Diworsification?

Is it really a word and what does it mean. Historically we have been bombarded by the axiom of not putting all your eggs in one basket. Respectfully good advice is if the basket falls, your eggs are likely all broken. This also has the assumption of your eggs falling as a binary event. When eggs fall they break, making them no good. Investing is somewhat different.

 

Consider that when the price of IBM stock falls that it is not broken and no good, but rather still a going concern and likely could continue lower or higher in the future. In investing, we really need to somewhat distance ourselves from these absolute inferences. Right now for example, Inter Pipeline has had a pretty significant sell off with the price of oil. The stock peaked in price at $38.95 on September 19th and recently traded as low as $27.13 on December 12th. In simple terms, a 30% decline from its top to its recent bottom. The stock still pays a 5% dividend and to the best of our knowledge has not had a significant event at any of their pipelines. However, oil is down about 50% from its high. It may make sense that the stock should absorb some of the volatility that represents its core commodity.

 

Investors understand a diversified portfolio contains holdings across multiple sectors and asset classes. The topic of the moment is energy. Portfolios with energy exposure in the first half of 2014 benefitted from an increase in the price of energy commodities. More recently, this sector has taken a U-turn and has experienced dramatic price declines. Is this good or bad? Simply put, it is good to be in a sector or theme when things are good, and out when things are bad. Yet not all benchmarks are constructed the same. At the current moment, the S&P 500 contains 43 energy names, representing just over 8% of the total index. Closer to home, the TSX has 69 energy names, representing about 21% of the index, almost triple the concentration in energy than the S&P 500. An increase in the number of positions and concentration does not necessarily represent a diversified group of holdings. Someone once said there is no such thing as a free lunch. They were likely correct in their assessment at the time.

 

Today, we might suggest that there is a partial free lunch if you do rotate among asset classes and occasionally have less diversification and more focus. Yes there will be times of pain, but over time this focus will provide the opportunity for lower volatility and a clearer return profile.

 

Is now the time to be putting money back into oil and/or energy related companies? From the simple book of buy low and sell high, one might suggest that it would be better to buy energy companies when oil is $50 as opposed to when it is $100. Is it better to buy oil companies at $40 or $50? The answer likely remains the same but the posture is different. Today, oil is at $55 not $40.

 

Diversify or diworsify?