Capital Markets U.com » Diversification

Reality Show for Investors: “Survivor”

Admin — Fri, 16 Sep 2011 21:00:32 +0000

Weston Wellington September 16, 2011

Anyone studying the long-run history of American business cannot help but observe how many of the prominent firms of one era fail to make it to the next. Free-market economies are characterized not only by intense competition but also by disruptive change. Sometimes a company’s toughest competitor turns out to be a firm it has never heard of selling a product or service that didn’t exist until recently. The list of companies that once dominated their industry but have fallen on hard times is lengthy enough to give every thoughtful investor reason for sober reflection.

Among many possible examples, a number of firms come to mind that were once highly regarded but later encountered serious or even fatal problems.

Bethlehem Steel pioneered the steel I-beam, which launched a skyscraper boom in cities across the country. Its engineering expertise supplied the steel sections for the Golden Gate Bridge. But growing competition and a changing marketplace eventually took their toll, and the firm filed for bankruptcy in 2001.
In 1973, Eastman Kodak held a seemingly impregnable position in the lucrative market for photo film and chemicals, enjoyed a reputation for innovation and astute marketing, and boasted a market value even greater than oil giant Exxon. Kodak shareholders had been favored with an uninterrupted stream of dividends dating back to 1902. Today the company is struggling to reinvent itself as the film business shrivels, the dividend has been suspended, and the share price is limping along under $3.
A Fortune article profiling Pfizer in mid-1998 praised it for having “one of the richest product pipelines in the Fortune 500.” A Wall Street analyst enthused that “some of my clients refer to Pfizer as the best company in the S&P 500.” In early 1999, a Forbes cover story sounded a similar note, crowning Pfizer “Company of the Year” and observing that “the people who brought us Viagra have more blockbusters on the way.” Thirteen years later, the Viagra boom has subsided, patents are expiring on highly profitable products, and the gusher investors expected from the research pipeline has slowed to a trickle. The share price has slumped over 50% since year-end 1998 compared to a 3% loss for the S&P 500 Index.

Some companies almost single-handedly create new industries but still find it difficult to turn innovation into a permanent advantage. Pan Am (air travel), Kmart (discount retailing), Polaroid (instant photography), and Wang Laboratories (word processing) all had impressive initial success and provided handsome rewards for their investors. Alas, neither Pan Am nor Polaroid survives today, and Kmart shareholders were wiped out when the firm emerged from bankruptcy in 2003. (Kmart, Polaroid, and Wang Laboratories were all cited as examples of “excellent” companies in the 1982 bestseller In Search of Excellence.)

Evidence of this “creative destruction” appears all around us. For example, the Wall Street Journalreported that shares of Minnesota-based Best Buy Co. slumped Wednesday to their lowest level since 2008 after reporting a 30% drop in quarterly profits. For most of its life, Best Buy has been the toughest kid on the block, vanquishing rivals such as Highland Superstores and Circuit City on its way to becoming the nation’s leading electronics retailer.

Will Best Buy fall victim to even tougher competitors such as Amazon.com or Walmart? Or is this current downturn just a speed bump on the road to even greater success? No one can say. For every riches-to-rags story, we can find another tale of decline followed by dramatic recovery. According to some accounts, for example, Apple was only a few months from bankruptcy when Steve Jobs returned to the company in 1997. Now it vies with ExxonMobil for the number one spot in a ranking by market cap. And who would have imagined that a floundering New England textile firm with a low-margin business that sells suit-lining fabric would one day become a financial colossus known as Berkshire Hathaway?

The thrill of owning a great growth company during its most lucrative phase is a powerful incentive to search for the Next Big Thing. But almost every company with a highly profitable position is under constant attack from competitors seeking to garner a portion of those hefty profits for themselves.

As a result, the search for firms destined to generate greater-than-expected profits for many years into the future is fraught with peril and likely to end in frustration. Most investors will be far better off harnessing the forces of competitive markets and putting them to work on their behalf by holding a diversified portfolio. As Nobel laureate Merton Miller once observed, “Above-normal profits always carry with them the seeds of their own decay.”

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Miguel Bustillo and Matt Jarzemsky, “Best Buy Gets Squeezed” Wall Street Journal, September 14, 2011.

David Stipp, “Why Pfizer Is So Hot,” Fortune, May 11, 1998.

“Pfizer: Company of the Year,” Forbes, January 11, 1999.

Standard & Poor’s Stock Guide, 1974.

Thomas Peters and Robert Waterman, In Search of Excellence (HarperCollins, 1982).

Merton Miller, “Is American Corporate Governance Fatally Flawed?” Journal of Applied Corporate Finance, Vol. 6, No. 4, Winter 1994.

The Wisdom of Solomon – Diversification is not new

Charles L. Stanley CFP® ChFC® AIF® — Wed, 16 Dec 2009 02:02:54 +0000

We are all familiar with the idea of “the wisdom of Solomon” because he figured out how to discern the real mother of an infant by threatening to cut the infant in half and each woman could have half an infant. Of course the real mother said, “No, give it to the other woman” and their true identity was revealed.

Is there such a thing as the “wisdom of Solomon” when it comes to investing? Well, you betcha! And, it has powerful contemporary application. Here it is, Ecclesiastes 11:1-6 (ESV).

1 “Cast your bread upon the waters,
for you will find it after many days.
2 “Give a portion to seven, or even to eight,
for you know not what disaster may happen on earth.
3 “If the clouds are full of rain,
they empty themselves on the earth,
and if a tree falls to the south or to the north,
in the place where the tree falls, there it will lie.
4 “He who observes the wind will not sow,
and he who regards the clouds will not reap.
5 “As you do not know the way the spirit comes to the bones in the womb of a woman with child, so you do not know the work of God who makes everything.
6 “In the morning sow your seed, and at evening withhold not your hand, for you do not know which will prosper, this or that, or whether both alike will be good.”

The first principle in verses one and two is diversification to reduce risk. In Solomon’s case, he was referring to sending “bread”, the wheat and other grains harvested in Israel, on ships to other ports as trade. Sending your grain on a ship was risky but was the most efficient way to participate in trade. Take risk and after many days your profits will come back after the grain is sold.

Now to the diversification part, “Give a portion to seven, or even eight, for you know not what disaster may happen on earth.” Interpretation: Do your shipping on several ships, not just one. If a bad storm comes up on the sea your one ship may go down and you will have lost all (Can anyone spell Enron, Bear-Stearns or Lehman Brothers?). So, spread your shipping across multiple ships and multiple routes and reduce your risk of loss.

Diversification is primarily a way to reduce your risk of loss, not a way to make more profits. However, if you compare the results of a shipper who always spread his risk across several ships versus the merchant who always used only one ship, eventually the diversifier would make more profit. That is because statistically, both will lose a shipment occasionally and the diversifier will only lose part of his crop whereas the non-diversifier will loose 100% of that year’s crops (like Enron, etc.).

Carry this forward to contemporary equity or stock investing and the same principles apply. Diversify broadly and you will reduce the risk of loss and the risk of volatility of returns.

If I construct an equity portfolio of three funds, one with US stocks, one with non-US stocks of companies in mature markets and one with stocks from Emerging Markets and each of these own virtually every publicly traded stock in their respective markets, then I have diversified away every conceivable risk except one; market risk. And, I would own virtually the entire world stock market. Every time someone buys or sells and makes profit, I own a little (very little) piece of that deal.

Principle number two: Risk is everywhere, you can’t escape it.

3 “If the clouds are full of rain,
they empty themselves on the earth,
and if a tree falls to the south or to the north,
in the place where the tree falls, there it will lie.”

When rain comes it may be a nice rain to increase crops or it may be an old fashioned “gully-washer” and wipe out everything in sight. We have no control over this. We can do our best to apply good agricultural principles in how we plant and how we plow but some things are just overcome by the rains.

None of life is free of risk. Regarding investments there is inflation risk, interest-rate risk, company risk, industry risk, country risk, money-manager risk, currency risk, etc. Here a risk, there a risk, everywhere a risk – risk. Old MacDonald had a risk. Sorry… got carried away there.

Proper diversification can eliminate all of these risks except market risk; that is one risk an investor just can’t eliminate.

Principle three: Don’t procrastinate because of risk.

4 “He who observes the wind will not sow,
and he who regards the clouds will not reap.”

The farmer who is always waiting for calm winds before planning seed so it won’t get blown away will never get around to planting his seed and the farmer who is afraid to begin harvesting for fear the clouds will bring rain and cause his crops to rot in the field will never get around to harvesting his crops – no profit.

Does it sound familiar? I can’t invest because:

Of the war in Iraq/Afghanistan

Of the credit crisis

Of the real estate/mortgage crisis

Of the failure of Lehman Brothers

Of the failure of Enron, WorldCom and Tyco

Of the bursting of the tech bubble

Of the recession

Of the George W. Bush administration

Of the Barak Obama administration

Of the Republicans being in charge

Of the Democrats being in charge

History is filled with excuses for not investing and accepting the risk of the equity markets and yet, since 1926 the large cap stock market has averaged approximately 10.5% per year. If one was willing to accept more volatility risk and invested in small cap stocks instead, the average return was much greater than 10.5%.

5 “As you do not know the way the spirit comes to the bones in the womb of a woman with child, so you do not know the work of God who makes everything.”

The world is complex and just as we don’t understand everything about the development of a child in the womb, we don’t understand everything about how God oversees the economies of the world and allows for profits to be made fairly consistently over time. If I diversify broadly enough, I don’t have to understand the minutiae of the markets to profit from investing in them. I know God has placed in man the desire to produce, to make profit, the desire to do better for himself and for his family and as long as man has sufficient freedom to pursue those interests, there will be profit, and profit is a good thing (this will be the subject of another article later). Go capitalism!

Principle four: Keep on investing

6 “In the morning sow your seed, and at evening withhold not your hand, for you do not know which will prosper, this or that, or whether both alike will be good.”

The picture here, again, is a farmer in the ancient near east. He is encouraged to sow seed all day long, from morning to night, because he doesn’t know which seed and which part of his fields will have all the right conditions to produce an excellent crop – or if none of it will. This is another way to approach diversification.

Regardless of the great efforts of our finest young MBAs to research the markets and make the best most informed decisions possible, the track record shows that we don’t really know which stocks will perform best or if, as over the past couple of years, none of the seed will do well. This past market decline was characterized by stock market losses in all markets, domestic, international and emerging markets. That was not anticipated and it is unusual. Some have referred to this as a “Black Swan” event. When looking at a flock of swans, you don’t expect to see a black one, but occasionally you will. We did!

So, lets review quickly the Wisdom of Solomon regarding investing.

Diversify broadly to reduce risk.
Risk is unavoidable. There is no such thing as a risk-free investment.
Don’t procrastinate because of risk.
Keep on investing.