buy||Industrial Equipment Wholesale|
|Arthur J. Gallagher||AJG||Barclays Capital||Underweight||Equal Weight||Insurance Brokers|
|Brown & Brown||BRO||Barclays Capital||Underweight||Equal Weight||Insurance Brokers|
|Canadian Natl Rail||CNI||RBC Capital Mkts||Sector Perform||Outperform||Railroads|
|Dell||DELL||Rodman & Renshaw||Mkt Perform||Mkt Outperform||Personal Computers|
|Host Hotels||HST||Robert W. Baird||Neutral||Outperform||REIT - Hotel & Motel|
|Journal Commun||JRN||The Benchmark Company||Hold||Buy||Publishing - Newspapers|
|Marsh McLennan||MMC||Barclays Capital||Underweight||Equal Weight||Insurance Brokers|
|Owens Corning||OC||KeyBanc Capital Mkts||Hold||Buy||General Building Materials|
|Sprint Nextel||S||Argus||Hold||Buy||Wireless Communications|
|Suntech Power||STP||Canaccord Genuity||Sell||Hold||Diversified Electronics|
|Valero Energy||VLO||RBC Capital Mkts||Sector Perform||Top Pick||Oil & Gas Refining & Marketing|
|Western Refining||WNR||RBC Capital Mkts||Underperform||Outperform||Oil & Gas Refining & Marketing|
|Willis Group||WSH||Barclays Capital||Underweight||Equal Weight||Insurance Brokers|
For analyst downgrades, we short the following stocks and pick only one per industry group.
|Aegean Marine Petrol||ANW||Dahlman Rose||Buy||Hold||Basic Materials Wholesale|
|Anadigics||ANAD||DA Davidson||Buy||Neutral||Semiconductor - Integrated Circuits|
|Compass Group||CODI||BB&T Capital Mkts||Buy||Hold||Diversified Investments|
|Greenhill||GHL||Ticonderoga||Neutral||Sell||Investment Brokerage - Regional|
|Maxwell Tech||MXWL||Stifel Nicolaus||Buy||Hold||Diversified Electronics|
|SolarWinds||SWI||MKM Partners||Buy||Neutral||Application Software|
|Talisman Energy||TLM||Ticonderoga||Buy||Neutral||Independent Oil & Gas|
|TCF Financial||TCB||Stifel Nicolaus||Buy||Hold||Money Center Banks|
|ValueClick||VCLK||The Benchmark Company||Buy||Hold||Advertising Agencies|
For many long investors, it may seem undesirable to short sell stocks. What are the advantages to doing so? While there is the chance of an upside gain even during bull markets, this provides a hedge when markets fall. Many other hedging tactics such as buying VIX options or selling Puts will usually result in losses during bull markets. This portfolio diversification strategy tries to create a profitable hedge instead of one that costs money.
It may be that there are too many industry groups for the average investor to diversify with. In such a case, consider spreading the long and short picks across various sectors which are broader.
Just remember a few things: this strategy is not targeting hot or cold industries but trying to make a industry neutral strategy which should reduce overall volatility and dilute industry specific momentum.(If you like forecasting which group of stocks might outpeform next, read the research here on the corresponding signals of the put/call ratio with value and growth stocks)
Try to achieve an equal weight of long to short investments in the portfolio. Buy the upgrades and short the downgrades. Of course, when sentiment changes on the stocks you own(downgrade on one of your long picks), consider investing with another new upgrade. Of course, picking industries based on broad ETF's or funds would be discouraged since industry-weighting is only to lower the risk of our analyst upgrade strategy.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.