Why diversification is the prudent strategy
(MoneyWatch) I recently came across as good an example of the benefits of diversification as one could find. Although it wasn't the intent of the authors, the example comes from the book Quantitative Value. The authors, Wesley Gray and Tobias Carlisle, do a great job of explaining the benefits of using a quantitative approach to value investing. They show why a quantitative approach is the strategy most likely to provide the highest returns because it provides the benefits of a value strategy without any of the behavioral errors associated with active stock picking.
The book takes investors through a quantitative approach to finding the stocks that are the most likely to deliver the highest returns. In the end, they show that combining value metrics (such as price-to-earnings, price-to-book, price-to-cash flow) with profitability metrics (such as return on equity, earnings-to-total assets, gross profits-to-total assets) has resulted in superior returns rather than just focusing on one value metric (such as book-to-market).
Gray and Carlisle explain how investors should look for companies that have sustained high returns over a business cycle. That way they can avoid buying companies that look great, but are simply outperforming because their industry is at its peak point in the business cycle. They suggest investors look for companies with strongest and stable profit margins that have generated massive amounts of cash after capital investments over the business cycle (they look at eight year horizons). This demonstrates financial strength.
They then presented the metrics of some of the leading companies including Google (GOOG), Microsoft (MSFT), Procter & Gamble (PG), and Walmart (WMT). They showed one particular company with a ranking above the 94th percentile in return on assets and above the 95th percentile in return on capital. They then showed how this company had increased its margins over the period 2004-2011 from 27.9 percent to 42.4 percent, a compound increase of 5.4 percent. That showed a true franchise value.
What stock was the magic formula presenting? It was Apple (AAPL). As it turns out, Apple would not have been a great stock pick this year. Apple closed 2012 at $532 and as of this writing is now at $437, down 18 percent. Over the same period the S&P 500 is up about 36 percent. That's an underperformance of 54 percent.
While quantitative value strategies focusing on both value and profitability metrics have added significant value to portfolios, they cannot identify which individual stocks you should buy. There's just too much idiosyncratic risk in single stocks, as Apple's performance demonstrates.
To be confident you can reliably capture the value and profitability premiums, you need to buy a large number of stocks. The best way to accomplish that type of diversification is through a passively managed mutual fund that is using quantitative methods to identify the stocks that they will hold.
AQR has recently introduced three "core" funds that combine value, momentum and profitability. They are a U.S. large fund (QCENX), a U.S. small (QSMNX) and an international fund (QICNX). Dimensional Fund Advisors plans on beginning to incorporate the profitability factor into their value strategies in the near future. (Full disclosure: My firm recommends DFA funds in portfolio construction.) And, given the power of the data, it seems likely that there will be other fund families following suit.
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