Tuesday, January 27, 1998

The Daily Workshop Report
by Robert Sheard (TMF Sheard)

LEXINGTON, KY. (Jan. 27, 1998) -- In yesterday's column, I discussed the uses, and more to the point, the potential abuses associated with margin leverage. Today, I want to talk about another danger, one that may even come straight from the use of our own Workshop screens.

I'm referring to industry concentration risk. Because of the way our screens are set up -- keying on individual financial elements like earnings growth rates or industry rankings or relative strength -- it's not unusual to see several stocks from the same industry group show up in any single screen's current rankings. This is especially the case with the original Investing for Growth screen, where the final test is Value Line's industry ranking.

In a portfolio of only ten stocks, for example, if four or five stocks (or even more) are from the same industry group, the diversity in your portfolio plunges. Let's say you own ten stocks and four of them are from the oil services sector. As long as that sector rises, your whole portfolio is going to look wonderful. But if an industry leader suddenly warns Wall Street about troubled times ahead or posts a really lousy quarterly report, we've all seen how the entire industry group can get hammered. Nothing is spared and your entire portfolio gets creamed.

It's crucial, then, to consider not just how many stocks you hold in your overall portfolio, but also what kind of industry concentrations you're holding. A twenty-stock portfolio with sixteen computer-related stocks is not more diverse than a ten-stock portfolio with eight or nine different industry groups represented.

Which screens in the workshop seem the most likely to generate high concentrations in a single industry? As I mentioned, the original Investing for Growth screen is built almost to guarantee such concentration, but in the two years since that primer was published, I've come to view such concentration as a flaw rather than an asset. One way around the problem would be to impose a limit on the number of stocks one would choose from any single industry group. Another way several readers have chosen is to use something other than the industry ranking for the final IFG screen. That, of course, has led to our experimental IFG (with Relative Strength) screen.

Unemotional Growth can, at times, also become too concentrated in a single industry. The same double-edged sword we've seen with IFG exists for Unemotional Growth. When it's good, it's great. When it's bad, it hurts -- a lot! The same type of preventive measures can be used with Unemotional Growth. First, don't just use a five-stock UG approach in isolation. Supplement it with other stocks from other approaches to round out a more stable portfolio. Only the most stoic of investors can endure the wildness of Unemotional Growth's short-term fluctuations and not lose the discipline called for with the approach. Using UG as only a portion of one's portfolio might help calm the willies.

Consider industry concentration when you're building your own portfolio strategies. Beyond simply holding a set number of stocks, it helps to make sure that a number of industries are represented to avoid having all your proverbial eggs in the same basket. (Just recall the last crushed package you received, courtesy of the post office. That's what your portfolio can look like if everything goes in the same parcel.) Fool on!

[Want to be the first Fool on your block to get a copy of Robert Sheard's forthcoming book? Click here to pre-order your copy of The Unemotional Investor.]