Diversifying a portfolio is a portfolio management tool, which aim is to lower risk and increase returns.
There are many ways to diversify a portfolio. Some of the more popular ways are, investing across: asset classes, market sectors, geographies and market cap.
David Fish's CCC spreadsheets offer the possibility of taking 2 of those 4 diversification ways into account: market sectors and market cap.
In previous articles I have used the Dugan Stock Scoring System to identify high quality stocks by market sector. See here for the latest post.
This article analyzes David's October All-CCC list of +/- 750 stocks by quality and then market cap. In the quality realm, only CCC stocks in the top 50%, by Dugan Score, are considered; insuring that only high quality stocks make the first cut. In the market cap realm, I then identified the highest scoring stocks in each of 3 cap sizes: greater than $20B (large cap), $5B to $20B (mid cap) and $1.5 to $5B (small cap).
No consideration was given to yield. I think yield is an important consideration to SA readers. But, I also think the absolute level of yield which makes it important varies all over the SA reader map. So, for this article, the results vary only by quality and size.
For your consideration as you might seek to rebalance, I offer the following counsel from Investopedia: " Studies and mathematical models have shown that maintaining a well-diversified portfolio of 25 to 30 stocks yields the most cost-effective level of risk reduction. Investing in more securities yields further diversification benefits, albeit at a drastically smaller rate."
Speaking for myself, when managing a portfolio it's important to stay current with detailed information about each holding in the portfolio, all the time. As it relates to individual investors, I believe it's impossible to always stay so current with such detailed information if portfolio size exceeds about three dozen holdings. Remember, "manage" is an active verb. If you aren't staying current with information about each of your holdings, all the time, you aren't "managing."
The Dugan Scoring System is a tool to identify the overall quality of CCC companies. I believe there is a strong correlation between Dugan Scores and the quality of stocks. Those companies' stocks earning high Dugan Scores are high quality stocks which should produce better investing results, going forward, than otherwise would be attained by simply filtering for desired characteristics. In this context, highest quality means companies which have:
STRONG CURRENT CONDITIONS, as exemplified by: great value as measured by relative Graham number, low payout ratio, low debt/equity ratio and high Most Recent dividend increase %. EXCELLENT FUTURE PROSPECTS, as exemplified by: high EPS growth forecasts for This Year, Next Year and 5 years out, and excellent dividend growth histories.
The Dugan Scoring System isn't a popularity contest. It is a disciplined, systematic and dispassionate approach that evaluates each CCC stock on the basis of a wide variety of investment criteria from four broad categories: Risk, Value, Past Performance and Future Performance Expectations.
So, the purpose of the Scoring System is to determine the all-around quality of a stock for buying, holding or selling purposes.
But, no stocks, like no people, are perfect. Even high quality and high scoring stocks have weaknesses, the same as low scoring and low quality stocks have some strengths. So, a Dugan Score is a balanced, holistic picture of a stock, which includes its strengths and weaknesses.
You can see from the above explanations, the Dugan Stock Scoring System is about the current state, and expected future performance, of a company's stock; not necessarily the company itself. And, it doesn't matter how well a company's stock has performed for its owners in the past. What only matters are the current condition and expected future performance of the stock.
The table below is a summary of the metrics used in the Dugan Stock Scoring System, along with each metric's relative weighting in the overall formula. The weightings are my assessment of each metric's relative importance in calculating the company's overall quality.
After calculating the Dugan Score, a small bonus, or penalty, is applied to the earned-score for each CCC stock, based on a few brokers' recommendations for current sector weightings. The base bonus or penalty calculation is simple: market weight earns zero points, overweight earns 1 point, underweight earns minus 1 point, net/net from each of the 3 brokers.
Using the Dugan Stock Scoring System, and the market cap filters, yields the following companies as the highest scoring, October 2016 CCC companies by market cap:
Each of these 30 companies has at least one weakness which should give pause and require further due diligence. For instance, many of the companies have rather short tenure on the CCC list - 5, 6 or even 7 years. This implies they had to cut or freeze their dividend during the great recession. Personally, I like a minimum of 8 years on CCC for my own purchases. It's not an absolute rule, but fewer than 8 years causes me to pause and look for many strengths to outweigh the weaknesses.
I hope you enjoyed this journey. Comments are encouraged. Happy investing.
Disclaimer: The opinions in this document are for informational and educational purposes only and should not be construed as a recommendation to buy or sell the stocks mentioned or to solicit transactions or clients. Past performance of the companies discussed may not continue and the companies may not achieve the earnings growth as predicted. The information in this document is believed to be accurate, but under no circumstances should a person act upon the information contained within. We do not recommend that anyone act upon any investment information without first consulting an investment advisor as to the suitability of such investments for his specific situation. (Borrowed from Chuck Carnevale.)
Disclosure: I am/we are long THG, VLO, PRU, DOW, ADM, LNC.
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.