Diversifying With Cyclical Investments in a “New Age” Market
Brian is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
Diversification is always a hot topic among retail investors. In my opinion, there are many who have a skewed perspective when it comes to diversification, believing that index investing is most effective. However, we have more than a decade worth of proof that this is incorrect, as proper diversification must be changed accordingly to current market conditions. As a result, I am sharing my views, as I have experienced success in a flat market, and am looking at the importance of cyclical diversification in a “new age” portfolio.
Recap: This is a New Age Market
In a previous article, which looked at “new age” diversification from the secular point-of-view, I discussed how money managers often lure prospective investors with charts of annualized returns of more than 12%. These “annualized returns” are taken from the bull markets of the 80’s and 90’s, as most money manager’s charts consist of long term performance. The problem is that this isn’t the 80’s or 90’s, and since the year 2000, the market has performed virtually flat.
In today’s market you simply can not buy an index, sit back, and watch it grow. The performance simply is not present, and while the markets have traded higher historically, we have no idea of knowing if they will continue or when this flat market era may end. Therefore, the only way to invest is to purchase stocks based on value, and to invest in secular, cyclical, and speculative stocks that will return gains regardless of market conditions.
The Importance of Cyclical
In the previous article, which I call “Part 1,” I looked at the importance of secular investments in a portfolio. These are stocks that will remain consistent regardless of the economy. Cyclical investments, on the other hand, grow with a strong economy. A successful portfolio in today’s market requires a balanced mix of secular, cyclical, and speculative investments. This will provide security, growth, and a portion of your portfolio that could grow aggressively and produce large gains. As an investor, you will want a balanced collection of cyclical stocks, which are also safe and present value, therefore let’s take a look at a few things you want from a good cyclical investment, and five good stocks that meet the qualifications.
- High beta (more volatile than the market but not too much)
- P/E ratio below the S&P 500/sector (roughly 16x) or close to it
- High yield (investments that outperform bonds)
- History of increasing dividend and returning capital to shareholders (five years)
- High ownership
Of course there is more that goes into finding a good investment in addition to the things listed above. However, this is a good starting point, and will allow you to then narrow your selections. Therefore, here are a few top stocks that meet the requirements.
- General Electric is a diversified business with a presence in everything from financial to aviation. The company has not increased its dividend over the last five years, but only because of the recession, which has in turn made it really cheap. The stock is controversial, but in a growing economy it should appreciate nicely.
- Caterpillar is involved in construction equipment, engines, mining, and financial products. The company is very diversified, giving investors a presence in several cyclical segments. And with it trading so cheap, the stock could see massive upside if the economy grows.
- Apple has a forward P/E ratio of 7 minus cash and is expected to grow by at least 20% in 2013. There are many who believe the company will more than double its dividend this year, and with it having one of the best ecosystems in history, what’s not to like (besides its recent performance)?
- The auto industry is the strength of the market. Ford recently doubled its dividend and now sees a bottom to the economic hole in Europe. As a result, this is a stock that could very well appreciate with large gains as a high yield investment.
- Best Buy has not been consistent over the last few years. However, upcoming tax legislation could create some balance between it and online competitors such as Amazon. The stock trades with a price/sales of just 0.12 and could see massive growth in an economy where consumers have more expendable income. Therefore, I say Best Buy is worth the “buy.”
I feel it is important to remind you (from previous piece) that the strategy described in this article is nothing more than an intro into a topic that I discuss thoroughly in my new book “Taking Charge With Value Investing (McGraw-Hill).” My goal is to simply provide the basics, or enough for you to understand the idea and how to utilize diversification in a new era.
It would be impossible for me to fully break this topic down in this one article, because there is no one-size fits all system. As a person’s wealth grows larger that person typically feels less of a need to take chances, and therefore might invest heavily into secular investments. However, someone who is just starting out, with a $10,000 portfolio, would find it more rewarding to invest overweight in cyclical stocks, those with the greatest chance of returning the largest gains. Therefore, the idea is to find balance, determine your investment goals, and then invest in companies that can return wealth over a period of time, not indexes that could trade flat for the next decade.
BrianNichols owns shares of Apple and Ford. The Motley Fool recommends Apple and Ford. The Motley Fool owns shares of Apple, Ford, and General Electric Company. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!