A Smart Diversification From Leading Sectors

Chief Executive Officer and President of The AES Corporation Andres Gluski. 


With the market slowing down in April from the torrid pace set in the first quarter, Marketocracy’s managers have been discussing how to intelligently reduce risk. To that end, Wayne Himelsein, my top quant manager, recommends AES Corporation , a company that looks ready to make new highs but is outside of the sectors that have performed the best this year.

Ken Kam: It’s nice to see you moving the discussion away from technology and consumer discretionary which have performed so well this year. I suspect you’re doing so because you have found a particularly strong stock outside of the sectors that now look overbought?

Wayne Himelsein: I have no doubt that most investors when hearing about a company in a wholly different corner of the market, will straight away appreciate, or at least understand, that the driver for that tangent is diversification.

We all grow up being taught, and believing, that diversification is better. I would like to, at first, agree with that broader statement, and then, just after demonstrating how amenable I am to its value add, spin around and say that diversification is not always the right answer, and sometimes, not at all.

Kam: Diversification is the most common sense understanding of lowering risk, so I am quite curious to hear where you are going to go with this. Please elaborate, and of course, don’t forget to share your pick!

Himelsein: My pick for today is AES Corporation, with the glaringly obvious ticker: AES. I like AES for the usual reasons, including where it has been, where it is, and where it appears to be going. All of which I intend to elaborate on.

But before I get into that, I want to jump back into the “yes” and “no” of diversification. The yes is easy, we all know the list of reasons and assumed benefits. But the “no” is more complex. The downside of diversification is a lowering of the signal quality. Diversifying for the sake of diversifying is, necessarily, moving away from conviction.

Someone might say “I love this stock, and for a ton of reasons” but then shortly after admit “but I have these others for diversification.” That word is used to justify taking money out of the stocks we believe in the most, and putting it in a second or third tier stock — just in case.

Kam: That’s an incredibly interesting perspective. So by diversifying, one is often accepting lower quality. But isn’t it worth some lower quality to reduce risk, which is the whole point of diversification?

Himelsein: Again, yes and no. It depends if the risk is really reduced. If one “diversifies” a tech name with another tech name, but of lower quality, they are still deeply entrenched in 1) market risk, 2) sector risk, and 3) industry risk.

The distinction of sector and industry, by the way, differentiates between say, broader technology, and actually owning two very similar companies within the wider sector, like buying two chipmakers, AMD and Intel.

If one loved one chipmaker for a variety of good reasons, and just for diversification, bought a second inferior one, they may be literally creating a lower risk-adjusted return for the portfolio. What many do not realize is that a purchase for the sake of diversification is, necessarily, a purchase that is lowering the net quality of your portfolio.

Think of this broad analogy; by definition, not every stock can outperform, and also, the more stocks one owns, the closer they get to being the index; thus, the more stocks, the lower the probability of being able to outperform.

In fact, if one already has above average performers in their portfolio already, when adding lots more stocks, they are actually adding below average performers, as the whole set must, by definition, equal the average.

Kam: That makes perfect sense. So why this time did you move to an energy stock?

Himelsein: Well, that’s an easy answer. The answer is precisely the reason to always diversify, which is when you find a high-quality stock.

In other words, given the benefit of diversification — the “yes” side of things — if one already has a portfolio within certain sectors or industries, and then comes across two great new stocks, of similar signal quality, but one is in the same industry or sector as an existing position, and one is from left field, always go left field!

In the land of benefiting from conviction, and avoiding diversification for the sake of diversification, there is nothing better than when the new shining star you happen to identify is far out in industry or sector from anything you have.

That is essentially the best new buy you can make, given that it hits risk and reward from both sides; upping the portfolio reward potential while distinctly lowering the portfolio risk stance.

Kam: That’s a terrific explanation. Diversifying by buying second and third rate stocks doesn’t make sense, but when you see strong stocks in different industries, diversification results in a better risk-adjusted return. With that in mind, please tell us the true benefit of AES?

Himelsein: Sure thing. For AES, I will start with where it’s been, and in doing so, use the widest angle lens that I own. In going back over a decade, we see a stock that was in a nice uptrend from 2003-2007, at which point it fell with the rest of the world in 2008, establishing the same bottom, and same rebound point, as most other stocks did in early 2009. But what’s different about AES, is that its vigorous recovery was short-lived, stopping in September 2009.

From September 2009 until the end of 2018, the stock has effectively done nothing. It just moved sideways in giant oscillations to end up, on 12-31-18, at the very same $15 level it stopped at its September 2009 peak, a level it also touched along the way, in June 2014, amidst its giant oscillations.

But then, after sleeping for an entire decade, in late 2018, it stood up, took in a deep breath, and arose from the ashes, outperforming the rest of the market during the Q4 correction, and coming out of it with, pun intended, unparalleled energy. While the market has strived to recover to old highs, AES not only fully recovered its Q4, but also broke out to new highs in January of 2019.

And when I say new highs, I’m referring to the very same $15 level that shared a decade of attempted tries. And as such, from that moment forward, it has just plowed ahead; “I’m free” it is screaming, perhaps, never to look back again. It’s a new stock now, with new energy for the energy sector.

My Take: As impressed as I am with the market’s performance in the first quarter, I worry that the market is vulnerable. The technology and consumer discretionary sectors have led the market up so finding strong stocks in other sectors is a good way to reduce exposure to the sectors that might be hit hardest in a downturn.

Wayne’s argument in favor or AES is exactly the kind of judgment call that is behind Wayne’s excellent long-term track record.

Wayne Himelsein’s Logica Focus Fund (LFF) has an 18+ year track record that extends through 2 market crashes, numerous corrections, and sector rotations. Over that period, Wayne’s model averaged 12.07% a year which compares well to the S&P 500’s 5.93% return for the same period.

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