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25% Allocation To Apple – Too Much Risk?

Summary Apple remains my largest position at 25.9%. The portfolio risk factor is not necessarily increased with position size. Reflect your knowledge or confidence in a company with your position size. After releasing the details of my Young and Cautious portfolio , one of the most frequently presented criticisms is of the very high allocation to Apple (NASDAQ: AAPL ). My current allocation is just north of 25%. Company Current p/e Current yield Annual dividends ($) Portfolio weighting (%) Apple 13 1.75 110.2 25.9 Aberdeen Asset Management ( OTCPK:ABDNF ) 10.53 5.21 130 9.6 Bank of America (NYSE: BAC ) 13.07 1.13 5.8 2 Coca-Cola (NYSE: KO ) 27.47 3.08 36.96 5 DaVita HealthCare (NYSE: DVA ) 33.16 0 0 11.6 General Motors (NYSE: GM ) 13.24 4 72 7.5 Gilead Sciences (NASDAQ: GILD ) 9.78 1.61 46.44 11.9 McDonald’s (NYSE: MCD ) 24.64 3.12 27.2 3.7 Rolls Royce ( OTCPK:RYCEY ) 8.28 4.18 62.42 7.5 Transocean (NYSE: RIG ) n/a 4 100.8 11 Wells Fargo (NYSE: WFC ) 13.51 2.7 27 4 Note: Average Yield = 2.6% The following comments sum up the main criticisms of the portfolio, which can be found in Young and Cautious – One month on and First Portfolio review – Young and Cautious , respectively. (click to enlarge) (click to enlarge) Although I respect the views of many commentators and contributors, I do not accept that the best strategy for an active investor is to just divide your capital equally among a list of companies that you think might perform well, regardless of their individual valuations and business circumstances. I will set out below why a higher allocation in a common stock does not necessarily lead to higher overall risk for your portfolio, and specifically, why I have allocated such a large percentage to Apple. Risk Risk can be split up into systematic risk and company specific risk, or non-systematic risk. However, for the purposes of this article, only company-specific risk will be analyzed. When talking solely about stocks, it is undeniable that non-systemic risk can be mitigated through splitting your capital among a variety of common stocks. This leads many investors to argue that the best way to reduce risk is to evenly distribute your capital over all your holdings. For example, 10 stocks with 10% weighting, or 20 stocks with 5% weighting. Many writers disagree on the ‘perfect number’ that provides the best risk/reward scenario for an active investor. Arguments generally range from 10 at the low end, to around 40 at the high end of the scale. Anything higher than this leads to a significant amount of money spent through transaction costs, which will impact significantly depending on how frequently positions are bought and sold. A higher number of stocks in a portfolio would most likely warrant the need to just take on a more passive approach through using a cheap index fund, such as provided by Vanguard. The risk that is not mentioned when talking about diversification Apart from individual company risk and systematic risk, one of the most prominent risks inherent in over-diversification is yourself. Your knowledge and time has to be spread over a higher number of companies, undeniably leading to the risk of gaps in your knowledge. This could be not having enough time to go through each company’s quarterly reports and individual valuations. This inefficient manner of investing has the potential to lead to sub-par returns. In addressing this view, investment icon Warren Buffett has stated: Once you decide that you are in the business of evaluating businesses, diversification is a terrible mistake to a certain degree. His reasoning is based on the idea of the mistake of omission in investing: Big opportunities in life have to be seized … Doing it on a small scale is almost as big a mistake as not doing it at all. This is not a scarcely held belief of prominent investors around the world. Below you see how frequently a large position plays a role in those investors’ portfolios: Warren Buffett Wells Fargo 19% Kraft Heinz (NASDAQ: KHC ) 18% David Einhorn Apple 20.5% Carl Icahn Icahn Enterprises (NASDAQ: IEP ) 27.5% Apple 21% Bill Ackman Valeant Pharmaceuticals (NYSE: VRX ) 25% Air Products & Chemicals (NYSE: APD ) 18.8% Chase Coleman Netflix (NASDAQ: NFLX ) 22.9% Amazon (NASDAQ: AMZN ) 20.1% Although not all of the companies have performed well over the past year, most notably Valeant Pharmaceuticals, most of them have. This high allocation in a company would classify as a ‘conviction buy’, exemplifying each investor’s confidence in these respective companies. It is what separates them from the rest of the market, allowing them the opportunity to beat the market returns. Know your strengths Every investor has their own strengths. This is down to the fact that whatever their profession is, or if they have a strong passion for something, they will generally have a deeper knowledge of it. This gives them an advantage over the general public and can give them the edge when it comes to putting their capital to work. This can be reflected in your portfolio. For example being a student has its perks. Many trends over what is popular originate from this age group. This could be said with regards to Apple, Facebook (NASDAQ: FB ) and Nike (NYSE: NKE ). What is popular with this age group has a tendency to spread to other age groups to create the norm. Looking back at Facebook, I grew up alongside the likes of Bebo, MSN Messenger and MySpace. My age group saw a shift from these social networking sites to Facebook, because we were causing the shift. Examples such as this give investors of certain age groups, professions, or hobbies that advantage in the market. This is one of the reasons why I am still so bullish on Apple. Regardless of what some financial news websites publish about Apple losing it’s ‘shine’ or ‘cool factor’, it is evident that Apple still has the backing of its supporters. It only takes a trip to any university library to see the momentous number of Apple products being used by students, who are in effect the future. For example, the Mac lineup has been of great popularity. Many students are making use of their university discounts and either upgrading from the previous model or other brand laptops. Growing up, these students will see Apple as the norm and are more likely to continue using their products. On the contrary, there are many areas where my knowledge lacks. This could come down to being young, lack of interest in the subject matter, or just plain ignorance. This is absolutely fine. It just means I don’t invest in these areas. If I invested in these areas for the sole reason of ‘achieving diversification’, I would be opening myself up to a great deal of risk. This is just not necessary. When opportunities are present, grab them by the horns The second part of investing in your strengths is investing at the right price. There are many companies I see doing well. Nike and Starbucks (NASDAQ: SBUX ) are both companies I want to own, just not at these prices. There is too much optimism built into the stocks. On the other hand, Apple is a company I understand well. I have a strong insight into how my generation sees their products and services over their competitors, and most importantly, the valuation is cheap. Valuation The company stands at a huge discount to the overall market. Apple’s trailing P/E ratio stands at just under 13 while the forward P/E is 11. This represents a 41% discount to the current ratio of the wider market, currently standing at 22. Apple is priced for a deceleration in earnings, while it is posting ever-growing earnings. The last earnings report showed EPS growth of 38% over the previous year, with guidance showing further record earnings for the near future. An earnings growth that surpasses the wider market. In addition to this, I believe Apple has in recent years been paving the way to become a future dividend champion. It is managing to consecutively increase dividend payments to shareholders year over year, while maintaining a low payout ratio. Currently, the dividends to shareholders represent only 21% of total earnings. This gives the company a great deal of room to increase payments several years from now. On top of this, Apple stated in April of this year that the share repurchase program would be increased to $140 billion. What are my risks? Having over a quarter of my capital in one stock does mean that if the share price drops significantly, this will drag down the portfolio significantly. Bill Ackman has recently been a victim of this, as Valeant has dropped like a rock after allegations of price gouging surfaced. This has led to him suffering a severe loss of capital and significant underperformance to the market. To compare this to Apple would be unfair. Apple has many factors that give it a large margin of safety to prevent this. First of all, almost a third of the entire market capitalization is made up of cash and equivalents, and this continues to grow. This allows Apple to raise cheap cash in corporate bonds to facilitate large share repurchases. Secondly, Apple’s great P/E discount to the wider market and higher growth rate provides a safety buffer, as it is already priced for no growth. The only time I will reduce this high allocation is if either of two things happen: Earnings begin to fall, or the share price rises resulting in a P/E ratio similar to the wider market. Conclusion Everyone has their strengths in investing. This means having a high allocation of your capital in one company will carry different risks depending on who owns that particular company. When you have the opportunity to own a good company trading at a cheap valuation that you have a deep understanding of, allocate more capital to this to increase your chances of outperforming the rest of the market. Thank you for reading. If you have enjoyed reading this article, or want to follow the progress of the ‘Young and Cautious’ portfolio please hit ‘follow’ at the top of the page. Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.

What Drives The Financial Sector?

Summary The financial sector is the second largest component of S&P 500. Its performance to a large extent is a combination of long equities and short bonds. XLF’s performance clearly illustrates the diversification benefit an investor achieves as opposed to individual stock investment. With a 16.5% share, financial sector stocks currently account for the second largest part of S&P 500, trailing only behind the information technology sector. According to ETFdb , there are 41 ETFs tracking U.S. financial stocks. By far the largest of them is the Financial Select Sector SPDR ETF (NYSEARCA: XLF ), which has $18.5 billion of assets under management (AUM), exceeding the total number for the remaining 40 funds combined. In this article I would like to probe the main contributors to XLF returns, splitting them into two categories. The first one contains broad market forces, or so called factors, driving the ETF’s performance. The second category includes the largest individual holdings, which set the tone for overall funds performance. Factor analysis Analyzing daily price changes from the last 12 months, the simple factor analysis on risk analysis tool InvestSpy gives the first insight into the driving forces behind XLF returns. Using asset classes as explanatory variables, the results table looks as follows: The practical interpretation of this output is that to replicate performance of $1,000 invested in XLF as closely as possible, an investor would need to buy $1,000 of the Vanguard Total Stock Market ETF (NYSEARCA: VTI ), whilst shorting $580 of the Vanguard Total Bond Market ETF (NYSEARCA: BND ), $80 of the SPDR Gold Trust ETF (NYSEARCA: GLD ) and $10 of the United States Oil Fund (NYSEARCA: USO ). The important takeaway is that essentially XLF acts as a combination of long equities and short fixed income. The coefficients estimated by this basic factor analysis enable one to project potential performance of XLF in various market scenarios, incorporating views about stock and bond markets. Largest holdings XLF has 87 holdings, which range from banks to insurance companies to real estate investment trusts. Whilst 82 of these positions have a weight below 3%, each of the largest 5 holdings accounts for more than 5%. This means that 37% of the AUM is invested in only 5 stocks, naturally making them the primary drivers of the fund’s returns. Wells Fargo & Company (NYSE: WFC ) – 8.7% weight Berkshire Hathaway Inc. Class B (NYSE: BRK.B ) – 8.4% JPMorgan Chase & Co. (NYSE: JPM ) – 8.2% Bank of America Corporation (NYSE: BAC ) – 6.1% Citigroup Inc. (NYSE: C ) – 5.4% Over the last 12 months, these five stocks contributed 0.70% to XLF total return of 1.2%. Four out of five largest holdings are banking stocks, which, upon further inspection, demonstrate fairly similar risk characteristics: Source: InvestSpy All four banking stocks have a beta coefficient above 1, showing higher than average sensitivity to the broad market movements. Their annualized volatility ranging from 19.2% to 24.8% substantially exceeds that of the SPDR S&P 500 Trust ETF (NYSEARCA: SPY ), which stood at 15.0% over the same period. BRK.B is a bit of an outlier here and exhibits more contained risk parameters, largely due to the fact that it is to a certain extent a funds in its own right, heavily tilted towards value stocks. Further analysis of the correlation matrix reveals that the same BRK.B is the position that is most correlated to the S&P 500 index with a coefficient of 0.87. Comparing with other top holdings, BAC appears to be the position that is most independent. Source: InvestSpy One observation from both tables in this section is that XLF demonstrates two main features of a pool of individual stocks. First, it has lower annualized volatility and maximum drawdown than its individual holdings, which is a great illustration of the diversification effect. Second, it is significantly more correlated to the broader stock market than its individual holdings as the idiosyncratic risk becomes reduced in a portfolio. Conclusion Putting all pieces together, XLF tends to behave as a combination of long stocks and short bonds. The performance of the financial sector can be projected incorporating investor’s outlook for both of these markets. Furthermore, 37% of the fund is concentrated in 5 mega cap stocks, four of which are banks. Whilst these stocks individually are more volatile than the broad market, putting them together in one basket reduces volatility, beta and drawdown metrics. Unless an investor has a strong preference for a specific financial stock, XLF performance brings all the benefits that one may expect from a sector ETF.

Utilities: Across The Universe

Summary I currently favor utilities in the current market environment. While the sector has trailed in 2015 in anticipation of rising interest rates, this may be present investors with opportunity today. Investors may be well served to focus on specific themes within this space. With this in mind, it is worthwhile to take a walk across the utilities universe. I currently favor utilities in the current market environment. Following a strong advance in 2014, the sector has been under pressure for much of the year due in large part to concerns about the U.S. Federal Reserve and plans to raise interest rates. This recent weakness may be presenting investors with opportunity as they position for the future. But instead of taking a blanketed approach in allocating to the sector, investors may be well served to focus on specific themes within this space. With this in mind, it is worthwhile to take a walk across the utilities universe. Why Utilities? Utilities have struggled in 2015 in anticipation of the Fed raising interest rates. Given the interest rate sensitivity of the sector, this is not necessarily surprising. But many reasons exist to expect that utilities may be set to perform well once the Fed finally ends the suspense and starts hiking rates. First, utilities have demonstrated the ability to perform well during past rate hike cycles. During the period from June 2004 to June 2006 when the Fed last completed a interest rate normalization cycle by increasing the funds rate from 1.00% to 5.25%, the utilities sector managed to increase by a cumulative +52% in value. Not too shabby for a sector that investors are supposedly inclined to abandon when interest rates are rising. (click to enlarge) Of course, this assumes that the Fed will actually be able to complete a rate normalization cycle this time around, which is doubtful at best. This is due to the fact that unlike June 2004 or the numerous past interest rate hiking cycles that came before it, the Fed is seeking to accomplish the unprecedented by sustainably raising interest rates off of the zero bound, but also do so in a global and domestic economic environment that is languid at best and increasingly deteriorating in many parts of the world. As I’ve mentioned in past articles, the Fed is seeking to raise interest rates not because of the economy but despite the economy. As a result, it should be anticipated that the Fed may squeeze out one or two rate hikes at most in the coming months before they are forced to either stop or reverse course. And given that utilities offer stock investors both relative safety from a price stability perspective as well as high income from a total returns standpoint, such an outcome would likely prove beneficial to the utilities sector. And this may be particularly true given the fact that the sector has been sold off throughout much of 2015 in anticipation of an event in the Fed normalizing interest rates that may never come to pass. Exploring The Utilities Universe Suppose you are an investor that has interest in the utilities sector. One of the challenge that many immediately face when exploring utilities is that they like financials are not like most other sectors in the equity marketplace. In the case of utilities, they are mostly domestically focused (which may be an added plus for the sector given increasing currency volatility and expectations for a stronger dollar with operations that are located in a specific region of the country with pricing that in many cases is regulated by local government officials. Moreover, some of the metrics that investors focus on in evaluating utilities are unique to the sector. And among the individual names in the space are wide differentiations in terms of exactly how they are generating their power, getting along with their regulators and running their businesses. With all of this in mind, it is worthwhile to establish a snapshot framework for viewing and organizing the utilities industry. For the purpose of this report, I will be focusing exclusively on utilities that are domiciled in the United States and trade on one of the three exchanges in the NYSE, the NASDAQ and the AMEX. In total, there are exactly 100 U.S. firms that are designated as utilities that are exchange traded. But not all of these firms fit the specific criteria of the types of utilities that we would expect to perform generally in line with what we have defined for the broader utilities universe above. For example, some are master limited partnerships concentrated more on pipeline operations than distributing electricity to customers. Others are electricity wholesalers, which is a notably different business model than the traditional utilities business. With these items among others in mind, it is worth filtering down the utilities universe to its representative components. Included in this process is screening out companies that are set to be acquired as well as those that are trading at small market capitalizations and low average trading volumes that have the potential to present challenges from a liquidity standpoint. Lastly, only those utilities that pay investors a dividend are included, as this income is an important aspect in supporting the price stability of the utilities sector, particularly during periods of market instability. After conducting this screening process, we are left with 53 core public exchange traded utilities domiciled in the United States. These can be broken down into three main categories, which are shown below. Electric Utilities – 37 Gas Utilities – 7 Water Utilities – 9 The characteristics of the latter two categories are fairly straightforward, but electric utilities warrant further discussion. Electric Utilities First, let’s introduce the 37 names in the group including their market capitalization and current dividend yield. NextEra Energy (NYSE: NEE ) $46.4 billion 3.1% Duke Energy (NYSE: DUK ) $46.3 billion 4.9% Dominion Resources (NYSE: D ) $40.4 billion 3.8% Southern Company (NYSE: SO ) $39.9 billion 4.9% American Electric Power (NYSE: AEP ) $27.2 billion 3.8% Exelon (NYSE: EXC ) $26.3 billion 4.3% PG&E (NYSE: PCG ) $25.9 billion 3.5% PPL Corporation (NYSE: PPL ) $22.4 billion 4.5% Public Service Enterprise (NYSE: PEG ) $19.7 billion 4.0% Edison International (NYSE: EIX ) $19.6 billion 2.8% Consolidated Edison (NYSE: ED ) $18.3 billion 4.2% Xcel Energy (NYSE: XEL ) $17.9 billion 3.6% Eversource Energy (NYSE: ES ) $15.9 billion 3.3% WEC Energy (NYSE: WEC ) $15.6 billion 3.4% DTE Energy (NYSE: DTE ) $14.4 billion 3.7% FirstEnergy (NYSE: FE ) $12.8 billion 4.8% Entergy (NYSE: ETR ) $11.7 billion 5.1% Ameren (NYSE: AEE ) $10.6 billion 3.8% CMS Energy (NYSE: CMS ) $9.7 billion 3.3% SCANA (NYSE: SCG ) $8.5 billion 3.7% Pinnacle West (NYSE: PNW ) $6.9 billion 3.8% Alliant Energy (NYSE: LNT ) $6.6 billion 3.8% NiSource (NYSE: NI ) $6.1 billion 3.2% Westar Energy (NYSE: WR ) $5.8 billion 3.5% OGE Energy (NYSE: OGE ) $5.2 billion 4.2% Great Plains Energy (NYSE: GXP ) $4.1 billion 3.7% Vectren (NYSE: VVC ) $3.4 billion 3.7% IdaCorp (NYSE: IDA ) $3.3 billion 2.9% Portland General Electric (NYSE: POR ) $3.1 billion 3.4% Northwestern (NYSE: NWE ) $2.6 billion 3.6% ALLETE (NYSE: ALE ) $2.5 billion 4.0% PNM Resources (NYSE: PNM ) $2.2 billion 2.9% Avista (NYSE: AVA ) $2.1 billion 4.0% Black Hills (NYSE: BKH ) $2.0 billion 3.6% El Paso Electric (NYSE: EE ) $1.6 billion 3.0% MGE Energy (NASDAQ: MGEE ) $1.5 billion 2.8% Empire District Electric (NYSE: EDE ) $1.0 billion 4.7% An initial observation about the group listed above. It is worth noting that consolidation and acquisition activity has been taking place within the electric utility industry. This has included, Pepco Holdings (NYSE: POM ), TECO Energy (NYSE: TE ), Hawaiian Electric (NYSE: HE ) and Cleco (NYSE: CNL ), each of which has a market capitalization between $3 billion and $7 billion. Exactly how these utilities generate their electricity for their customers has a meaningful impact on their business operations and their stock prices. For example, electric utilities that emphasize using coal in the power production process are dealing with operational pressures resulting from increased carbon emissions standards from the U.S. Environmental Protection Agency. The nuclear generators have also been dealing with unfavorable market conditions and face event risk concerns that can spillover from high profile accidents like the Fukushima disaster in Japan back in 2011. As a result, it is worthwhile to consider exactly how these utilities generate their electricity. Coal The following is a subset of utilities that are most heavily reliant on coal in producing electricity including the percentage of their generating sources concentrated in coal. It should be noted that some publicly traded utilities do not disclose this information and may not be included in the list below as a result despite being reliant upon coal for power generation. NiSource 77% Ameren 74% DTE Energy 67% Great Plains Energy 64% PNM Resources 57% WEC Energy 56% ALLETE 56% SCANA 48% Westar Energy 48% MGE Energy 48% Alliant Energy 47% Empire District Electric 47% FirstEnergy 44% CMS Energy 44% OGE Energy 44% Southern Company 39% Duke Energy 37% Pinnacle West 34% IdaCorp 34% Black Hills 34% Dominion Resources 30% Of course, a small utility heavily reliant on coal for electricity generation may not be having the same environmental impact as a large utility that is more diversified in its power generation. As a result, it is also worthwhile to list those utilities mentioned above that are ranked highest in terms of carbon dioxide emissions according to a report by Ceres. According to the report, Duke, AEP, Southern Company, FirstEnergy and PPL all rank in the top ten in terms of total carbon dioxide emissions. Nuclear Applying the same criteria from above, the following are the subset of utilities that rely most on nuclear power in generating electricity for their customers. Exelon 67% El Paso Electric 47% Dominion Resources 33% Entergy 33% PNM Resources 30% Duke Energy 28% Pinnacle West 27% FirstEnergy 26% NextEra Energy 23% PG&E 21% Ameren 21% Hydro Two utilities standout in particular for their emphasis on hydroelectric power generation, while a few others register on the list. IdaCorp 35% Avista 32% PG&E 8% Portland General Electric 8% Exactly how each utility is generating their power is just one of the many factors to consider when evaluating an investment opportunity in the electric utilities space. Gas Utilities The natural gas distribution utilities universe consists of seven names. These are firms that are focused on the sale and distribution of natural gas and energy related products to its customers. In short, while a number of the utilities mentioned above have varying degrees of natural gas electricity production in their business, these are more purely natural gas electricity producers. Atmos Energy (NYSE: ATO ) $6.1 billion 2.6% WGL Holdings (NYSE: WGL ) $3.0 billion 3.1% New Jersey Resources (NYSE: NJR ) $2.6 billion 3.0% Laclede Gas (NYSE: LG ) $2.4 billion 3.3% South Jersey Industries (NYSE: SJI ) $1.7 billion 4.2% Northwest Natural Gas (NYSE: NWN ) $1.3 billion 4.0% Chesapeake Utilities (NYSE: CPK ) $0.8 billion 3.3% It should be noted that this group consisted of ten names at the start of the year, as AGL Resources (NYSE: GAS ), Piedmont Natural Gas (NYSE: PNY ) and UIL Holdings (NYSE: UIL ) are all in the process of being acquired in 2015. A primary driver of the acquisition binge in the natural gas distribution utilities space is the priority by many electric utilities, particularly those that are more reliant on coal, to diversify their generation sources with a shift toward natural gas. Water Utilities Distinctly different from their electricity producing relatives listed above but similar in the fact that they are also regulated at the local level, the following is the list of nine publicly traded water utilities. Within the broader utilities sector, these stocks have their own unique return and correlation characteristics that are differentiated from electric utilities as well as the broader market. American Water Works (NYSE: AWK ) $10.1 billion 2.4% Aqua America (NYSE: WTR ) $5.0 billion 2.5% American States Water (NYSE: AWR ) $1.5 billion 2.2% California Water Service (NYSE: CWT ) $1.0 billion 3.1% SJW Corporation (NYSE: SJW ) $586 million 2.7% Middlesex Water (NASDAQ: MSEX ) $397 million 3.1% Connecticut Water Service (NASDAQ: CTWS ) $391 million 3.1% York Water (NASDAQ: YORW ) $297 million 2.6% Artesian Resources (NASDAQ: ARTNA ) $223 million 3.6% Next Steps The opportunity set in the utilities universe is attractive and is likely to continue to be so for some time regardless of whether the Fed ends up raising rates or not. As a result, I will be placing an increased concentration on the utilities sector going forward on Seeking Alpha and will be drawing upon the framework introduced in this article for the purpose of future discussion and analysis. This will include a more in depth focus on individual names within the utilities space and timely recommendations on my premium service on Seeking Alpha. Disclosure : This article is for information purposes only. There are risks involved with investing including loss of principal. Gerring Capital Partners makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made. There is no guarantee that the goals of the strategies discussed by Gerring Capital Partners will be met.