Weighty Matters

 | Oct 21, 2013 | 2:00 PM EDT
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Portfolio performance is driven almost as much by both capital and sector allocation as it is by good stock picking. Being underweight or overweight the right asset classes and  sectors is a critical key of outperforming the market over the long term.

Every quarter, I review my entire portfolio to see how I am currently allocated and make adjustments based on where I think the market will go over the next three to six months. This week, I'll discuss how I have adjusted the sector allocation in my portfolio recently. Today's and Tuesday's column will focus on a couple of sectors I am underweighting right now due to what I perceive as poor conditions that companies in these areas are liable to face for the rest of the year and into 2014. On Thursday and Friday, I plan to talk about a couple of sectors I am currently overweight.

Financials are one sector I am significantly underweight right now for a variety of reasons. Major banks are under substantial strains just to maintain current revenue and earnings levels. Mortgage refinancing has been curtailed severely by the rise in interest rates since May and most of the largest banks are laying off significant numbers of personnel. Loan growth also remains tepid.

In addition, the regulatory environment is becoming more challenging by the day and it seems every state attorney general and federal agency is trying to extract its pound of flesh for the financial crisis. These crosscurrents have made themselves known within the mostly disappointing earnings reports that have hit the wires so far this season. I believe this will continue for at least a few quarters and, given some of huge runs these banks have had since the end of the financial crisis, it might be a good idea to take some profits.

I have also exited all of my mortgage servicing plays. They had a great run -- especially Ocwen Financial (OCN). However, the valuations are not as compelling as they were earlier in the year. In addition, the subsector has attracted multiple analyst downgrades in the last week or two. Finally, the 10-year Treasury yield has dropped about 40 basis points since the Federal Reserve decided not to taper its quantitative easing program in September. This could increase customer churn as refinancing activity should pick up as result of this recent rate decline.

As a result of my recent paring of the sector within my portfolio, I currently own only three financial stocks. One is Bank of America (BAC) as it is selling at 70% of book value and seems to have given up its long time "whipping boy" status to JPMorgan Chase (JPM) over the last few months. I also like the long-term value and potential for an eventual spinoff of its Merrill Lynch business.

I also continue to hold Morgan Stanley (MS) in my portfolio at this time. The company is making progress in its turnaround efforts, which was evidenced by its recent sterling earnings report. The company is concentrating on its retail brokerage business. This exposes the firm to less volatility than trading and requires less regulatory capital as well.

Finally, I own Aegon N.V (AEG), the large European insurer and asset manager for reasons I highlighted this summer. The company is selling for a fraction of book value and more than two-thirds of its business is actually in the U.S. In addition, Europe seems to be coming out of a six-quarter contraction, which should improve sentiment on European equities across the board over time. In tomorrow's column, I'll discuss why I am underweight the consumer discretionary sector.

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