Theory Time

We've been cabin bound riding this storm out for almost a week. Yesterday was the first day in a long time with no new snow fall. The combination of a lot of snow, living in the mountain time zone and not being able to go anywhere lends itself to some interesting theorizing.

I tend to be easily captivated by certain theories from other people, not that I might implement them but because when thought about in the proper context they can teach a lot about risk budgeting and portfolio construction. Not that I can substantiate this but I am convinced my openness to learning about unusual portfolio construction ideas has made me better at my job.

One is from Nassim Nicholas Taleb who has talked many times about putting 90% into t-bills from various countries and be very aggressive, in his case with options, with the other 10%. This is easy to understand. If on January 2, 2009 you put 90% in t-bills from various countries and put 10% into Apple (AAPL) at $90.75 and sold it at $210.73 on December 31, 2009 you'd have made a little over 100% in the stock and so 1000 basis points for the portfolio. In addition to the 1000 basis points from AAPL you'd have gotten some small return from the t-bills. This might all add up to 11% before figuring any currency gains. Do this every year and you have a decent chance of having whatever number you need in the future assuming a proper savings rate.

Picking one stock that will go up 100% is not an easy thing to do obviously but most of us know where to look for stocks with this potential and where not to look. You are not likely to get a double in one year out of a utility stock or a toothpaste company.

There are certain sectors that do have the requisite volatility that allows stocks to double. As hard as picking the few that actually do go up 100% is, options on even middling stocks in these sectors or groups may get enough of a pop for the speculative 10% portion of the portfolio.

Zvi Bodie has written about putting 90% in TIPS and the rest in equities but not with the same volatility characteristics that Taleb seeks. Bodie's idea is less intellectually appealing because collectively we do not save enough to put into a "normal portfolio" so if we went that heavy into TIPS it seems like we would have to save much more than we do now but I concede that for some folks Bodie's theory is perfect and gives them permission to shun risk assets (that is not a sarcastic comment, some people are better off with very little in risk assets).

The 90/10 sort of portfolio is not something I am interested in doing but it teaches some important things, things I've mentioned before. In a diversified portfolio with 40-50 stocks (or mostly stocks) the odds are pretty good that in most years the portfolio will have a couple of stocks that will double (this is more difficult with narrow ETFs). Guessing ahead of time what those couple might be is very difficult but that a couple of them go up a lot is a good bet.

The best example of this from my past is Advanced Auto Parts (AAP) a name we have long since sold. I bought it for most clients in 2004 thinking more people would fix cars than trade up. I thought it would be a fine grower but from October 2004 to August 2005 it doubled. I would have never thought that would be the stock to be one of the best performers in the portfolio but it was.

Point being that you never know where it will come from which is why I prefer to own a lot of stocks in small weightings. If in a year a portfolio is going to be up 10% and 200 basis points come from one 2% holding doubling, another 200 basis points come from dividends then maybe the rest of the portfolio doesn't have to work so hard or be too heavy in volatile names; volatility budgeting. As a clarification I sold AAP a little before it had actually doubled.

The latest theorizing on my part is to wonder whether the larger indexes could be destined for growth that is way below average because of the heavy weighting in financial stocks they all have. One big difference between the financial crisis and the tech wreck is that Internet stocks were allowed to fail but large banks, the ones that dominate the various indexes were not, mostly. The failure of many tech companies helped to cleanse the indexes.

The overweight to financial stocks also applies to quite a few other countries. Take a look at how many country funds are very heaviest in financial stocks. To the extent the crisis was/is global and the folks who believe in Japan-like zombie banks are correct then many of these indexes could be in for a rough road. I'm not talking about every country index imploding but maybe a world where US, Western Europe and Japan are way below normal and other countries are a little below normal.

In that sort of a world it would become crucial to not only invest at the country level but also at the foreign sector level. This would mean picking certain themes and also some individual stocks. in exploring this idea in the past I have explored many things like food related, water related, certain types of alternative energy and various infrastructure projects (like toll roads, airports and the like) but I think I have been looking at them in the wrong way. I've tried to think of them as having a low correlation and low volatility which doesn't necessarily hold water.

A better way to think of them is closer to regular stocks that, if there is anything to the theory being espoused above, would simply outperform the broad indexes. The fact is there are a lot of food and water problems that need to be solved and hopefully they will be solved. I do not know whether these problems can be solved but money is going to be spent in pursuit of solving them. This offers no guarantee of success but it creates a big tailwind.

If the world is getting smaller and emerging countries are in fact becoming more important in the world economic order and more people in emerging countries are ascending to middle class lifestyles then it would seem that traffic of all sorts would increase, not just traffic on the roads but that ports (air and sea) would see more traffic capturing growth of global commerce.

Alternative energy is trickier. I think it will be a long time before solar and wind at peoples houses will become really big--I'm not sure it will ever happen. However the possibility of more and more utilities getting more power to distribute from their own solar or wind farms seems more likely. I think there is more meat on the bone with wind turbine makers than solar companies. I also think companies that clean and filter the air or water could be attractive as well.

You can decide for yourself whether there is anything to this and whether the concept has any place in your portfolio but investing and portfolio construction can evolve. Would the Bogleheads or other hardcore indexers be so entrenched if we had had the same results as Japan for the last 20 years? Obviously some people think we are tracing Japan's trajectory.