Quarterly Investment Guide

A stock portfolio that's doubled index return since 1991

Tim Mullaney, special to CNBC.com
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It's an age-old investing question: Does a smart investor stick with winning stocks or bet on quality companies that have been beaten up and are on the rebound?

How about both?

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A new report suggests that stocking up on both the best- and worst-performing sectors of the prior year — while leaving out the stocks in the broad middle — is the better way to go.

A portfolio composed of the 10 best-performing and 10 worst-performing of the 129 sub-industries in the S&P 500 from the prior year has risen an average of 13.5 percent each year since 1991, a new study from S&P Capital IQ shows. That nearly doubles the 7.6 percent gain of the S&P 500. (Both figures exclude dividends.)

"Usually you're better off with last year's winners than losers as a group," said Sam Stovall, equity strategist at Standard & Poor's Capital IQ, speaking of the stock market broadly.

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When looking at the 10 best-performing and 10 worst-performing industry groups, however, the rebound stocks have performed slightly better, on average, than those that are coming off of good years. "When something is grossly oversold, there's opportunity," Stovall said.

This stock market finding could be key to maximizing gains in a year that many market pundits are predicting will be another lackluster one, at best, for the S&P 500 as a whole — Goldman Sachs' chief U.S. equity strategist, David Kostin, came into the year with a flat S&P 500 target, and some other Wall Street firms have already lowered their year-end S&P targets since Jan. 1.

For 2016, the so-called barbell portfolio would have investors stock up on hot sectors, including brewers, building-products makers, distillers and winemakers, Web retailing and Internet media. (The other five top sub-industries last year were footwear, restaurants, construction materials, home-entertainment software led by video games and, in a potential surprise, oil-refining companies that were among the industry's few beneficiaries of declining oil prices.)

(Sub-industries should not be confused with the 10 primary sectors within the index. Brewers, for example, would fall within the broader, consumer staples sector.)

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To add contrarian balance, the barbell portfolio would add industries that lagged last year, such as casinos, hotel and resort real estate investment trusts, home-furnishings retailers, department stores and aluminum. Not surprisingly, the laggards list is also heavy on energy sub-industries: oil exploration and production companies; oil and gas transportation and storage businesses, independent power producers, many of which are renewable energy plays that benefit from more expensive competing utility fuels; diversified metals and mining; and, for the truly risk-preferring, coal companies.

"If that group turns around, it's going to turn around big,'' Stovall said. "If they're priced to go out of business and they don't, that's the biggest opportunity.''

To get exposure to these sectors, many of which aren't specifically tracked by exchange-traded funds, Stovall's model portfolio singles out companies whose shares score highly on Capital IQ's five-star rating system.

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That leads to recommendations to buy Facebook and Expedia to represent the two Web sub-industries, building-supply manufacturer Masco, which makes familiar brands like Behr paint and KraftMaid cabinets; and gasoline refiner/retailer Valero. Nike represents the footwear segment and Electronic Arts the video game business in Stovall's model. Starbucks is Capital IQ's top restaurant-industry pick. Asphalt and concrete maker Vulcan Materials, up 40 percent in the past year, brewer Molson Coors and winemaker Constellation Brands (which owns the Robert Mondavi brand) complete the list of recently hot stocks that are still good bets.

Of these, the best performer in the last year has been Valero, with a 48 percent gain, followed by Expedia at 44 percent.

When something is grossly oversold, there's opportunity.
Sam Stovall
equity strategist at Standard & Poor's Capital IQ

To bet on rebounds, the portfolio adds names such as aluminum leader Alcoa; casino operator Wynn Resorts; department-store owner Macy's; specialty retailer Bed, Bath and Beyond; and hotel owner Host Hotels and Resorts.

In the materials and energy group, it adds pipeline operator Kinder Morgan; copper miner Freeport McMoRan; Southwestern Energy, to represent exploration and production companies; NRG Energy, to represent the alternative-electricity group; and coal-maker Consol Energy, which has diversified into natural gas production.

Each of the energy and commodity shares on the list fell by at least half last year, as oil and metals prices tanked. Freeport eliminated its dividend, and Southwestern and Bed, Bath and Beyond don't pay one. On the plus side, Macy's pays a 4 percent yield, NRG pays 4.9 percent, Host pays 5.9 percent and Wynn pays 2.9 percent annually. Beaten-up Kinder Morgan shares pay more than 13 percent to take the risk of holding them.

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The key to the strategy is the combination of betting on sustained excellence from one group and the idea that many of the beaten-up companies are oversold based on problems that will eventually be solved, Stovall said.

That doesn't mean all of those problems will be solved soon, however. There's little way to reliably predict when prices of oil and commodities may rebound, for example, or by how much. But hotel metrics, like revenue per available room, are running at all-time highs, according to industry researcher STR, and consumer spending is growing at a 3 percent annual clip in the U.S.

"One can say owning the good, the bad and the ugly doesn't turn out so ugly after all," Stovall said.

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"I like the simplicity of the barbell approach," said financial advisor Mitch Goldberg, president of ClientFirst Strategy. "It gives investors the opportunity to be both momentum and bottom-fishing traders in a 'set it and forget it' way."

In other words, the approach lets investors blend the extremes in growth and value "in a neat and tidy package," Goldberg added.

It's not an approach that can be expected to work every year — no strategy does. So Goldberg said investors should be prepared to give it several years to attain the potential benefits.

Other advisors resist trying to tease too much out of historical stock market data and say another 'set it and forget it' approach is best: Set basic goals for a long-term portfolio and forget the rest.

"For us, the most important thing is to have clearly designed risk parameters and match these to (a client's) desired returns,'' said Braden Schipke, a financial planner at Maplewood, New Jersey-based GenWealth Group. For investors who can make the case to stick with winners while also betting on stocks in the doghouse: "Higher risk tolerance means higher volatility and higher returns," Schipke said.

— By Tim Mullaney, special to CNBC.com