When you think about having a diverse portfolio, you think about diverse asset classes (such as a mixture of stocks and bonds). Alternatively, if you are just concerned with stocks, you might think diversity is a mixture of companies in different industries. I say there is another way to think about diversity, and that is the diversity of holdings among companies that are cash-flow-positive and cash-flow-negative.
In my previous blog that I posted on February 12, I said one way to analyze companies is to look at their cash flow and determine whether they generate and throw off cash flow from their operations, or if they require additional cash flow in order to continue to operate and to achieve their goals. You should look at your stock portfolio in the same way. At an even higher level, you should look at your overall portfolio in the same way.
Let’s first take an entire portfolio that is a mixture of stocks and bonds. The bonds are current cash flow to you, although the amount of cash flow may not be that great because interest rates are currently low, albeit rising. Stocks may be cash flow positive or negative, depending on where they are in their development cycle. If you have a larger percentage of your assets in bonds, should you balance that out by having a larger percentage of your stock portfolio invested in high-tech, high-beta companies that are early in their cycle and will require additional cash to be successful? That is certainly a viable asset mix strategy. Or should you avoid the risk of cash-flow-negative stocks altogether? It depends on your goals, wants and needs with respect to returns and your own cash flow. Your age of course plays a role. The older you are, the less time you have for a young company to come to fruition. You might not be around any more when it does.
Now, let’s take just a stock portfolio. If stocks are the entire universe of what you invest in, perhaps because you are young, have a job, and are willing to take a greater level of risk in your investing, then I would recommend that you make sure you have a good mixture of ownership of companies that are cash-flow-positive and cash-flow-negative. If you do so, you are diverse because the cash-flow-positive companies will probably provide support and downside protection for the companies earlier in their development cycle. If you are high-tech investor specialist, for example, for every new, innovative cloud-computing or cyber-security company that may have recently IPO’d, make sure you balance out by owning companies like Apple, Microsoft, and Intel that spin off buckets of cash flow. In the medical sector, for every biotech you own, make sure you also own a Merck, J&J, or Bristol-Myers, all of which generate cash flow and dividends. If you are excited about the upcoming IPO’s of Uber and Lyft, both of which are a long ways from being cash flow positive, go ahead and jump in, but don’t bet the farm.
You will be able to keep up with the indexes only if you own some companies that are high-risk and high-reward. Warren Buffet can make money owning only cash-flow-positive companies because he can buy the entire company and therefore control its cash flow. You cannot. You need to give yourself a shot at some upside by making sure you own companies that have more upside than companies that are already established.
Looking at differing cash flow models as a way to diversify your portfolio is not necessarily a substitute for traditional models of diversity, such as having a mixture of stocks and bonds. However, it is another layer and another way to think about how you structure your portfolio, either among the general mixture of asset classes or among stocks specifically.