Often the money pages in the National Press tout good ideas or a new investment theme, and it is easy for Investors to be swayed by convincing, plausible articles. In reality though, they are better off sticking to buying the Stock Market through well diversified Index Funds as the following example shows…

Fans of concentrated portfolios love fundamental analysis. The story goes that you can build a sound portfolio around a few stocks with buoyant earnings growth, solid balance sheets and strong return on equity. Well, how does that turn out?

Australia’s Smart Investor magazine in July 2009 published a front cover titled ‘Making Money in the Year Ahead’. The issue featured an article that recommended a set of stocks which its experts said were good for any stage of the business cycle.

These were described as the ‘tough stocks for tough times’, companies that had to clear a number of hurdles to be considered for an all-seasons portfolio.

Among these screens, each stock had to have a net debt-to-equity ratio of less than 50 per cent, as well as annual compound earnings per share growth and average return on equity of more than 10 percent over the previous five years. On top of this, they had to be judged as likely to increase earnings per share by more than 10 percent over the ensuing five years.

As it turned out, the magazine found that just 10 stocks of the top 200 listed on the Australian market managed to clear all these obstacles to qualify for the “tough company” portfolio.

The chosen ones were uranium miner ERA, coal producer New Hope, oil and gas producer Origin Energy, diversified engineering company United Group, services group WorleyParsons, hearing implant maker Cochlear, brick and tile manufacturer Brickworks, investment holding company Washington H Soul Pattinson and retailers JB Hi-Fi and Woolworths.

“Any company that displays all these characteristics we call a tough company,” the magazine said. “They have the ability to suffer the slings and arrows of the business cycle and come out stronger on the other side.”

Well, quite possibly. But as it has turned out, at time of writing (17 months later), you would have been better off just holding the index than buying an equal-weighted portfolio of these 10 built-to-last stocks.

The portfolio’s total return between July 1, 2009 and early December 1, 2010 was 14.85 percent, according to Bloomberg. As a comparison, the Australian market, as defined by the S&P/ASX 300 Accumulation index, delivered a total return of 25.74 percent, or 73 percent better than the “tough stocks for tough times” portfolio.

‘Tough’ Stocks Portfolio                                                                                                       Total Return

                                                                                                                                01/07/2009 – 01/12/2010

United Group                                                                                                                                    47.09%

Cochlear                                                                                                                                              44.54%

JB Hi-Fi                                                                                                                                                30.57%

New Hope Corp                                                                                                                                28.48%

Washington H Soul Pattinson                                                                                                     24.81%

Origin Energy                                                                                                                                    14.51%

Worley Parsons                                                                                                                                12.88%

Woolworths                                                                                                                                      7.94%                 

Brickworks                                                                                                                                       -14.64%  

Energy Resources of Australia                                                                                                 -46.05%

‘Tough’ Portfolio Total Return                                                                                                  14.85%

S&P/ASX 300 Accum. Index Return                                                                                         25.74%

Of the 10 stocks, four – United Group, Cochlear, JB Hi-Fi and New Hope – did better than the index. One – Washington H Soul Pattinson – performed broadly in line with the index. And the remaining five did worse. One of those, ERA, was a shocker, delivering a negative return of 46 percent in this period.

The magazine’s view on ERA had been that it was well positioned to reach major agreements with Chinese buyers. As it turned out, the company later admitted it had struggled to deliver uranium at a grade that met its customers’ requirements.

Likewise, Brickworks was spruiked as play on a housing recovery. But as it turned out, the expected upturn was not as strong as the company expected , particularly in New South Wales where building approvals were the lowest since World War II.

And it’s not just the stocks you DO hold in your concentrated portfolio. It’s the ones you don’t hold that can hurt you – in this case Fortescue Metals (up 72 percent over this particular period), Iluka Resources (up 171 percent), Rio Tinto (up 63 percent) and Oz Minerals (up 78 percent).

So in the end, it doesn’t really matter how deeply you analyse the fundamentals of individual companies, stuff can happen that renders your analysis redundant. And if you have a concentrated portfolio, you are leaving yourself open to these idiosyncratic factors that can harm your returns.

The fact is you don’t need to take these sorts of risks. As we have seen, just holding the market in the past 17 months would have delivered a much better investment result and without having to pay for all the brokerage and stock research.

The bottom line is that it’s hard to pick stocks and even an elite list of the “toughest” companies can let you down. And that’s why it’s better to diversify beyond a handful of stocks.

Cautionary note

Investment types or areas mentioned may not be suitable for all investors and therefore no actions should be taken as a result of this article. Guidance should be sought before making any investment decision.

The value of your investment may go down as well as up.

Past performance is not a reliable indicator of future results.