$2 Billion In Wealth Vs. $591,000 In Wealth

From 1900 through 2000, an investor that owned a tobacco index would have compounded wealth at 14.6% annually. Someone that invested in shipbuilders would have compounded wealth at 6.4%, over three full percentage points below the market at large over the course of the century. It’s a sector allocation that has profound consequences: A tobacco investor in 1900 would have turned $1,000 into $2 billion today. Someone that instead chose to hitch their fortunes to the shipbuilding industry would have turned $1,000 into $591,000 over the course of the past century. One investment approach would buy you the Dallas Cowboys and all of Jerry’s World included, the other would buy you an upper-middle class home after a century of patience.

This disparity came to my attention after I recently wrote about Carnival Cruise Lines. If you ever feel the need to own a ship, invest in Boeing or Lockheed Martin. Don’t invest in the shipbuilders themselves or companies that rely on commercial ships to generate profits. It does not work out over very long periods of time because the costs of manufacturing ships, paying for fuel, and then creating new ships once the originals become obsolete does not compare favorable to the profits generated from customers over long periods of time.

Sometimes, when it comes to diversification, people want to adopt the Noah’s Arc approach and own a little of each sector. That is not how diversification should be practiced because all sectors of the economy are not equal when it comes to creating long-term wealth. There is a hierarchy. The sectors that have historically beaten the market are tobacco, electric utilities, chemicals and healthcare, food, and railroads. The sectors that have underperformed the S&P 500, but generally hold pace with the market as a whole, are: household goods, telecommunications, industrials, and non-electric utilities. The sectors that trail the S&P 500 by a sizable gap are: paper, steel, textiles, and shipbuilding.

The energy sector is tricky because it has outperformed the S&P 500 handily if you include Royal Dutch Shell, but it was removed from the calculation of most indices because it is not an American firm. Otherwise, energy companies have a more modest superiority to the index as a whole. If you include Royal Dutch Shell, the performance of energy companies trails tobacco stocks but nearly ties healthcare companies as the best performing sector.

The most common question for investors is: Where on earth do I start? I would pay special attention to healthcare, food, and energy stocks because they have long-term records of outperformance. Generally, healthcare stocks grow revenues at a solid clip over the long term. Food companies rarely experience declines in earnings, and are great for beginning investors that want to avoid doing something stupid just as much as they want to deliberately find success. Energy companies are successful because of their volatility (not in spite of it) and now is one of the better times in recent years to consider the industry.

Railroad and tobacco stocks may also be considered, but their markets are perpetually shrinking, and that makes the psychological component of investing more difficult. The shrinking industry has historically led to extended undervaluation that made these sectors outperformers over the long haul, but an investment strategy is only useful if you can actually stick to it. Seeing tobacco volumes decline by 3% annually and seeing the railroad industry shrink to less than 1% of the U.S. economy from a high of 63% in 1892 could make it difficult for some investors to actually stick to the strategy. That is where the “Know yourself well” aspect of investing kicks in.

The telecom sector is useful if you want to perform roughly equal to the S&P 500 as a whole but want to receive a big chunk of your total returns in the form of dividends. From 1956 through 2003, AT&T performed exactly equal to the Dow Jones Index over that time period (around 9.8%). Through all the breakups and reassemblies, it basically tracked the index. However, it gave investors dividend yields of 5% and 6% along the way, and that is useful for someone that wants to live off assets without selling. It is generally less useful if your goal is to compound wealth at 12% annually for 20 years. They’re too big and carry too much debt to have the capacity to deliver returns of 10% over long periods of time (though if you buy during a recession, you might have a fighting chance at it).

I would stay the heck away from paper, steel, textiles, and shipbuilders. Those stocks require you to (1) know when to get in and (2) know when to get out, and (3) the reward for getting it right still isn’t better than holding something like Johnson & Johnson for twenty years. Those are absolutely the worst sectors of the economy for investors over the long haul, and there is no need to invest in them merely for the sake of diversification. That’s the point where Peter Lynch’s warnings about diworsification kick in.

It’s far better to go through life with a collection of healthcare stocks, food stocks, energy companies, utilities, an occasional tobacco investment, a telecom or two, and a few niche companies like Disney, Visa, Tiffany, and Nike rather than thinking you have an obligation to own every sector of the economy in your portfolio. The long-term records are so divergent that the difference between the cluster of best sectors will give you a much better lifestyle than what you’d get making investments in the worst sectors. Over long enough periods of time, it eventually makes a $1.9995 billion difference.