Barbell Your Portfolio to Reduce Risk and Boost Returns

by: Alan Brochstein, CFA

Here we are, almost 1/3 of the way through the year, and anyone following a simple strategy would already have made more money in just 16 weeks than he or she will likely earn over the next several years in cash or short-term investments. That simple strategy was simply to "go long". If one did it the easiest way, buying the S&P 500, the return would be 9.78%. A little fancier: Buying Small-Caps, which are up even more, with the Russell 2000 up an astounding 19.04%. Even fancier yet, just piggy-backing the 20 picks I shared right here at the beginning of the year, as they are up an average of 20.4% YTD (that's equal weighted - my weights helped a bit, improving it to 22.5%). Of the 20 stocks, 2 have declined marginally, but 8 are up 30% or more.

I have pursued a slightly more time-consuming and only modestly more productive variant of the "go long" strategy that has rewarded investors this year. It works like this:

  1. Buy
  2. If it goes up a lot, sell
  3. Repeat

The Top 20 Model Portfolio has done better than the 22.5% that those 20 stocks would have returned if I had done nothing, but probably not enough to justify all of the turnover. In fact, the model currently owns just 10 of those names (and some exited and returned actually). Note to self: Check out the on-line brokerages for investment potential!

As the year has progressed, with the markets surprising nearly all of us with their continued momentum, I have found myself gravitating to two distinctly separate types of stocks. We can always talk about growth or value, small or large, high beta or low beta, or a multitude of other ways to slice and dice the market, but my focus has been laggards (as opposed to pursuing the leaders), which I have divided into a barbell. This is what I look like as I implement this strategy:


OK, I don't really look like this, but allow me to describe the two sides that I have tried to keep in balance as I rotate into laggards:

  • Consolidating (price-wise), inexpensive secular growth companies or companies with strong balance sheets and reasonable valuations
  • Deep Cyclicals that trade at low valuations to book value but are difficult to value otherwise due to the lack of earnings

In the first camp, I have written about a lot of these ideas. In general, we are talking about perhaps mega-caps, like Johnson & Johnson (NYSE:JNJ), which just hiked its dividend 10% (as I projected) and trades at 13 PE, or perhaps Utilities, which I described as "too cheap to ignore" in March. The two utilities that I highlighted are up 5% and 10% respectively, so there is some potential to actually make money on the side that would be viewed rather universally as "safe". I mentioned also that I have added some laggards that have strong secular growth potential but that have reasonable valuations and have been in a consolidation for the past 6-12 months. Most recently, we bought CyberSource (CYBS), but it was acquired less than a week later. So, that side of the barbell could actually produce solid returns. If you would like to see a report I sent to clients earlier this month on CYBS, Download CyberSource (CYBS) 4-12-10.

The other side has been most interesting to me and also continues to look extremely promising. While some might not view this side of the barbell as "safe", I believe that the rotational strategy I am employing makes it so. I have been focused on companies that trade at extremely low valuation of tangible book value but also high amounts of cash. Some of these companies aren't the greatest, but some are highly unique franchises that are just not profitable at the moment. A great example that we exited too early from was Foot Locker (NYSE:FL), which began the year near 11. This was less than 1.1X TBV despite the company having net cash of almost $2 per share at the time. We exited our last piece in the Top 20 Model Portfolio at 14.13 in early March (the original purchase was near 10 in December). It's hardly unique. If you check out the current portfolio, which anyone can do with a 30-day free trial, you will find several longs that fall into this camp. In fact, there are at least 5 (1/4 of the portfolio) that trade at low P/TB with excellent balance sheets.

One that I will mention is Haynes International (NASDAQ:HAYN). If you want the longer story, email me and I will send you a report I sent to clients in March similar to the CYBS report. The stock has moved up just a little since then but looks to have about 15-20% upside in the short-term if I am reading the chart right. The company makes specialty metals primarily, including those that stand up to extremely high temperatures or that resist corrosion. It is very leveraged to aerospace (both engines and bodies) as well as land-based gas turbines and chemical processing plants. If you follow my work, you are probably aware that I am looking for companies that benefit from persistently low natural gas prices. HAYN should benefit from the move from coal to gas-based power plants. The stock currently trades at about 1.7X TBV, with 8 of those 38 points covered by net cash. Plus, the company recently implemented a dividend. I am not sure how long it will take to get back to the peak earnings from 2007 of $6 per share, but it could be within 3 years.

While HAYN is up 15% this year, it isn't exactly leading the way, especially considering how hammered it was from late 2008 until March 2009. All of the other peers that are leveraged to the commercial aerospace cycle here are leading the way. My theory is that it's smaller and not currently profitable. Astute investors need to look at companies like this and imagine how the market will be looking at them when their profitablity does return. In the case of HAYN, the company is expected to earn a small profit this year.

Not every single stock in the Top 20 Model Portfolio is a laggard that can be contemplated as part of this barbell strategy, but at least half the portfolio does line up this way. It's pretty easy to see by considering that the current portolio is up an average of just 8.3% on a dollar-weighted basis despite still holding several names from the beginning of the year that are up 10-37%. Of the six names that are down YTD, only one was in the portfolio at the beginning of the year. The other 5 are part of this strategy. I believe that the overall portfolio can still participate if the market continues to rally, but I have removed some downside risk in pursuing this strategy.

Disclosure: Long HAYN and JNJ in a foundation I manage as well as in the Top 20 Model Portfolio (for both) and JNJ in the Conservative Growth/Balanced Model Portfolio