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The (Non)Sense Of Diversification In A Buy And Hold Portfolio

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Includes: AAPL, ABT, ALIZF, AVGO, CMCSA, CSCO, DIA, ELIAF, EQIX, IWM, JNJ, KMB, KO, MLXSF, MMM, MO, PG, SPG, SPY, WDPSF
by: Option Generator
Summary

In my previous article about my favorite investment strategies, I gave you some color on my screening process and why I focus like a laser on a few stocks.

Our core buy and hold portfolio is currently diversified into 10 stocks, all of which have great long-term prospects.

Driven by a false feeling of safety, most investors tend to over-diversify thinking they reduce the overall portfolio risk.

Introduction

In my previous article about my favorite investment strategies, I gave you some color on my screening process and why I focus like a laser on a few stocks which I believe are poised for market-crushing returns. Over the past several months and years, I've had the very good fortune of analyzing dozens of companies, but because of following too many stocks, I acquired undervalued stocks that didn't necessarily meet my high-quality requirements. That's why I decided to turn around my portfolio and to prefer quality over undervaluation. Today, I believe my fine-tuned portfolio now reflects a good balance between growth, dividend, and safety.

Long-Term Performance

As you can see from the pie chart below, our core buy and hold portfolio is currently diversified into 10 stocks, all of which have great long-term prospects, but their current valuation metrics deviate heavily from each other. When I've done my due diligence properly and balanced out the overall risk by selecting top stocks that have proven to bring forward outstanding value creation (and I expect them to retain that favorable status going forward), I'm determined to hold onto these shares for a very long time, even if market sentiment is depressed. Today, the following 10 core positions form the basis for first and foremost appealing dividend streams and additional share appreciation because of multiple expansion:

(Source: Author's work)

Over the past several years, this basket of stocks has easily outpaced the S&P 500 (SPY), Russell 2000 (IWM), Dow Jones (DIA), and the Eurostoxx 600 thanks to the amazing amount of cash flow growth, smart acquisitions, and below-average gearing. Additionally, they've also outpaced the returns generated by the Dividend Aristocrats such as Coca-Cola (KO), Kimberly-Clark (KMB), Abbott Laboratories (ABT) et cetera.

(Source: Tradingview)

I'm quite sure that most of you tend to invest in more than 10 names and may think that this portfolio will be more susceptible to steep market corrections. Hypothetically, that should be true as it is composed primarily of smaller family-controlled companies and thus less liquid underlying securities.

Now, let's look in the rearview mirror to see whether this statement is arguable. I put this long-term portfolio to the test and I was glad to see most of my positions weathered the December storm of last year very well. The reason why they keep up during downturns might be long-term ownership shared by many other shareholders who are of the same mind: simply retaining your shares, ignoring the noise, and only looking at the fundamentals.

(Source: Tradingview)

More importantly, these stocks tend to have a substantially lower beta compared to their reference index, adding to their attractiveness during market corrections.

Name 3-Year Beta

5-Year Performance,

(Excl. Dividends)

Month

Of First Purchase

Sioen Industries 0.81 178.9% April 2018
Ter Beke 0.25 134.8% June 2018
TINC 0.15 - June 2018
Jensen Group 0.39 148.0% May 2018
Elia (OTC:ELIAF) 0.31 74.3% March 2018
Melexis (OTC:MLXSF) 1.10 109.5% September 2018
VGP 0.20 290.2% November 2017
Warehouses De Pauw (OTC:WDPSF) 0.50 155.5% January 2018
Kinepolis 0.66 71.3% March 2018
Moury Construct 0.13 41.0% February 2018
AVERAGE 0.45 133.72%

(Source: Infrontanalytics)

Industry Breakdown

Despite the fact that our buy and hold portfolio is highly concentrated on a few stocks, we've consciously targeted industries that have economic resilience, allowing for secured dividends.

(Source: Author's work)

Delving even more deeply into their activities, we spot the wide variety of end markets that these companies are operating in. Let me run through their business models.

Elia is a transmission system operator with a monopoly in the Belgian market and plays a key role in other European markets such as Germany where it retains a majority stake in 50Hertz. Elia remains a stable company that provides secured dividends while keeping their payout ratio under control to free up capital for investment opportunities. Since its IPO, the company has never been forced to cut its dividend.

TINC focuses on investments in infrastructure providing cash flows of a long-term sustainable nature. This company is considered to be a bond proxy stock. Management has a very clear long-term view of future cash flows.

(Source: company presentation)

Kinepolis is a cinema group that wants to offer its audience the ultimate movie experience. Through several acquisitions, Kinepolis has extended its traditional profile to a broader entertainment company. Two years ago, the company announced it was planning to acquire Landmark Cinemas. Bearing in mind that Landmark's profit margins remain one-third of those of Kinepolis, this move should be the driving force for many years to come.

(Source: Valuespectrum)

Car safety and automation are two areas which Melexis has worked in for many years and that's ultimately the only reason why investors should look at this interesting tech company. Until the end of September, Melexis shares had been trading at expensive multiples, but due to fears of a slowing world economy, price levels have become more acceptable.

Building constructor Moury Construct proves it can be an erroneous view to suggest that the constructing industry doesn't offer buy-and-hold opportunities. When bearing in mind that at least 75% of today's market cap is net cash, shares are trading at depressed multiples. Moreover, Moury Construct will manage to grow its revenue to more than 100 million for the first time this year. This bond proxy stock offers opportunities for patient investors looking for boring and predictable dividend income.

The last ones are VGP and WDP, specialized in logistics real estate. While WDP is forced by law to distribute at least 80% of its annual net profits, VGP continues to recycle its capital invested in big projects, thanks to its joint venture with Allianz (OTCPK:ALIZF). Through the issuance of bonds at interesting rates, both companies focus on growing their property portfolio in Eastern Europe, especially in Romania where logistic property yields hit the 8% mark. I expect VGP to hike its dividend really fast through a combination of receiving new projects (and rental income) and a steadily rising payout ratio.

As you can deduct from the pie chart, I highly overweight REITs because of the humungous returns this industry has brought forward for quite a long time. With most of them being up 20% year-to-date, REITs are hot and there are definitely less opportunities presenting themselves in the high-quality space. Nevertheless, as long as its growth machine is running at full capacity and the multiples remain very reasonable, I plan to add more to my existing position in VGP.

(Source: Author's work)

Dividend Income

My parents and I hunt for rock-solid and predictable dividend streams and in order to eventually live off our income streams, we've created several categories to classify our stocks in and explicitly opted to cherry-pick dividend growth companies.

(Source: Author's work)

Just to get my point across, these classifications have a personal interpretation. For me, if the annual dividend growth rate can't keep up with the inflation rate and the gross dividend yield is above 3%, I consider this to be 'high dividend'. Besides selecting some dividend cannons, we still have decades to go, so we're also intended to focus on growth companies for which rapidly growing dividends are not a priority as they prefer to use their cash surplus to opportunistically chase after takeover preys.

By scooping up dividend growth stocks, I aim at doubling our dividends over the next two years.

(Source: Author's work)

The dividend breakdown for 2019 is as follows:

(Source: Author's work)

Heading into the new dividend season of this year, our dividend income is buoyed by three key players: VGP, TINC, and Warehouses De Pauw. While TINC's dividend growth rate is barely beating the Belgian inflation rate, VGP and WDP intended to hike their dividends by 15.6% and 7.0% respectively over FY 2018. Ter Beke and Jensen froze their dividend last year, but they are definitely capable of retaking their impressive streak of dividend growth over the next two years.

(Source: Author's work)

The Perfect American Buy And Hold Stocks

Of course, the fundamental guidelines (such as dividend safety, manageable leverage, attractive capital allocation, long-term visibility) I've implemented in my own Belgium-based portfolio can be used for American securities as well. If I had to put a basket together containing the 10 best blue-chip stocks for the next years, I would have made the following selection.

Name FCF Yield Leverage (Net Debt/EBITDA) (e) 3-Year Beta
Broadcom (AVGO) 6.9% 1.9x 0.49
Apple (AAPL) 6.4% Net Cash Position 1.09
Altria (MO) 7.8% 1.9x 0.61
Comcast (CMCSA) 6.8% 3.4x 0.72
Cisco (CSCO) 5.4% Net Cash Position 0.90
Johnson & Johnson (JNJ) 4.9% 1.5x 0.73
Simon Property (SPG) P/FFO = 14.5 5.1x 0.42
3M (MMM) 4.0% 1.7x 1.19
Equinix (EQIX) P/FFO = 23.6 5.0x 0.48
Procter & Gamble (PG) 4.3% 2.0x 0.54

(Source: information based on company results and infrontanalytics)

Takeaway

Driven by a false feeling of safety, most investors tend to over-diversify thinking they reduce the overall portfolio risk. Nevertheless, by doing that, they add unsystematic risk and superfluous management work to their portfolio.

In contrast to this mindset, I'm a strong believer in stock picking and that's why our buy and hold portfolio consists of 'just' 10 cherry-picked stocks. From a long-term point of view, instead of giving into stock market fickleness, only operational performance matters to me and with the stringent control of their founding families, it's very likely that these companies won't squander free cash flows but safeguard future dividend payments. Heading into the coming years, VGP continues to play a key role in achieving our financial goals.

Disclosure: I am/we are long ALL BELGIAN STOCKS MENTIONED IN THIS ARTICLE. 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.