Two-Minute Portfolio beats index in a tough year

Things were so rotten in the stock market last year that the 19-per-cent loss in the Two-Minute Portfolio looks like quite the sweet deal.

The Two-Minute Portfolio is a continuing experiment designed to test a theory: that stock-picking can be as simple as annually investing equal amounts in the two largest dividend-paying names in each of the 10 sectors of the Canadian market. No investing smarts are required for this strategy, and yet the results of the past year and beyond show it works quite well for patient investors who don't mind periods of weak returns.

While the Two-Minute Portfolio did much better last year than the 33-per-cent loss by the S&P/TSX composite total-return index (dividends included), it underperformed the index each year from 2004-2007. But what does a four-year slump amount to if you're able to lose a lot less money than a broader market in a historically bad year, and do far better over the long term?

Historical data for the Two-Minute Portfolio are maintained by CPMS Computerized Portfolio Management Services Inc. (cpms.com), a provider of independent Canadian and U.S. equity research to institutional clients and advisers. CPMS says that from Dec. 31, 1985, through the end of 2008, the compound average annual return for the portfolio was 10.1 per cent with dividends included. The S&P/TSX composite total return index averaged 7.6 per cent.

What makes this performance edge notable is that it has come with substantially less risk than the composite index, which includes about 220 stocks and is thus more diversified.

The worst possible setback you would have ever endured in the Two-Minute Portfolio (they call this maximum drawdown in financial circles) was the 25.7-per-cent decline from October, 2007, through November, 2008. The worst result for the total return index was a 43.2-per-cent plunge lasting from August, 2000, through September, 2002.

CPMS says the Two-Minute Portfolio's monthly returns beat the index 77.3 per cent of the time in down markets, but just 36.1 per cent of the time during up markets. Add it all up and the portfolio has beaten the index 52.5 per cent of the time on a monthly basis since inception.

These results are better than you'd get trying this strategy on your own because they don't include fees. Starting up the Two-Minute Portfolio or rebalancing it at the end of each year requires that you pay brokerage commissions costing anywhere from $5 to $29 per transaction, depending on how large your account is and which online broker you use.

With 20 stocks to buy, your brokerage commission to start up the portfolio would be somewhere between $100 to $580. Subsequent annual rebalancing costs - the mix of buys and sells you'd have to do to keep stocks in equal proportion - would be similar.

On a $50,000 investment, paying commissions like these would act like a penalty of 0.2 to 1.2 per cent. Your costs would decrease on a percentage basis as your portfolio grows, but it's clear that low brokerage commissions are the key to making the Two-Minute Portfolio work.

Choosing stocks for the portfolio is easy. Never mind what analysts, strategists and economists are saying, just pick the two largest stocks by market capitalization in each of the 10 Canadian stock market sectors. Market cap is what you get when you multiply a company's share price by the number of shares it has outstanding.

Last year's comparatively good return highlights one of the benefits of the two-minute strategy, which is that it prevents you from getting too deeply into a sector and forces you not to ignore any sectors. In a bull market, this will drag your returns down because you'll have a limited ability to participate in the winning sectors that run ahead of the others.

This was the case in 2004-2007, when energy and materials stocks were riding a surge that left them accounting for just short of half the S&P/TSX composite index in the middle of last year. The Two-Minute Portfolio had only 20 per cent of its assets in these sectors and suffered as a result.

That level of exposure to resources helped the portfolio in 2008, when commodity prices plunged on concerns about how a global recession would affect demand. The portfolio's limited exposure to financial stocks also helped.

Conversely, the two-minute strategy forces you to invest in sectors like consumer staples and telecom services, which are bull market laggards but strong when stock prices plunge. BCE was an exception last year, but that was a result of investor disappointment over the collapse of a deal to take the company private.

A modest number of changes are required to set up the Two-Minute Portfolio for 2009. Imperial Oil has replaced Suncor Energy, Bombardier replaces Canadian Pacific Railway and Toronto-Dominion Bank replaces Manulife Financial. Teranet Income Fund was acquired by a pension fund last fall and replaced in the portfolio this year with Constellation Software.

In its early days, the Two-Minute Portfolio used the largest stocks in each sector, regardless of whether they paid a dividend. But limiting the selection to dividend-payers brings a couple of benefits. First, you have income flowing in regardless of what stock prices are doing. The dividend yield for the portfolio at the beginning of this year was 3.9 per cent, which beats anything you'll easily get from government bonds or guaranteed investment certificates, especially on an after-tax basis.

Better overall performance also comes from emphasizing dividends. CPMS found that if you used the largest two companies in each sector without insisting on dividends, your loss last year would have been 25.6 per cent and your compound average annual return since the beginning of 1986 would have been 8.1 per cent. The dividends-only approach refines the two-minute strategy and helps it focus on a better class of stocks.

The Two-Minute Portfolio: Yesterday and today

An experiment to see if you can use a very simple stock-picking strategy to invest successfully, the Two-Minute Portfolio is made up of the two largest stocks as measured by market capitalization in each of the 10 sectors of the S&P/TSX composite index. Here's how the portfolio did in 2008:

The Two-Minute Portfolio in 2008

*compound average annual returns

This year's Two-Minute Portfolio

(listed by sector)

THE GLOBE AND MAIL