A Portfolio That Rewards Patience

01/10/2011 5:05 pm EST


Rob Carrick

Columnist, The Globe and Mail

Globe and Mail columnist Rob Carrick explains the strategy behind a simple, “two-minute” portfolio.

Patience, my fellow investors.

Even with a sound approach to investing, there are times when forbearance is required. Take, for example, a simple stock-picking strategy called the two-minute portfolio.

Data going back 25 years shows the two-minute portfolio has outperformed the S&P/TSX composite index by 1.6 percentage points on an average annual basis. But along the way, there have been some trying times.

Last year was not one of them, mind you. The two-minute portfolio returned 19% in 2010, while the index made 17.6% (both numbers include dividends). But the two-minute approach fell well short of the index in 2009, and in its first three years it lagged the index consistently.

And yet, here we are today with not only index-beating returns over the long term, but also significantly less risk than the broader market.

The two-minute portfolio is built on the two largest dividend-paying stocks by market capitalization—that’s share price multiplied by shares outstanding—in each of the ten sectors of the S&P/TSX composite index. The portfolio is rebalanced at the beginning of every year to change market cap leaders as required and to more or less equalize the size of the holdover stocks that have either soared or fallen in value.

Think of the two-minute portfolio as a middle path between index investing, where you buy exchange traded funds or mutual funds that mimic the returns of various stock indexes, and active management, where stocks are chosen individually.

Simplicity Is the Key

You have no discretion over which stocks you hold with the two-minute strategy, but your holdings will look different from the S&P/TSX composite index, which is a proxy for the Canadian stock market. You’ll have more of a dividend-paying, blue-chip focus than the index, and you’ll be better diversified.

Financials and commodity stocks account for two-thirds of the index, while the more conservative health care, utilities, and consumer staples sectors come in around 4.5% combined. In the two-minute portfolio, all sectors account for 10% of the whole.

The two-minute portfolio was devised by me in 1999 as an experiment in quick and easy stock picking. For the past several years, the portfolio has been maintained by CPMS, a Toronto-based equity research and portfolio analysis firm owned by Morningstar Canada.

CPMS set a start date of Dec. 31, 1985, which means we now have 25 years of data to look at. The two-minute portfolio outperformed the index in 15 years during that period, with much less risk if you judge by a measure called beta, which compares a stock or portfolio’s volatility to the broader market. The index has a beta of 1.0; at 0.71, the two-minute portfolio’s beta is considerably lower.

The two-minute portfolio is not appropriate for people who are nervous about owning stocks, although it does offer a smoother ride than the index. The portfolio lost money three times in the past 25 years, compared to seven times for the index.

The worst decline for the index—they call this a drawdown in the financial business—was a 43.4% plunge from May, 2008, through February, 2009. The portfolio’s worst setback was a decline of 30.4% from October, 2007, through February, 2009.

The portfolio’s worst loss over a calendar year was the 19% decline in 2008, the year the index fell 33%. Here, you can see the conservative nature of the two-minute portfolio working for investors.

In 2009, that conservative approach was a drag on returns. While the index soared 35.1%, the two-minute portfolio made just 14.6%. That gap of 20.5 percentage points was the largest in the portfolio’s history.

Index-beating returns in bear markets combined with index-lagging gains in bull markets—such is the long-term record of the two-minute portfolio. The reward for patiently sticking it out was a compound average annual return of 10.6%, compared to 9% for the index (again, dividends are included).

The 2011 Two-Minute Portfolio

Now, let’s translate these returns into real-world numbers that reflect the impact of fees. You can buy the S&P/TSX composite index through the iShares S&P/TSX Capped Composite Index Fund (Toronto: XIC), an ETF that trades under the symbol XIC and has a management expense ratio of 0.25%.

At an online broker charging $10 per trade, the cost of setting up the portfolio would be $200. If you invested $30,000 in a two-minute portfolio, your effective management expense ratio would be 0.66%.

If we subtract 0.66% from the 25-year average annual return of 10.6% for the two-minute portfolio, we get 9.9%. If we subtract 0.25 of a point from the 9% return of the index, we get 8.75%. The two-minute portfolio still comes out on top after fees, and its advantage only grows as you invest larger amounts and thus have a larger base on which to apply your commission costs.

Once you’ve set up the two-minute portfolio, annual maintenance costs should be quite reasonable. There are five new stocks to be introduced to the portfolio for 2011 and five to be sold, which means a total of ten trades. Rebalancing the other stocks back to a weighting of approximately 5% would require another five trades, which brings us to a total of 15. At $10 per trade, that’s $150 in total.

New stocks for 2011 are Magna International, replacing Shaw Communications; George Weston, replacing Shoppers Drug Mart; Telus, replacing Rogers Communications; Fortis, replacing TransAlta; and, Medical Facilities Corp., replacing Valeant Pharmaceuticals International (Valeant, formerly Biovail, has said it will no longer pay dividends).

Among the holdovers are a few small companies in the most sparsely represented Canadian market sectors—technology and health care. The two tech names are Evertz Technologies, which makes equipment for the broadcast industry, and Constellation Software, a provider of software services. The health care stocks are Medical Facilities and CML HealthCare.

As with all investing strategies, the past results for the two-minute portfolio are no guarantee of future success. Still, 25 years of history for this strategy suggest a little tinkering each New Year and a lot of patience over the long term can be rewarded.

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