Stock market investors seek diversification for a multitude of reasons. Stock specific risk can be diversified by increasing the number of holdings in order to mitigate the effects of a blow up in any particular stock. However, the greater challenge lies with eradicating systematic or market risk.

Market risk can never be totally eliminated within a stock portfolio however it is possible to decrease the level of correlation within a portfolio. For example, investors could favour small caps over large caps. This is feasible because it is possible to find stocks whose earnings are less exposed to the economy at large. Indeed, it is easy to find counter-cyclical stocks within the small cap universe.

Another option is to reduce the number of holdings and have a few ‘focused’ positions. However, this approach will increase stock specific risk, so it is hard to argue that it is reducing risk.

Non-Correlated Portfolio. Absolute Returns

Equity market risk can be reduced via hedging or other alternative strategies. Indeed, the single most important issue facing investors today may well be how to produce non-directional returns in a world that is becoming increasingly correlated.

Stock Beta

Capital Asset Pricing Model CAPM enthusiasts such as Harry Markowitz would tend to argue that all the profit and price drivers will be captured in the beta of the stock. However, beta-by definition-is always a historical measure and will tell not necessarily predict the future. Markets change and there is an art to identifying and diversifying the profit drivers within a portfolio. Whilst beta will capture some elements, the factors of error in this approach may preclude its usefulness.

Diversifying Investment

The essence of diversifying a portfolio is to diversify the profit drivers within it. Naturally, this approach relies on the corollary that earnings drive prices. The difficult part lies in identifying the profit drivers. The following method is a process based on that taken by the founder of Sony, Akio Morita in Made in Japan: Akio Morita and Sony. The investor discovers the individual profit drivers, he can then seek to diversify them within a portfolio.

Company Administration

How is the company run internally? Examples of the things investors can look for are who, are the key personnel and what are their motives? Some companies are run more for the interests of their directors than the shareholders. Is the company run by reputable businessmen? Are they serial stock option issuers? Is there business model unusual or opaque?

Operational Drivers

How they perform within their markets compared to competition? This is the area where ‘science’ can play a large part since investors can compare a host of operational metrics across industry competitors. For example, comparing a company’s gross margins compared to the industry will help gauge their competitive position.

With retail stocks, analysts will look at comparable like for like sales growth across the industry. With Pharmaceutical stocks, analysts will focus on their research and development programme. The list of specific metrics is almost endless, but the key point is to focus and identify what is likely to move earnings and prices in future.

Strategic Investments

What are the strategic end drivers of their business? This is usually the most important part. Industries like miners and many energy companies are strategically exposed to the prices of the commodities that they deal in. Indeed, most companies are exposed to an over- riding macro factor. For example, consumer goods companies are exposed to consumer spending cycles.

A simplistic view of this approach would be to define companies in terms of having cyclical or defensive qualities. However, in reality, economies and, individual company prospects are far more complex. Defining a strategic profit driver may appear to be a science but in fact it is more of an art.

Portfolio Management

Once this process is completed and the investor has defined the key drivers, he can thing bring about diversifying the portfolio. For example, a properly diversified portfolio will not be overweight in one sector or theme. So if an investor finds that he is overweight in stocks benefiting from rising oil prices, then he should look to buy companies that are positively exposed to falling oil prices. For example, plastics manufacturers or data centre operators.

This hedging process will not necessarily result in flat performance because the companies involved will have other growth kickers. In this example, the oil companies may discover significant new reserves and the data centre could see significantly increased demand for its centres. However, the exposure to rising oil price movements will be limited via diversification.

This process is particularly applicable to portfolio that has been constructed through a bottom up process because a bottom up portfolio could be manifesting an unintentional style or sector bias.

The point is simple. Everyone knows that they key to a successful investment portfolio is to manage the diversity within it, however you choose to do this is, and always will be a personal choice or strategy. The objective and end result should always be the same, protecting your investments and knowing when to let go.

Dynamic Wealth Management is an independent investment advisory firm which focuses on global equities and options markets. Our analytical tools, screening techniques, rigorous research methods and committed staff provide solid information to help our clients make the best possible investment decisions. All views, comments, statements and opinions are of the authors. For more information go to www.dynamicwmanagement.com