Along with countless other shareholders, my portfolio suffered a setback on March 16, when General Motors (NYSE:GM) announced that it would be missing its earnings target for the quarter by a staggering $1.50 per share. Times are tough for this former titan of the automotive industry. Between its falling market share, escalating health care and pension costs, its spat with Italian carmaker Fiat, and high gas prices scaring customers into smaller, more fuel-efficient, and less-profitable automobiles, about anything that could turn against GM has turned against GM.
In spite of those troubles, the company had until recently expected to break even for the quarter and earn between $4.00 and $5.00 for the year. With its warning, GM not only dropped the bombshell on the current quarter, it also dramatically lowered its annual earnings target to between $1.00 and $2.00 and (more importantly) mentioned that it expected to be cash flow negative for the entire year. Ouch.
Driven by that single hot potato of an announcement, the company's stock fell almost 14% in one day, capping off a descent that began early last year. While its previous valuation had anticipated some sort of earnings miss, the depths of the sell-off suggested that I was not the only one surprised by just how poorly GM was doing. When the dust settled on the day, GM led a broad market sell-off that took the major indexes down with it. Predictably, GM's fellow troubled domestic automaker Ford (NYSE:F) dropped on the day, as did GM parts supplier Delphi (NYSE:DPH).
Insulated oven mitts
Yet not every company tanked along with the carmakers. Mortgage REIT Annaly Mortgage Management (NYSE:NLY) actually finished up for the day, as did personal computer and iPod maker Apple Computer (NASDAQ:AAPL). For investors that owned Annaly and Apple, March 16 was just another typical day in the market.
Right now, you may be asking yourself what exactly mortgage companies and computers have to do with automobiles. Or with each other, for that matter. The answer, of course, is very little. Almost nothing, in fact. And that's precisely why they were completely unaffected by the news that shocked the car industry. That is pretty typical behavior in the market. One large company stumbles, taking the market indexes down with it. While the market may tumble, not every company will go along for the ride.
As an independent investor, you can use that behavior to your advantage to protect your portfolio from the inevitable stumbles that affect nearly every company from time to time. You don't need to have your portfolio completely tied up in General Motors, or even Apple Computer, for that matter. You can diversify into both, assuming, of course, that you like the prospects and valuation of each. Doing so, in fact, can help reduce the impact of problems in either business. Nobody knows for certain what will happen tomorrow. After all, there was a time, prior to the iPod, when the market expected Apple to spoil, just like it's now expecting continued wrecks from GM. This chart, in fact, shows that the two stocks have historically rarely moved together, as would be expected for companies in unrelated businesses.
You don't know the future; I don't know the future. All we as investors can do is make educated choices based on estimations and expectations. Sometimes we're wrong. Yet by appropriately spreading the risk around -- by buying and owning unrelated companies that individually appear to be value-priced -- we can protect our overall portfolio from those instances when one company simply doesn't perform as expected.
Been there, done that
As I've mentioned before, I've caught another hot potato as a partial owner of pharmaceutical giant Merck (NYSE:MRK). I've been a Merck shareholder since before the company withdrew Vioxx, its prescription painkiller that caused unfortunate and potentially fatal cardiac side effects. As bad as GM's recent tumble was, it paled in comparison to the more than 26% Merck collapse on the day it pulled Vioxx. Yet when Merck crumbled last year and when GM stumbled last week, my overall portfolio held up well, protected by the power of diversification.
I'm not alone in having built an overall portfolio that survives and thrives in spite of troubles affecting one company within it. Philip Durell, chief analyst for Motley Fool Inside Value, has done much the same. His hot potato has been government-sponsored home loan financier Fannie Mae (NYSE:FNM). Thanks to an accounting scandal, a congressional investigation, a dividend cut, and about $9 billion worth of suddenly evaporated historical profits, that particular newsletter selection is down more than 20% since it was picked. Yet overall, and including the effects of Fannie Mae, Philip's Inside Value portfolio has outperformed the market by better than 7% since inception.
The keys to investing success
Philip's picks have been protected by diversification from Fannie Mae's troubles, while simultaneously being strengthened by the margin of safety inherent in selecting value-priced companies. It's a one-two combination for value investing that has stood the test of time, from Benjamin Graham's The Intelligent Investor through Warren Buffett's Berkshire Hathaway and Philip Durell's Inside Value. While every investor will be handed a hot potato from time to time, with a focus on value and an eye toward diversification you can have the proper equipment to protect yourself from being severely burned.
Want to learn how to build a portfolio that can stand up to the next General Motors, Merck, or Fannie Mae meltdown? A free 30-day trial to Inside Value startshere.
Fool contributor and Inside Value team memberChuck Salettaowns a vehicle made by GM's Saturn division. He also owns shares in General Motors, Annaly Mortgage Management, and Merck. The Motley Fool is investors writing for investors.
