Diversify Like The Big Boys Do

September 14, 2016

Diversify Like The Big Boys Do

  • Temporal diversification diversifies your portfolio through time by buying only the assets that are cheap at the moment and avoiding the ones in a bubble.
  • By buying in cycle troughs you enjoy high-dividend yields that allow you to buy other assets that are in temporal distress.
  • This high yield lowers the need to sell and lowers your tax bill.

Introduction

Today we’ll introduce you to a new concept—“temporal diversification,” a term that has begun to gain traction, especially in academic circles—that isn’t yet common knowledge but is already being used by the best investors. Using the example of Berkshire Hathaway, we’ll provide an overview of the concept of temporal diversification and will provide some ideas for increasing your returns by diversifying your portfolio not just for the current moment, but for your whole investing life.

Berkshire Hathaway

Berkshire Hathaway holds a well-diversified portfolio which makes it a relatively safe and sound investment. Such a situation is both praise for Berkshire and diversification.

Berkshire directly owns many companies operating in various sectors.

figure-1-operating-companies
Figure 1: Berkshire’s operating companies. Source: Berkshire Hathaway.

In addition to the companies listed above, Berkshire owns car dealerships, real estate agencies and a vast portfolio of stocks. The portfolio of stocks is again, well diversified.

SharesCompanyTickerPercentage of Company OwnedCost (in Millions)Market (in Millions)
151,610,700American ExpressAXP15.6$1,287$10,545
46,577,138AT&TT0.8$1,283$1,603
7,463,157Charter Communications Inc.CHTR6.6$1,202$1,367
400,000,000The Coca-Cola CompanyKO9.3$1,299$17,184
18,513,482DaVita HealthCare Partners Inc.DVA8.8$843$1,291
22,164,450Deere & CompanyDE7.0$1,773$1,690
11,390,582The Goldman Sachs Group, Inc.GS2.7$654$2,053
81,033,450International Business Machines Corp.IBM8.4$13,791$11,152
24,669,778Moody's CorporationMCO12.6$248$2,475
55,384,926Phillips 66PSX10.5$4,357$4,530
52,477,678The Procter & Gamble CompanyPG1.9$336$4,683
22,169,930SanofiSNY1.7$1,701$1,896
101,859,335U.S. BancorpUSB5.8$3,239$4,346
63,507,544Wal-Mart Stores, Inc.WMT2.0$3,593$3,893
500,000,000Wells Fargo & CompanyWFC9.8$12,730$27,180
Others$10,276$16,450
Total Common Stocks Carried at Market$58,612$112,338
Figure 2: Berkshire’s stock portfolio. Source: Berkshire Hathaway.

So, if Berkshire is a perfect example of a well-diversified portfolio, why is Buffett against diversification, or how he prefers to call it diworsification? His own words are that “Diversification is protection against ignorance, it makes little sense for those who know what they’re doing.” For the sports fans out there, we have the LeBron James analogy “If you have Lebron James on your team, don’t take him out of the game just to make room for someone else.”

It might look like Buffett is self-contradictory but there are two reasons behind such a situation. The first one is that with a portfolio of $112 billion in stocks and 90 whole owned companies, it is impossible to own just the best stocks. The second, and the basis for this article, is that Buffett has diversified his portfolio through time, exhibiting excellent temporal diversification ability.

What Is Temporal Diversification?

Generally speaking, the amount of time in our lives that we have something extra to invest is more or less 40 years, or the average life employment span.

With Buffett as an example, in 1951 he had most of his net worth in GEICO. In 1961, he put 35% of the partnership’s assets in Sanborn Map Company, in 1964 he put 40% in American Express in the aftermath of the so-called “Salad Oil Scandal,” in 1973 he bet heavy on the Washington Post during the 1973 stock market slump, from 1976 to 1996 he invested in GEICO to the point of full ownership through Berkshire Hathaway, in 1988 he invested $1.2 billion in Coca-Cola, and in 1990 he bought 10% of Wells Fargo.

As Berkshire got bigger and bigger, so too did his investments. In 2010, Berkshire bought the railroad company Burlington Northern for $44 billion, and in 2015 it bought Precision Castparts for $32 billion among many other acquisitions and stock purchases.

This short summary can teach us how diversification works well, but works even better when you can do it on the cheap by buying those assets that are in a downturn period like railroads were back in 2010 or like American Express was in 1964.

The benefit of temporal diversification is that you buy when assets are cheap and therefore have a higher dividend yield which fills your pockets with cash and enables you to buy other assets on the cheap. You don’t switch to other stocks when they seem cheaper or a better opportunity at the moment because you still have a great yield if you look at it from the point of your initial investment.

Temporal diversification enables you to be well diversified through your investing lifetime but without overpaying for diversification. For a simple example, let’s look at the Nasdaq index. The Nasdaq is the place to go for tech diversification, but the index is much more volatile than the S&P 500 and it gets crushed in recessions only to quickly turn into a bubble in periods of economic growth.

figure-3-nasdaq
Figure 3: Nasdaq composite index performance since 1990 with recession periods. Source: FRED.

Therefore, the logic behind temporal diversification would suggest diversifying your portfolio with tech only in periods of economic downturns. This seems a very strange concept and difficult to grasp especially in an environment where news is constant and economic cycles are easily forgotten, but the average economic cycle since 1945 is 68.5 months from peak to peak. This means that in our average 40 year investment lives, we will have the opportunity to invest in 7 recessions.

Current Opportunities & Risks

The Nasdaq index mentioned above—which is full of companies that have PE ratios above 100—is certainly not the place to start with temporal diversification, but there are some sectors that seem very distressed at the moment and are certain to see better times in the future.

As food prices are at their multiyear lows, anything related to food is in distress at the moment, especially fertilizer stocks.

Another opportunity is mining stocks that have been battered in the last 5 years. Gold and silver stocks have already regained much of their losses and are a great example of how a whole sector can quickly rebound, you can download a report I wrote on one such miner (that is still a good buy today), here.

This is bound to happen for other miners as well as low commodity prices limit new investments that will limit future supply while the global population is growing and getting more developed, which will most certainly increase global demand.

Alongside mining stocks, energy stocks have also felt pain in the last two years alongside energy exporting countries like Russia and Brazil, which at the moment represent great long term diversification pics. Another example of a sector in distress is shipping, so if you have ever contemplated adding shipping stocks to your portfolio, now might be a good time to start looking at the sector.

Conclusion

Temporal diversification is a brand new concept that hasn’t been discussed much but is one of the main success factors of arguably the greatest investor of all time. Such a strategy requires a high level of discipline, the courage to invest when others are fleeing a sector or a stock and the character to stick to your guns no matter what is going on at the moment. This is much easier if you possess a high level of knowledge about the long term outlook of the sectors you are investing in and also of the ones you are avoiding in order to precisely know when a sector or asset is below or above its long term equilibrium value.

Another issue is that temporal diversification requires a certain amount of cash available when an opportunity arises, which again points to the discipline factor.