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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.

Analyst Upgrades

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 17th Upgrades
BioMed Realty BMR FBR Capital Mkt Perform Outperform REIT - Industrial
FICO FICO Northland Securities Market Perform Outperform Business Services
FICO FICO Wedbush Underperform Neutral Business Services
Itron ITRI Wedbush Neutral Outperform Scientific & Technical Instruments

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
Analyst Downgrades
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


Portfolio Wrap-up
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.

Source: A Different Approach to a High Reward/Low Risk Portfolio