The Problem With 'Diworsification'

by: Tim McAleenan Jr.

When Peter Lynch lamented the fact that some companies expand into areas widely different from their core business, he termed this strategy "diworsification." Over the years, this term has also been used to poke fun at some investors who choose to own 25-30 stocks. After all, the logic goes, "Why would you want to invest in your 22nd best idea when you can invest money in your best or second-best idea?"

Besides the fact that such an attitude ignores the possibility that an investor may prioritize capital preservation over the pursuit of total returns, it also makes quite the assumption: that we can definitively predict the future outcome of our investments.

For instance, let's say than an investor bought shares of Wal-Mart (NYSE:WMT) for $50 each in 2007. Now, in 2012, he has some money to invest in a chain store. After reading the balance sheets of the blue-chip chain stores, he concludes that he should buy Walgreen (WAG) for $30. Did this decision to add Walgreen to the portfolio make it worse? Personally, I couldn't tell you whether the Walgreen stock or the Wal-Mart stock will appreciate more by 2022.

Coca-Cola (NYSE:KO) and Pepsi (NYSE:PEP) are the more classic examples often used to prove this point. Which company will perform better over the next 10 years: Coca-Cola if you pay 20 times earnings for the shares, or Pepsi if you pay 15 times earnings (and we'll assume, for the sake of this discussion, that those are the lowest multiples available to establish an entry point)? For me, the answer would be the flip of a coin.

When the topic of diworsification comes up, there is this assumption that suggests that we can order our 30 stocks in a line and say "IBM (NYSE:IBM) will be the best-performing stock over the next 10 years, Becton, Dickinson (NYSE:BDX) will be the second best, and Aqua America (NYSE:WTR) will come in last." There are too many moving parts in play to make that kind of determination successfully; not only will we have to accurately predict the success of future business decisions that have not even been put in place yet by management, but we also have to determine the future dividend policy, earnings multiple, etc., that will take place over that time.

The suggestion that we can segregate our investments into these neat piles of "good" and "worse" also ignores the fact that valuation can make any company an equal investment to a superior company. For instance, Wells Fargo (NYSE:WFC) is my favorite bank company in terms of earnings quality. It'd probably be a screaming buy in the $15-$20 range. Bank of America (NYSE:BAC) does not excite me nearly as much as a company. But there comes a point when Bank of America's valuation could get so low that it would be equally attractive to Wells Fargo on a risk-adjusted basis -- maybe that price point is around the $3-$5 range, where the beaten down valuation of the Bank of America shares would compensate for the fact that Wells Fargo has higher earnings quality. If I could buy both Wells Fargo at $17 per share or Bank of America at $5 per share, how could I have the confidence to determine that one will give me much better total returns over the next decade? At that point, it's a crapshoot.

One of my favorite quotes from Ben Graham is that when we invest, we have to act like "prophets without the benefit of divine inspiration." We can look back on the past five years and say, "Oh yeah, Colgate-Palmolive (NYSE:CL) trounced Procter & Gamble (NYSE:PG) on a total return basis." But how many people in 2007 could say with confidence that Colgate was a much better idea than Procter & Gamble over the next five years? The theory that I'm diworsifying by purchasing shares of both Colgate-Palmolive and Procter & Gamble in 2007 only holds up if I have a crystal ball that tells me such things about Colgate's future outperformance.

Almost every industry has its one to three power players. Coca-Cola and Pepsi dominate beverages. Boeing (NYSE:BA) and Lockheed Martin (NYSE:LMT) dominate defense. Johnson & Johnson (NYSE:JNJ) and Abbott Labs (NYSE:ABT) dominate the diversified healthcare field. And on it goes throughout each industry. It's foolish to suggest that we are making ourselves worse off by adding all of these to our portfolios when the valuation becomes compelling.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.