There are many ways to think about diversification. We’re going to focus on two — using correlations and the barbell strategy — and how drawing a little bit from each can help Club members approach an uncertain market. We’re also going to show you how we use these concepts day in, day out in the Trust portfolio. Correlations With this mindset, you seek out investments with attractive risk/reward profiles that also have a minimal or negative correlation to your existing holdings. These correlations are measured from minus 1 to plus 1. A correlation of minus 1 means that two assets move exactly opposite to one another. A correlation of plus 1 means they move perfectly in sync in either direction. Zero means no correlation. For example, against a holding in Club name Alphabet (GOOGL), where earnings estimates will be closely tied to advertising budget expectations that are themselves hostage to economic growth forecasts, one may take a position in Procter & Gamble (PG), the consumer staples giant that investors will seek safety in when economic forecasts deteriorate because the company’s sales are tied to more recession resilient offerings. Put another way, corporations will cut advertising budgets when a slowdown is anticipated because they know consumers aren’t going to spend as freely as they would in an expansion. However, those same consumers are still going to pay for laundry detergent, diapers and toilet paper. Barbell strategy The other way to think about diversification — and one we used heavily during this year’s choppy market — is the barbell portfolio strategy. Rather than look at how closely stocks move in-sync, we approach the portfolio through the lens of a binary event. It’s kind of like saying the two sides of the barbell are totally inversely correlated. But rather than thinking about historical correlation, we are more so thinking about a how to hedge for two different outcomes. During Covid, that event was the shutdown trade and the reopen trade. Historically, there was nothing that dictated that if United Airlines (UAL) was going higher, Take-Two Interactive (TTWO) had to go lower. However, in the context of Covid, that was precisely the case. If the headline of the day was that restrictions were being lifted, the gaming stocks would decline while the travel-oriented stocks gained. If, however, the news was that some new variant popped up, the opposite was true with the lockdown names gaining and the reopening names declining. How we use both approaches These days, portfolio construction requires a bit of both — combining these thought processes is how we arrive at our current portfolio of stocks. The current environment is characterized by so many crosscurrents that it’s simply not enough to look at historical correlations or pretend that everything driving this market will have a binary outcome. Our current portfolio has a little of everything. At a high level, we seek to have a fully diversified collection of stocks. Consumer discretionary: We hold companies like Disney (DIS), Estee Lauder (EL) and Wynn Resorts (WYNN). Health care: We hold the aforementioned J & J, Eli Lilly (LLY) and Humana (HUM). Staples: We own like Costco (COST) and Procter & Gamble . Industrials: We hold an economically sensitive names like Honeywell International (HON) — and a less sensitive one in terms of the economic cycle in Danaher (DHR). In names where the dynamics are a bit more mixed, we own Microsoft (MSFT) and Amazon (AMZN). Both will get hit on the personal computer and consumer retail sales side in a slowdown, but are also likely see more resiliency in their cloud offerings through Microsoft Azure and Amazon Web Services (AWS). We have energy holdings, which are also a mixed bag: On one hand, they help to hedge against inflation and global tensions; but on the other, they can see demand falter should the economy really slow down. OPEC+ is trying to manage supply to mitigate any demand-induced weakness, and most of our energy stocks, including Coterra Energy (CTRA), Devon Energy (DVN) and Pioneer Natural Resources (PXD) pay investors huge dividends to hold their stocks. So, you could argue we maintain a barbell between economically sensitive names and those with more resilience in a slowdown. However, today’s environment requires much more nuance and we attempt to illustrate that with every move we make. Take Monday’s sale of Advanced Micro Devices (AMD). We can’t say that this is a name tied to the economy, because even if PC sales rebound with the economy at some point, we have to consider the hard stance the Biden administration has taken on restricting semiconductor exports to China. This is not an economic boom or bust stock because it’s now, more than ever, tied to geopolitical dynamics as well. The same can be said of fellow chipmakers Nvidia (NVDA), Qualcomm (QCOM) and Marvell Technology (MRVL). Or there’s our position in Estee Lauder (EL), which we purchased more of on Tuesday and Thursday . if the U.S. economy slows it wouldn’t be great for the prestige beauty company as it could get hit in a spending slowdown, even though skincare is one of the faster-growing consumer categories. But we also have to consider China, where Estee Lauder has historically generated a third of all sales. Sales in the region have been held back by China’s zero-tolerance policy on Covid. We hope that its stance will ease in the future and Estee Lauder sales can hold up on the back of a Chinese reopening, even if U.S. growth weakens further. If inflation cools and interest rates fall, we need some of those longer-duration names, something like Salesforce (CRM). If it lasts a while longer, a name like Linde (LIN) may hold up thanks to cost pass-through clauses written into long-term contracts. If inflation lingers but the economy slows, we need something defensive like P & G or J & J. And if inflation persists but also economic activity picks up, you better own energy stocks. What if Russian steps up its war efforts? Again, better have some natural gas exposure as we head into winter. What if the Russian-Ukrainian conflict is resolved? Natural gas supplies may pick up, taking prices down, but so too will European economic activity. This makes the outcome a bit more difficult to gauge, though we might see some selling due to a reduction in geopolitical risk. So we have to weigh energy accordingly and be sure that we are booking profits on outsized moves to the upside. We can’t sell all of our semiconductors because, while the facts have changed in terms of China, the secular trend of digitization remains heavily reliant on chips. We manage the exposure but can’t give it up altogether because the group has already been cut in half. Also, what if U.S.-China relations begin to improve — after all, it’s better for everyone when the world’s two largest economies get along. In that case, growth accelerates at chip companies. When China reopens, the names that stands to benefit most are Starbucks (SBUX) and Estee Lauder, perhaps enough to offset weakness here in the U.S. and is in no way tied to the semiconductor dynamics. That also brings more demand into the oil market, so expect oil prices and the energy stocks tied to it to benefit. If China irrationally holds to its zero-tolerance policy longer? We need names without the China exposure, like beer giant Constellation Brands (STZ) which generates 100% of sales in the U.S. and Canada and doesn’t have to worry about a supply chain tied to Chinese policies. What if rates hold steady and the economy picks up? Banks stand to make a boat load on the interest rate spreads like Wells Fargo (WFC) did this quarter. If that’s not the case well in the meantime we’re getting healthy dividend payments and strong buyback activity out of names like Morgan Stanley (MS). What about a name like Apple (AAPL)? On the one hand, it’s a consumer tech company and will be hit in a downturn. On the other, it’s got the balance sheet to not only ride out any slowdown but also to keep buying back shares. And when share prices decline, buybacks are even more powerful and accretive to longer-term earnings as more shares can be sucked out of the market. Bottom line By constantly considering the possible outcomes of certain events — and reevaluating our views as new data comes in — we can buy and sell holdings to create a diversified portfolio to help mitigate the risks of any market. To be clear: No portfolio will be 100% immune to broad-based selloffs. But using correlations and the barbell method to create a diverse mix of holdings can help you stay invested in market. There will almost always be an area of the market to pull fund from, and an area to redeploy those funds in. (See here for a full list of the stocks in Jim Cramer’s Charitable Trust.) As a subscriber to the CNBC Investing Club with Jim Cramer, you will receive a trade alert before Jim makes a trade. Jim waits 45 minutes after sending a trade alert before buying or selling a stock in his charitable trust’s portfolio. If Jim has talked about a stock on CNBC TV, he waits 72 hours after issuing the trade alert before executing the trade. THE ABOVE INVESTING CLUB INFORMATION IS SUBJECT TO OUR TERMS AND CONDITIONS AND PRIVACY POLICY , TOGETHER WITH OUR DISCLAIMER . NO FIDUCIARY OBLIGATION OR DUTY EXISTS, OR IS CREATED, BY VIRTUE OF YOUR RECEIPT OF ANY INFORMATION PROVIDED IN CONNECTION WITH THE INVESTING CLUB. NO SPECIFIC OUTCOME OR PROFIT IS GUARANTEED.
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