Wednesday, December 29, 2021

PWA Year-End Letter Part 5: True Diversification

Our US sector weightings (expressed primarily within our portfolios by their respective tracking ETFs) in order of prominence are: Materials, Industrials, Consumer Staples, Energy, Financials, Healthcare, Tech and Utilities.

In addition to the above, and the 6 positions we highlighted in part 4, our core allocation includes complementary securities that reflect our long-term thesis, as well as our overriding objective of proper balance/diversification.

Such as: Treasury inflation protected securities, Latin American equities, US banks, Base metals futures, metals miners, semiconductor manufacturers, telecom companies and equipment makers, Indian equities, rare earth miners, German equities, media/entertainment companies, oil services companies, water infrastructure companies, solar companies, wind technology companies, uranium miners and carbon credits.

As you can see, we're not lacking diversification!

That said, and frankly, there's diversification, and then there's diversification. All-too-often, and very dangerouslyfolks associate the act of simply holding a large number of securities with capturing the "safety" benefits of diversification. Alas, nothing could be further from the truth. 

For example, owning a sector fund may give one exposure to dozens of different companies, but they're all in the same sector, meaning their price movements correlate extremely close to one another. Or one could be very “diversified” within a single country and believe they've got it covered. Well, factors hitting the economy of a country, or a region, could easily see a mass exodus of virtually everything domiciled there. 

Then there's simply the passive way folks buy stocks these days, say, inside of their 401k accounts. Imagine what might happen to stocks across the board, should a global "risk-off" event occur!

Like last spring.

MSCI World Index (that's a 34% hit):

Yes yes, we know, stocks came roaring back in very short order! Amazing what $trillions of fiscal and monetary stimulus can do to the price of stocks everything!

But, you know, such quick rebounds aren't typically the case.

Imagine riding through the tech bubble burst (2000-2003), seeing global stocks careen to their 1995 levels (a 51% decline), only to see them peak once again at the real estate bubble top (followed by a 59% collapse!). Then riding that bust, seeing stocks right back to their 1995 levels (actually a little lower) once again. Then waiting all the way to the fall of 2016 before seeing them break strongly above those bubble highs. Then briefly threatening that 2016 level during the 2020 washout:

OH MY!!!!

So, back to diversification: There's a thing called the "correlation coefficient" that measures the strength of the relationship between two variables. We track it across our portfolios.

Here's a look at a correlation matrix for what we'll call an under-diversified portfolio:

This was actually the portfolio of a client previous to our engagement. While one could indeed design a diversified mix with a dozen positions, the overwhelmingly red shading (denotes strong correlation [blue denotes weak]) suggests that this particular allocation doesn't pass the smell test.

Here's a look at the correlation matrix for their top 25 positions today:

That's a healthy mix of red (highly correlated) and blue (weakly correlated) positions. I.e., that's a legitimately diversified portfolio.

And while indeed proper diversification can lead to a reduction in downside risk, today's overall setup has us also protecting against a major across the board collapse by strategically hedging with options.

As for the whys of what we're in, let's explore our top sector weightings.

Materials: Our largest expression of our bullishness around materials is XLB (Materials Sector SPDR ETF). The description of each of its top 10 (of 45 total) positions should -- in a world where infrastructure (traditional, and green) is of paramount (if not political) importance -- suffice as an explanation of our optimism over the space.
Linde PLC: Linde Public Limited Company operates as an industrial gas and engineering company. The Company offers products, technologies, and services that help customers improve their economic and environmental performance in a connected world. Linde serves customers worldwide.

Sherwin-Williams: The Sherwin-Williams Company manufactures, distributes, and sells paints, coatings, and related products. The Company's products are sold to professional, industrial, commercial, and retail customers primarily in North and South America. Sherwin Williams also has additional operations in the Caribbean region, Europe, and Asia. 

Air Products and Chemicals: Air Products and Chemicals, Inc. produces industrial atmospheric and specialty gases and performance materials and equipment. The Company's products include oxygen, nitrogen, argon, helium, specialty surfactants and amines, polyurethane, epoxy curatives, and resins. Air Products and Chemicals products are used in the beverage, health, and semiconductor fields.

Freeport-McMoRan: Freeport-McMoRan Inc. is an international natural resources company. The Company operates large, long-lived, geographically diverse assets with significant reserves of copper, gold, molybdenum, cobalt, oil, and gas. 

Ecolab: Ecolab Inc. is a global provider of water, hygiene, and infection prevention solutions for customers in food, healthcare, hospitality, industrial and oil and gas markets. The Company's services include food safety, sanitation, optimization of water and energy use, improvement of operational efficiency and sustainability. 

Newmont Mining: Newmont Corporation acquires, explores, and develops mineral properties. The Company produces and markets gold, copper, silver, zinc, and lead. Newmont serves customers worldwide. 

Dow: Dow Inc. produces and distributes chemical products. The Company manufactures and supplies chemicals for liquid injection molding, architecture fabrication, leather, textiles, automobiles, rubber consumer goods, and food industries. Dow serves customers worldwide.

Dupont: DuPont de Nemours, Inc. provides technology based materials and solutions. The Company offers a diverse range of products, such as construction materials, adhesives, electronic, fabrics, fibers, home garden, medical devices, resins, printing, and consumer products. DuPont de Nemours serves energy, automotive, construction, government, military, safety, and packaging industries globally.

PPG: PPG Industries, Inc. supplies products for the manufacturing, construction, automotive, chemical processing, and other industries worldwide. The Company makes protective and decorative coatings, flat glass, fabricated glass products, continuous-strand fiber glass products, and industrial and specialty chemicals

International Flavors and Fragrances: International Flavors & Fragrances Inc. creates, manufactures, and supplies flavors and fragrances for the food, beverage, personal care, and household products industries. The Company's flavors and fragrances are individual ingredients and compounds of a large number of ingredients that are blended, mixed, and reacted together to produce proprietary formulas.

Next up is Industrials, which is where (largely via XLI [Industrial Sector SPDR ETF]) we capture the major players across the space, which, along with the obvious, includes transportation and defense. 

Top 10 (of 90 total) positions being: Union Pacific, UPS, Honeywell, Raytheon, Boeing, Caterpillar, GE, 3M, Deere and Lockheed Martin.

Then consumer staples, your traditional economically-defensive space. I.e., the staples sector encompasses the companies that produce stuff people need (or think they need) to go on living. 

The top 10 (of 49 total) holdings within our main position there (XLP [Staples Sector SPDR ETF]) are: Procter & Gamble, Costco, Pepsi, Coca-Cola, Mondelez International, Philip Morris Intl, Walmart, Altria and Estee Lauder.

The top positions among the remaining sectors would be your usual suspects in each space.

In that resources is presently a prominent theme in our core allocation, we'll drill down (pun intended) further into that space in Part 6. 

Attention non-client subscribers, a reminder:  Nothing on the blog should be construed as investment advice. The examples expressed relate to portfolio management we perform on behalf of our clients, and, again, under no circumstances are they to be considered recommendations to the reader.

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