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April 4, 2011, 2:13 p.m. EDT
By Lance Helfert
SANTA BARBARA, Calif. (MarketWatch) "” The recent tragedy in Japan reminds us that while "black swan" events are unexpected, they are not uncommon.
In an ever shrinking world this has profound implications for investors because global economies are continually becoming more intertwined and dependent upon one another. While an earthquake or a political uprising on the other side of the globe might not have affected local businesses 50 years ago, today such events can cause aftershocks that rip across the world in a matter of seconds, causing fortunes to be lost or made.
Thus, we believe it is critical that risk adverse investors position their portfolios to protect against the worst. We have a saying, "If you take care of the downside, the upside will take care of itself."
Taking care of the downside means protecting against matters that are both within our control and outside of our control. Matters within our control include what we invest in and why, while matters outside of our control include macro events such as war, inflation, recession, and natural disasters.
The task of protecting one's stock portfolio may seem daunting, but we believe it can be broken down into a fairly simple formula: Invest in good companies at attractive prices, and adequately diversify investments to diminish company specific risk and unexpected risk. Now let's try and solve this formula in today's investment environment.
Thousands of companies are publicly traded and many of them represent high quality businesses. Unfortunately for new investors, the stock market has been on an absolute tear during the past 24 months and valuations aren't exactly screaming "buy." That said, a number of high quality large-cap businesses are selling at very attractive prices and paying hefty dividends. While cyclical and small-cap companies have seen their stock prices soar during the past two years, boring consumer staple companies have languished while their earnings have only continued to increase.
Take construction and mining powerhouse Caterpillar Inc. /quotes/comstock/13*!cat (CAT 112.97, -0.15, -0.13%) for example. The stock has tripled during the past two years and currently trades at more than 25 times earnings. There is no question that Caterpillar is a great company and is likely to continue benefiting from the modernization of developing economies and associated spending on infrastructure projects. However, at its current share price investors are already paying for a rosy future and don't appear to be discounting the possibility of an economic slowdown.
On the flip side, shares of soft drink maker Coca-Cola Co. /quotes/comstock/13*!ko (KO 67.68, +0.46, +0.68%) haven't kept pace during the past two years while the company has significantly increased profits. The company also has compelling growth opportunities in developing economies, but investors aren't paying for any growth at the current price, which equates to less than 13 times earnings and a 3.0% dividend yield.
How much diversification is enough? This is a highly debated subject, but we believe a portfolio of approximately 15 stocks provides the right balance between risk and reward, offering adequate protection against "company specific" risk, and rewarding investors for being right.
"Unexpected risk" is a tougher nut to crack, and a sensible way to mitigate it is to consider a broad spectrum of macro risks and invest in companies that provide a hedge against such risks. Unexpected risks of most concern to us today include the potential for a meaningful disruption to global oil supply, rising interest rates, hyperinflation, a decline in the value of the dollar, and a meltdown of the euro zone, all of which could result in a recession and a decline in the stock market.
Coincidentally, the same high quality companies that appear to be undervalued today also appear to provide the best hedge against unexpected risks. Consumer staple companies sell non-discretionary products that people purchase week in and week out regardless of whether the economy is booming or in a recession. These companies also serve as a hedge against inflation because they can pass rising input costs on to their consumers by raising prices. In addition, most large-cap U.S. companies are now multi-national and generate a significant amount (if not the majority) of their revenues and profits from a diversified mix of countries outside the United States. This not only provides protection against a declining dollar, but it also provides significant growth opportunities in emerging markets.
To quote Benjamin Franklin, "By failing to prepare you are preparing to fail." Not only does it make sense to always be prepared for the worst, but preparing for the worst today appears to present the best investment opportunity in the market place, regardless of whether any unexpected risks materialize.
Lance Helfert is president of West Coast Asset Management , and the co-author of "The Entreprenuerial Investor: The Art, Science and business of Value Investing."
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