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December 22nd, 2011 by

Lessons From the Oracle Plunge

What a day Oracle (ORCL) had Wednesday. Here was a seemingly bullet-proof company, with a great CEO (unless you ask his competitors), continuously growing internally and with insatiable appetite for acquiring competitors — and the stock was hammered on a wide earnings miss. Before this occurred, Oracle probably appeared to be an airtight investment. After all, what else could an investor want in a stock?

In my opinion, however — and these events have illustrated my point very well — a prudent investor needs to be diversified, and not focused on any single company. It is a well-known fact backed up by research, and I myself have often written on the subject: Appropriate asset allocation is key to prudent investing policy. That is, being in the right sector is more important than taking a risk of investing in an individual name.

In all, Oracle’s big announcement brought shares down nearly 12% Wednesday. Earnings had come to $0.51 per share, instead of the average estimate of $0.59, with targets ranging from $0.55 to $0.60, according to Yahoo! Finance. So, 38 analysts follow this company (yes, 38!) and all of them got it wrong. Not one had come even close to estimating the earnings correctly. If you consider this, you might wonder what exactly these experienced analysts — with significant research resources behind them — are getting paid to do.

But, before we get too negative on these folks, let’s remember it’s a fact of life that companies miss earnings estimates all the time, and analysts typically work with mostly public information. Further, although a good equity research analyst will do as much primary research as possible, it is very difficult to get a truly deep insight into the company financials and to forecast on-the-mark earnings. Most companies, especially the large ones, have mastered the art of earnings management. As such, blaming the analyst would typically be inappropriate.

So, in light of all this, what is a bullish-on-Oracle investor to do? A simple answer, of course, would be directly buying the company stock. But, as you know, if you had taken that route, your investment would have taken a sizable hit. A better answer, therefore, is to apply asset-allocation methodology, and to invest in an ETF that includes Oracle, as well as other IT stocks. In doing so, you diversify your portfolio by reducing your exposure to individual company risk, while taking advantage of the Oracle as your chosen investment.

On a very broad level you can start with Technology Select Sector SPDR (XLK). This ETF includes all 75 technology stocks, and eight telecommunications stocks, in the IT and telecommunications-services sectors of the S&P 500. Other choices include Vanguard Information Technology ETF (VGT) and SPDR Morgan Stanley Technology (MTK). Alternatively, if you favor the equal-weighting methodology, you can use Rydex S&P Equal Weight Technology (RYT).

The S&P 500 technology sector is further divided into three groups: software and services, technology hardware and equipment, and semiconductors and semiconductor equipment. So, in order to get exposure to Oracle, we need to look at ETFs focused on software — namely, iShares S&P North American Technology-Software Index Fund (IGV), PowerShares Dynamic Software (PSJ) or Software HOLDRs (SWH).

With that in mind, let’s compare an investment in Oracle with the large-cap diversified technology ETFs.

Oracle, XLK, VGT and MTK — YTD 2011
Source: Yahoo! Finance

In this case, with the exception of MTK, an investor would have fared significantly better with an investment in such broad technology ETFs as XLK or VGT. This makes perfect sense, of course: Investing in the larger group and avoiding individual stock risk an investor makes for a better risk-reward profile. In other words, you significantly reduce your risk while still getting investment exposure to Oracle.

If you want to get more granular and compare how ORCL has performed against software ETFs, you’ll get a different picture.

Oracle, IGV, PSJ and SWH — YTD 2011
Source: Yahoo! Finance

All the software ETFs track Oracle pretty closely, as opposed to the broad technology funds, so the graph reflects a much lower diversification value vs. that of the broad tech-sector ETFs. This, as well, makes sense. As of the end of last month, Oracle comprised 13.5% of the market weight of the software sector vs. 6% of the total technology sector.

To summarize, I believe we have seen another example how asset allocation works to our advantage. It reduces investment risk, and it improves the risk-reward profile of our portfolio. Use it wisely, and use it often.

At the time of publication, Gurvich and Rockledge clients were long XLK.

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