Diversification the Right Way
Justin is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
There are generally two schools of thought when it comes to investing: the trend is your friend and mean reversion. Some investors only want to buy stocks at a 52-week low and others when the stock is breaking to a new high. With the beginning of the year full of stock picks and forecasts, I propose a four stock portfolio comprised of the top two stocks in the S&P 500 over the previous calendar year and the two worst stocks in the S&P 500. I back tested for just the past three years, but the results are pretty remarkable; 100% success in beating the Index and an average return of 32.8% versus 14.5% for the S&P 500.
Hurry, show me the names!
This philosophy will test your behavioral biases, but it does bring together a best of both world’s philosophy. Knowing whether the previous year’s winners or losers would pan out in the subsequent year was kind of hit or miss; sometimes it was the losers and sometimes it was the winners and sometimes both. So are you ready to pull the trigger? First up is First Solar (NASDAQ: FSLR), which lost 74% in 2011. Second is Monster Worldwide (NYSE: MWW), which returned a negative 66% to investors in 2011. Third is the red hot energy patch with Cabot Oil and Gas (NYSE: COG) and El Paso (UNKNOWN: EP.DL), which returned 301% and 93%, respectively. Buy those four and walk away. It sure seems tough to stomach, but if the last three years are any indication then you won’t be disappointed.
And the previous year's results?
The four stocks to buy at the beginning of 2011 were Cummings (NYSE: CMI), Wynn Resorts (NASDAQ: WYNN), Dean Foods (NYSE: DF), and H&R Block (NYSE: HRB). The returns for the above stocks in the order they are listed were -18.8%, +12.2%, +26.7%, and +43.2% for an average return of +15.8% on an equally-weighted portfolio. That compares favorably against the +2.1% the S&P 500 mustered up in 2011.
The four stocks for to buy at the beginning of 2010 were Marshall & Ilsley, which was later acquired by Bank of Montreal (NYSE: BMO) in 2011, Huntington Bancshares (NASDAQ: HBAN), XL Group (NYSE: XL), and Tenet Healthcare (NYSE: THC). The returns for the above stocks in the order they are listed were +27.7%, +89.4%, +21.5%, and +24.1% for an average return of +40.7% on an equally-weighted portfolio. That more than doubles the S&P 500 and its +15% return for calendar 2010.
The four stocks for to buy at the beginning of 2009 were Fannie Mae (FNMA) and Freddic Mac (FMCC), which have both since been removed from the Index, Family Dollar Stores (NYSE: FDO), and H&R Block (NYSE: HRB). The returns for the above stocks in the order they are listed was +55.2% +101.3%, +8.7%, and +3.0% for an average return of 42.1% on an equally-weighted portfolio. Again, that far outpaces the S&P 500 and its 26.4% return.
Go for it
You look over the names and it might make you cringe, I know it does for me, but the results are quite remarkable. You would have had to buy the worst stories and the bubble stories. In the end it works out. It is also another way to try and generate market beating returns with stock correlations at all-time highs. I like this strategy a whole lot more than the super-cap dividend names that you read about on a daily basis. In fact, I think I am going to have to follow my advice and following through on this strategy.
I have no ownership position in the referenced entities at the time of publication.