Slow and steady for the two-minute portfolio

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After doing a stand-up job in the stock market chaos of 2008, the two-minute portfolio had a bit of a comeuppance last year.

This experiment in quick-and-easy stock picking delivered a return of only 14.6 per cent, while the S&P/TSX composite index surged 35.1 per cent (both numbers include dividends). Given that I've been nurturing the two-minute strategy since I thought of it (it took about two seconds) in 1999, I should be pained by this.

But I'm not, and here's why. If you look at 2008 and 2009 together, the two-minute portfolio beats the benchmark index for Canadian stocks. And even after being crushed by the index last year, the strategy still has a better long-term record.

Here's the thing about the two-minute portfolio: It's a tortoise that cuts hare like nobody's business.

It's also easy for do-it-yourself investors to manage. All you do is invest equal amounts in the two largest dividend-paying stocks in each of the 10 sectors comprising the S&P/TSX composite index. Largest in this case refers to market capitalization, which is what you get when you multiply a company's stock price with the number of shares outstanding.

Annual two-minute portfolio maintenance consists of buying any new sector leaders, selling the old ones that have slipped and otherwise making sure your holdings are in rough equilibrium.

Through the gracious assistance of CPMS, an equity research and portfolio analysis firm owned by Morningstar Canada, we have detailed performance data for the two-minute portfolio going back to Dec. 31, 1985.

Its tortoise-like characteristics can be seen in the fact that it has only once made in excess of 30 per cent, while the index has done it three times. And since 2004, the portfolio has underperformed in all years but one.

Now let's talk losses. The total number of annual declines for the two-minute portfolio in the past 24 years is three, including the 19-per-cent decline in 2008. The index fell seven times over the same period of time, including 33 per cent in '08.

Aside from 2008, the two-minute strategy produced losses of 8.7 per cent in 2002 and 7.5 per cent in 1990. The index's worst losses after the 2008 loss were 14.8 per cent in 1990 and roughly 12.5 per cent in both 2001 and 2002 (again, dividends are included here).

Why is the two-minute portfolio so much steadier?

"It's quite defensive," said Jamie Hynes, senior account manager at CPMS. "You've got exposure to all sectors, all the time, and a lot of the sectors are defensive in nature - consumer staples, health care, telecom and, you could even argue, utilities."

In a fast-moving market, however, defensives are a big, fat drag on performance. If you break down the S&P/TSX composite index, it's almost 58-per-cent-weighted to volatile financial and energy stocks. These two sectors are up more than 30 per cent for the past 12 months, which means they've given the index a big lift.

The two-minute portfolio limits exposure in any sector to 10 per cent, so it has benefited to a much lower extent from the rally in financial and energy shares. Oh, well. You win some with the two-minute approach - that would be 2008 and the long term. And you lose some - that would be years like 2009.

CPMS data shows us that the two-minute portfolio has gained 10.3 per cent annually on average since inception, compared to 8.7 per cent for the index. The portfolio's 10-year return of 7.1 per cent outpaces the index by almost the same margin.

For the most part, the two-minute portfolio is built on big, familiar blue-chip stocks. But the modest state of the Canadian health care and technology sectors, and the requirement that two-minute stocks pay a dividend, mean some smaller names are included as well.

In information technology, for example, we have Constellation Software and Evertz Technologies. Both pay a dividend, whereas larger and higher-profile names like Research In Motion, CGI Group and Open Text do not. In health care, we have CML Healthcare Income Fund, the sole income trust to make the two-minute portfolio.

Changes in the two-minute portfolio this year are minor. Suncor Energy and Canadian Natural Resources replace Imperial Oil and EnCana, while Potash Corp. replaces Goldcorp in the materials sector and Canadian Pacific Railway subs for Bombardier as an industrial stock.

Last year's update of the portfolio included Potash Corp. in the materials sector for 2009, when it should in fact have been Goldcorp (CPMS used Goldcorp in its calculations). Potash would have worked out well because it far outperformed Goldcorp in 2008.

A real-life analysis of the two-minute portfolio has to consider the brokerage trading commissions required to set it up and maintain it over the years. Depending on which online broker you use and how much you have in your account, you'll pay $5 to $10 at the low end and $20 to $29 at the high end. Figure on 20 trades to start off, and another dozen or so per year to bring the weightings of each stock into line.

Total costs could range from $100 to $580 to set up the portfolio, and from $60 to $350 annually to maintain it.

The less you pay in brokerage commissions, the more economical it becomes to try the two-minute approach with smaller accounts. Total the commissions you'd pay and calculate them as a percentage of the amount you have to invest. If you're in the 2-per-cent range, you're roughly comparable to the cost of owning a big Canadian equity fund. If you're in the 0.25- to 0.5-per-cent range, you're comparable to the cost of owning an exchange-traded fund focusing on the broad Canadian market.

Think of the two-minute strategy as being half-way between the active management of a mutual fund, where managers buy what they like, and the index-tracking nature of an ETF. The two-minute approach removes any subjectivity from stock picking, but it also avoids the "take the market as it comes" approach of indexing.

The net result looked weak last year, but the big picture is one that investors might find attractive if they're the sort who prefer the tortoise over the hare style of investing.

Follow me on Facebook. I'm at Rob Carrick - Personal Finance.

Two views of the two-minute portfolio:

2010: The portfolio for the year ahead