The Importance Of All-Cap Diversification

By Will Ashworth | May 12, 2010 AAA

The recent market meltdown saw the Dow Jones Wilshire 5000 lose 6.8% of its value in just five trading days. The 16-stock all-cap portfolio that I put together in four articles between late July and early September 2009 dropped just 7.6% despite the fact Hansen Natural (Nasdaq:HANS) and five other stocks in the portfolio dropped 9.1% or more. What saved it from a more devastating decline? Large-cap stocks. The four declined an average of just 2.3% and Dr. Pepper Snapple (NYSE:DPS) even managed to gain 10%, the only stock of the 16 to do so. The portfolio did exactly what it's designed to do - act as a team. Good teams manage to get performance from somewhere even when they're struggling. That's how they stay on top. Investing's no different. The wild ride we experienced the week of May 3 to May 7 clearly demonstrates the need for all-cap diversification.

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16-Stock All-Cap Portfolio - May 3 to May 7, 2010



Company Return
Best Large Cap Dr. Pepper Snapple (NYSE:DPS) 9.1%
Worst Large Cap Hess (NYSE:HES) -10.7%
Average

-2.3%
Best Mid Cap Safeway (NYSE:SWY) -1.5%
Worst Mid Cap Hansen Natural (Nasdaq:HANS) -15.4%
Average

-9.6%
Best Small Cap Cinemark Holdings (NYSE:CNK) -1.5%
Worst Small Cap Heartland Payment Systems (NYSE:HPY) -14.4%
Average

-7.8%
Best Micro Cap U.S. Physical Therapy (Nasdaq:USPH) -4.5%
Worst Micro Cap Cray (Nasdaq:CRAY) -22.3%
Average

-11.6%

Balance
Large caps saved the day this time but that won't always be the case. In fact, small cap stocks outperformed large caps in nine of the last 11 years. Ignoring small caps in favor of blue chip companies over the long-term will reduce your returns while only marginally minimizing your risk. That's a bad trade-off. In the first four months of the year, the 16-stock portfolio achieved a 24.6% return to the end of April, 16.7% better than the broader market as a whole. In this period, the large caps saw an average return of 11.0%, compared to 38.1% for small caps, 27.5% for micro caps and 19.9% for mid caps. If it was more heavily weighted in large caps in the first four months, it still would have outperformed the index but not by nearly as much. This catches up to you over time.

Surviving A Hit
The market meltdown wreaked havoc on 2010 returns. The Dow Jones Wilshire 5000 was up 7.9% at the end of April and appeared headed for more in the coming months when a supposed 'computer glitch' and European debt concerns brought the whole house of cards tumbling down. As mentioned earlier, the all-cap stocks dropped 7.6% in the first trading week of May, 80 basis points worse than the index. However, the drop erased only 30.9% of the gains to-date compared to 86.1% of those for the index. While these numbers clearly demonstrate the volatility in the markets, the all-cap portfolio performed better than most over the five-day stretch. Once the dust settles, one or more of the caps will jump ahead, pulling the rest of the portfolio along for the ride. At the very least, some of the price declines present buying opportunities.

Four Buying Opportunities
Hansen Natural is probably the best opportunity. In five days trading, the mid-cap saw its year-to-date returns entirely erased. The cause for the drop was an earnings miss in the first quarter. Long-term investors should view this as a bump in the road. It'll be back into the 40s in no time.

With a mid-cap out of the way, let's look at the best micro-cap, small-cap and large-cap buying opportunities from among the portfolio of 16. Although micro-cap Cray dropped the most (22%) during the market meltdown, U.S. Physical Therapy is the better buy here. The operator of 367 physical therapy clinics saw its first quarter earnings cut by 5 cents due to poor winter weather in January and February. Despite reduced patient visits, it still managed diluted earnings per share of 27 cents, 14% higher than a year earlier. It consistently generates annual revenue and earnings per share growth. Its 10-year average is 15% and 16% respectively. When I recommended its stock July 29, 2009, it was trading at $15.19. Not much has changed but I have faith it will come around.

All four small-caps are up more than 20% year-to-date, and that's after the market meltdown. However, I'll go with Cinemark Holdings. Its first quarter revenues and earnings were off the charts and I see this continuing for several quarters. Until the economy fully recovers, a night out at the movies is still your family's best bang for the buck. Lastly, we have large-caps, the market meltdown's best performers and I'll go with Hess. It hasn't done much this year but it's only a matter of time before oil prices start moving upwards again. Even if they don't, its first quarter price per barrel sold was almost double the same time last year. Eventually this will be reflected in its share price.

Bottom Line
Market meltdowns are a good reminder that investing is serious business. If you don't have a plan to deal with the volatility ahead of time, it will cost you. Personally, I'm content to ride out these storms because I don't have a clue what is oversold and what isn't. What I do know is that an all-cap portfolio with 16 companies I can count on to grow their businesses is more than enough to win in the markets. Whether this happens is another thing altogether. (To learn more, see Diversification: Protecting Portfolios From Mass Destruction.)

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