Now before you get all excited and congratulate us for being such forward thinkers, we’re not talking about “employee diversification”. What we’re talking about is “portfolio diversification”.
Using Diversification for Stock Selection
When we first developed our methodology for building the Quantigence DGI Portfolio, the foundation of our selection method was our belief in the importance of diversification, both in industry and number of stocks. When combing through the 11 GICS industries to look for the stocks with the highest Q-Scores, we would encounter cases where two stocks had similar Q-Scores and we couldn’t decide which one to add. In these cases, we would always pick the stock that had the most dissimilar business to that of companies we already owned.
NEE: A Theoretical Example
Let’s present a theoretical example of how important diversification is by taking a look at our utility stocks. These are traditionally “safe stocks” with low betas so we shouldn’t have to worry about risk, right? Wrong.
One of the 3 utility stocks we hold is called Next Era Energy (NEE). In addition to being one of the largest utilities in the U.S., they’re also the largest provider of nuclear energy in the U.S. What do you think happens to NEE if there is a terror attack launched on a nuclear facility, not just in the U.S., but anywhere in the world? The stock would likely take a dramatic hit, as would the entire utility industry. In a worst case scenario, let’s say NEE lost half their value and then cut their dividend. We’d sell that position exactly 10 days following the dividend cut announcement. We’d then shop around for other utilities that would be trading at a discount due to the entire sector taking a hit.
In this example, our target weighting for NEE would have been 3.33% because we always hold 30 stocks in our portfolio (1 / 30 = 3.33). Now prices do fluctuate, but we’ll always look to trim a position if it exceeds 5%. If NEE was held at 5% in our portfolio at the time the bad news came out, we would have lost half our position value before selling. That would have has an impact of only 2.5% across our entire portfolio. In a worst case scenario where any one of our companies goes bankrupt, we’re still only out 3.33% based on our target position size. Given that that the average size of a company in the Quantigence DGI Portfolio is $92 billion, this doesn’t seem to be a likely scenario.
Conglomerates and Diversification
You’ve probably heard the term “conglomerate” used before. This refers to a company which holds businesses that operate independently in entirely different spaces. Warren Buffet’s Berkshire Hathaway (BRK.B) may be one of the most popular conglomerates out there. The advantages of a conglomerate is that you get the exact same type of diversification we seek when we look to own companies that all operate in different business areas. That diversification means that your returns are not correlated so you are less likely to suffer huge losses if something catastrophic happens.
We were pleasantly surprised to see that after the dust settled and our Quantigence DGI Portfolio was complete, we are actually holding 5 conglomerates. In a future article, we’ll take a look at why these 5 companies would be considered conglomerates.