Staying Away Often Pays

 | Feb 14, 2014 | 12:00 PM EST
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I have concluded during my investing career that avoiding the wrong stocks and sectors is just as important as investing in the right stocks and sectors.

An investor can have a portfolio chock full of equities that gain 10%, 20%, 30% or higher for the year but it does not take more than a few stocks that get chopped in half to ruin overall portfolio performance. Even some 'dead money' stocks that go nowhere during the year can undermine performance.

The financial media is much more concerned, unfortunately, about providing content about what an investor should buy and extremely sparse with pieces on what should be avoided. "Buy these three stocks now for 2014" sells better than "Two stocks that look overvalued here" after all.

This in unfortunate, as avoidance is a critical factor in producing market-beating returns. Here are a couple of lessons I have learned around avoidance in my decades as an investor.

Growth matters

A company cannot grow by subtracting. Organizations that are focused on cutting operational costs are fine and good but some revenue growth has to be there to be considered for investment in my portfolio.

Cisco Systems (CSCO) and IBM Corp. (IBM) are two good examples of firms that are cutting personnel and other costs. They also look good strictly on a valuation basis. IBM, however, has not produced sales growth for many, many quarters. Cisco is seeing outright revenue declines in its core router and switch businesses. No amount of dividend hikes and stock buybacks can change that fact. Until and if growth returns, these stocks are the type of 'dead money' plays that should be avoided.

Skate to where the puck is going

An investor has to be aware of the primary tailwinds and headwinds in any industry and be cognizant when things change. For example, domestic farm income has hit record levels in the last few years. This has been great for sectors that benefit from robust income in the agricultural complex including farm equipment makers, fertilizer manufacturers and even retailers that cater to the space such as Tractor Supply Company (TSCO).

Thanks to falling prices for corn, soybean and other agricultural commodities, however, farm revenue is predicted to be down approximately 7% in 2014. Farm Income is predicted to be down by more than a quarter from 2013 levels in the New Year. An investor only has to go through Deere's (DE) earnings report this week to know things are going to be tougher this year. The big agricultural equipment maker expects declining sales in 2014.

Farm land prices are also starting to fall. I am deeply underweight the agricultural sector because of these headwinds. On the flip side, falling corn prices should be good for a variety of industries including livestock plays. Falling feed prices should be good for a variety of meat producers such as Tyson Foods (TSN) and they are worth a look.

It is much more exciting to find stock and sectors that can produce outsized gains. I have found, however, that putting in the same effort to understand what sectors and stocks should be avoided is just as critical for portfolio performance. Investors should embrace avoidance as much as they do acquisition.

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