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Fool On The Hill

Tuesday, March 30, 1999

FOOL ON THE HILL
An Investment Opinion
by Warren Gump

Why I Selectively Diversify

Over the past year, I'm thankful to have maintained an investment portfolio holding more than the small capitalization stocks that I think provide some of the most compelling investment opportunities in the market. The performance of these stocks has stunk, even as many of the companies in the sector continue to boost their intrinsic value by increasing their cash flows, earnings, and growth prospects. While I still have a strong affinity toward these stocks, I continue to allocate a portion of my portfolio into mid- and large-cap issues in the name of diversification.

For those of you who haven't been following the markets closely (or just hear the daily results of the Dow Jones Industrial Average and the Nasdaq Composite), a lot of stocks out there have not been doing phenomenally well over the past three years. While the Standard and Poor's 500 Index of the largest stocks has returned about 28% compounded annually over the past three years, the Russell 2000 index of smaller stocks has only increased at a compound annual rate of 7%. Over the past year, the small-cap index is actually down 15%!

This weak performance has not necessarily been caused by poor fundamental results. Steak 'N Shake operator Consolidated Products (NYSE: COP), trading at 19x earnings estimates for the year ending in September, has risen only 8% in the past year, despite growing earnings 16%. Convenience store operator Casey's General Stores (Nasdaq: CASY) has grown earnings 19% over the past twelve months with analysts expecting 18% growth in the future. Even though the Price/Earnings (P/E) ratio is only 20x estimates for the year ending in April, the stock has fallen 2% over the past year. Uno Restaurant Corp. (NYSE: UNO) has only risen 6% in the last year despite growing earnings 26% over that period. The stock now trades at 13x trailing earnings.

For a reference point, the S&P 500 is trading about 28x earnings estimates for calendar 1998, with earnings growth estimated to be about 4%. Evaluating a company relative to an index is somewhat like comparing apples to oranges since outliers distort the average. Hypergrowth company America Online (NYSE: AOL), for example, is trading around 330x estimates for calendar 1999 with estimated growth of 50%. On the other hand, tobacco and food conglomerate Phillip Morris (NYSE: MO) trades at only 12x estimates for 1999 with growth prospects of about 13% per year because of the uncertainty surrounding tobacco.

Looking at more representative companies, we find that Clorox (NYSE: CLX) is trading at 36x 1999 earnings estimates and has expected earnings growth of 13% per year. The stock has risen 40% over the past year. Consistent conglomerate General Electric (NYSE: GE) is trading at about 35x earnings estimates for 1999. The last twelve months yielded a 32% gain in the shares of this company. Super-retailer Wal-Mart (NYSE: WMT), which is trading at 42x expected 1999 earnings, has seen its stock price soar 88% over the past year. These last two companies are expected to have growth rates of about 14%.

These three large companies certainly have advantages over the smaller companies I mentioned above. The big boys control powerful international brands, not well-known regional names. The management strength of the large-cap representatives is recognized by both domestic and international investors, whereas the smaller companies have much more condensed shareholder bases. In addition, the financial resources of the larger companies are much greater than those of the small companies. Nonetheless, given the valuation disparities and each company's future opportunities for growth, I believe the small-cap companies listed offer better investment opportunities than the large-cap issues.

However, despite my belief that many of the best investment opportunities in America lie in small-cap stocks, I'm not putting all of my eggs in this basket. I strive to maintain exposure to a variety of investment styles in my portfolio. In other words, I don't want all of my investments to be in the small-cap stocks. I also don't want all of my investments to be in one sector of the economy. While I find restaurants and retailing to be intriguing businesses, I want to have exposure to other parts of the economy, particularly technology, pharmaceuticals, and services that are becoming increasingly prevalent in our society.

My style of investing can best be called selective diversification. I don't want to have a large number of stocks in my portfolio, yet the ones I hold should have some exposure to several different sectors of the economy and the stock market. It's okay to have an emphasis on small-cap stocks in my portfolio, but I also want exposure to other areas -- even if I think they offer slightly inferior long-term prospects. By being selectively diversified, I increase the likelihood of maintaining relatively strong overall investment returns through thick and thin. Over the past year, owning large-cap companies like Northern Telecom (NYSE: NT) and Starbucks (Nasdaq: SBUX) has enabled me to continue posting solid overall returns despite the not-so-impressive returns from most of my small-cap holdings.

If you don't care at all about the volatility of your portfolio and have a high level of confidence that you are invested in excellent growth companies, you don't need my advice. On the other hand, if you're getting a little queasy when significantly underperforming the market over yearly time frames, I think you would benefit from ensuring that your portfolio contains some level of diversification. Not having your all of your portfolio in a sector when it is hot is sometimes a challenge, but you'll likely be grateful when the sector goes out of favor. (Which always happens at some point.)

Those of you who have made a fortune in technology and Internet stocks over the past few years will understandably be hesitant to invest some of your money elsewhere. You will likely find at some point, however, that you are glad to have the balancing effect that a little diversity offers. Just think if you had a pool of reasonably priced stocks that grew earnings at 15%-20% as expected, yet their price stayed flat or even decreased while most other segments of the market soared. If such a situation happens to you, you will be awfully glad to own a wider variety of stocks.

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