Outperforming In Bull And Bear Markets (With Stocks Only)

Summary

• I have been using sector diversification and a bias towards business model resilience to create an outperforming, "all seasons" stock portfolio.
• Today, I talk a bit about my process for picking stocks that I believe can thrive in bull markets and do relatively well in bear markets.
• Within the framework described in this article, what other stocks would you buy at current levels?
• Looking for a helping hand in the market? Members of Storm-Resistant Growth get exclusive ideas and guidance to navigate any climate. Get started today »

I have spent the past couple of weeks passionately advocating for asset-class diversification. The strategy basically comprises of risk-balancing a portfolio into stocks, bonds, REITs, precious metals and other commodities. In fact, I have been a fan of the approach for the past couple of years at least.

While the performance of my broadly diversified strategy proved inferior during the stock market's roaring bull years (in absolute terms only, mind you, not always in risk-adjusted terms), the approach has been outperforming the S&P 500 by a mile in the past few weeks. Year to date, the SRG Base (my core storm-resistant growth portfolio) was up about +7% by end of day March 9th against the broad stock market's highly uncomfortable -15%.

Credit: lifehacker.com

But asset class diversification aside, I also have my thoughts regarding equity investing and stock picking. Case in point, I have been tracking my All-Equities Storm Resistant Growth (a.k.a. AE SRG) portfolio on a weekly basis since July 2018 alongside my marketplace community. Inception to date through March 9th, the AE SRG has been lavishly beating the S&P 500, as the chart and table below depict: +13% returns per year vs. the benchmark's timid +2%, on just a bit higher volatility and slightly steeper maximum drawdown.

Source: DM Martins Research, using data from Yahoo Finance

Of course, the AE SRG is much more highly concentrated than the S&P 500, as it contains only 20 stocks. But concentration alone does not seem to fully justify the portfolio's superior performance so far.

Here's what I mean: since the start of the stock market decline, on February 19th through March 9th, the AE SRG portfolio has declined "only" -14% vs. the S&P 500's -19% unwind. In annualized terms, the portfolio's volatility has even been slightly lower: 48% vs. the benchmark's 52%. And the portfolio's worst day during the correction has been a bit worse than -5%, while the broad market fell nearly -8% this past Monday alone.

Source: DM Martins Research, using data from Yahoo Finance

How come the AE SRG portfolio has so far produced better returns during bull and bear periods over the past 20 months (i.e. since inception)? One of the potential justifications is luck, of course. But I also believe that some of the same diversification principles that I use in my multi-asset class portfolio can also be successfully applied to an all-equities strategy.

Playing offense and defense at the same time

In assembling a stock portfolio, diversifying across sectors has been one of my key tenets. The Nasdaq 100 (QQQ), for example, has performed superbly during the bullish period of 2009-2019. Yet, the index is heavily weighted towards the technology sector. Should the space undergo a severe correction, as it did in the early 2000s, the portfolio could very well lose more than 50% of its market value (it sank 83% from peak to trough, following the bursting of the dot-com bubble).

For this reason, the AE SRG's allocation is well balanced across more aggressive (i.e. tech, financial services and consumer discretionary) and more defensive (i.e. consumer staples, telecom and gold mining) sectors. See pie chart below.

Source: DM Martins Research

The 5% allocation to gold miners is particularly interesting. Shares of Barrick (GOLD) and Newmont (NEM) have historically been highly correlated with the fluctuations in the price of gold. Not only that, but the moves tend to have a gold beta of about 3.0 - that is, each 1% move in gold prices tends to translate into a 3% move in the market value of GOLD and NEM.

The gold miner position in the stock portfolio, therefore, is in a way equivalent to holding a 15% stake in gold, which in turn is a very defensive asset class. During the coronavirus-driven correction of February 19th to March 9th, the GOLD and NEM positions combined returned -0.5%. That kind of return, even if negative, looks very much like a win given the weakness in the equities market.

Although AE SRG does not hold any utilities stock (yet), this sector (XLU) would probably be a good addition to a diversified, all-equities portfolio. A dividend yield of 3.0% in a low interest rate environment only begins to tell the story.

At least historically, utilities have outperformed the S&P 500 in absolute terms while producing similar levels of volatility. But even better, correlation between the sector's performance and that of the broad market has been low, at a coefficient of only 0.38 (see table below). Worth noting, however, utility names have corrected rather sharply during the two mega bears of 2000-2003 and 2007-2009, not unlike the S&P 500.

Source: Portfolio Visualizer

Aside from the ultra-defensive sectors, I tend to favor stocks of companies that have one or both of the following features:

1. A business that is agnostic or resilient to the ups and downs of the economic cycle.
2. A subscription-like or otherwise recurring revenue model that provides visibility and stability to future financial performance.

Regarding the first bullet point above, TJX Companies (TJX) comes to mind as a relevant example. I wrote an article in August 2018 in which I asked whether TJX was "an anti-gravity stock". Let me explain.

The retailer tends to thrive when the economy is strong, since it benefits from higher discretionary spending. However, due to the off-price model, the company also tends to do just fine when the economy is not doing so well, since consumers tend to turn to discounting when money is tight. As a result, during both mega-bear periods of the current century, TJX outperformed the S&P 500 by at least 12 percentage points annualized (see table below).

Source: DM Martins Research, using data from Yahoo Finance

Regarding the second point above, one of the best examples that I can think of is Adobe (ADBE). The San Jose-based company runs what can be described as a monopoly in the digital asset creation and management space at scale, and the company's enviable subscription-based business model should provide stability to revenue and earnings growth.

Interestingly, the stock had been down -19% from market peak to March 9th on COVID-19 and recession fears. In my view, these factors should have little to no impact on how many users sign up for Photoshop, Lightroom or Magento, or how many of them choose to cancel their product or platform subscriptions. Therefore, ADBE looks to me like both a long-term winner and a potential buy-on-dip opportunity today.

Parting words

In summary, I have been using sector diversification and a bias towards business model resilience to create an all-equities portfolio that, so far, has outperformed the S&P 500 during both good and bad times. By playing defense and seeking portfolio balance, I hope to continue creating market-beating returns with my stock portfolio going forward.

I would love to hear from the readers: within the framework described in this article, what other stocks would you buy at current levels? I appreciate if you leave your comments below.

Analyst’s Disclosure: I am/we are long ADBE, GOLD, NEM, TJX. 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.