Tuen's Blog

Infrequent diary of a procrastinator

Stock Diversification

Written By: Tuen

The following article is extracted from the Rivkin Report (no permission granted yet, but I doubt they will mind).

DIVERSIFICATION

Peter Guy, as highlighted in “Masters of the Market”, is one of Australia’s most successful long term small and micro cap fund managers. Peter is part of the Warakirri investment team responsible for the small cap stocks and is highly regarded by his industry peers both as a fund manager and gentleman. Peter has kindly provided us with the following article on diversification.

Diversification

Should a share portfolio have one stock, five stocks, ten stocks or twenty stocks? What would be over-diversification, what would be under-diversification? What is the appropriate number of stocks to own? Obviously there is no “correct” answer to this question. Anyone reading investment literature might get confused because some silly things get said about portfolio diversification. Here are a few observations which may help consideration of this important subject.

Benjamin Graham, the father of security analysis and the mentor of Warren Buffett, advocated broad diversification. To him it was the second safety net protecting the investor against risk, the first safety net being margin of safety. Graham calculated intrinsic value for a stock and sought to buy at a significant discount (margin) to his assessed value.

His protégé Warren Buffett is quite different. Buffett is a focused investor and advocates a concentrated portfolio. “Diversification is a protection against ignorance. It makes very little sense for those who know what they are doing” he says.

“Don’t put all your eggs in one basket” is an old proverb. The opposite point of view was advocated by Andrew Carnegie: “Concentrate; put all your eggs in one basket, and watch that basket”. The BRW rich list is, of course, full of (eggs in one basket) non-diversifiers.

To try and make sense of these conflicting views I think it is useful to consider a venture capital fund. Venture capital is essentially “start up” capital. I don’t invest in start-ups. I am more interested in “development capital” (as opposed to venture capital) – investing in companies that have survived start-up but need funding for growth. But a description of a venture capital fund illustrates a point I want to make about diversification.

A venture capital fund might have a fixed ten year life. You invest your money in 2007 and you get it out in 2017. The fund might invest in ten stocks. Of the ten, two might go under for 100% loss, two or three might disappoint somewhat, two or three might do as expected, a couple better than expected and two might do spectacularly – blow the lights out. I once read a US venture capitalist comment: “we live off our home runs”. Such is the nature of venture capital investing – they live off their home runs. So it would be a misunderstanding of the nature of that type of investing (and indeed be churlish) to say: gee, if you didn’t have stock X and stock Y (the home runs) your performance would have been lousy. Serious gains and serious losses are the nature of that type of risky investing.

It should be clear that diversification for a venture capital fund makes sense. It also makes sense for my style of investing in micro and small cap stocks. I try to find companies that are at their inflection point, at the beginning of a strong growth phase. Such companies often have not been public for very long and they may in fact be an IPO. So they have limited track records. They are unseasoned. You don’t know whether the management can cope with growth. You try and form a judgment of course, but you don’t know because they are early days.

A small cap investor can also live off home runs. You can only lose 100% but on a great stock you can make 1,000% or more. ABC Learning Centres increased by 2,200% between March, 2001 and December, 2006. A “twenty two bagger”! So this type of investing can be relatively risky with big losses and big gains. The companies may not have long track records, their future is one of expected growth but it is often very difficult to forecast. Diversification makes sense for this type of investing.

Now back to Warren Buffett. He favours seasoned companies with predictable (forecastable) future cash flows. Portfolio concentration makes sense for that style of investing.

There is a good investment book called “Becoming Rich. The Wealth Building Secrets of the World’s Master Investors Buffett, Icahn, Soros” by Mark Tier. Chapter 2 is “The Seven Deadly Investment Sins” and sin No 4 is “Diversification”. A very successful Sydney fund manager states that “diversification works for the ‘know nothing’ investor. If you don’t know what you are doing, broad diversification makes sense”.

The mistake Mark Tier and the Sydney manager make is to make a blanket claim. Diversification makes sense for some styles of investing. A highly concentrated non–diversified portfolio makes sense for different styles of investing.

How many stocks should there be in a portfolio? I once met a US fund manager who had a portfolio of 4 stocks. I’d say that was under-diversified. I’d be more inclined to say that if you invest in companies with well established track records and fairly predictable future cash flows then at least 6 stocks might be adequate diversification. But for the small cap investor like me, owning 4 or even 6 stocks would be in my judgement far too risky.

Over-diversification is very likely to lower the quality of a share portfolio for the obvious reason that good investment ideas are not easy to identify and if you added 10 stocks to a 15 stock portfolio, it is likely that the additional 10 stocks would not be as good as your best 15 ideas which comprised the portfolio in the first place. Just as under-diversification can increase portfolio risk, so too can over-diversification increase risk, because you are spreading yourself more thinly and won’t know 25 stocks as well as 15. (But if you are a “know nothing” investor, then going from 15 to 25 stocks may provide lower risk through greater diversification).

Three other comments on diversification.

(1) All ideas are not equal. If you choose to have a portfolio of 10 stocks then equal weighting (10% in each) would be ridiculous because your best idea should have a lot more weight than your 10th best idea. Portfolios should be skewed in their weighting based upon the risk/reward ratio for each idea.
(2) If you owned the four major banks you should recognise that they should probably be looked at as a group in portfolio weighting. Similarly, if all your stocks were cyclicals, then you may not have appropriate diversification to protect against an economic downturn. So the concept of diversification is not just a function of the number of stocks in a portfolio the industry types should be considered too.

(3) Relevant to the subject of diversification is the fairly common problem of stocks being in the portfolio that shouldn’t be there. There might be failed investments where the investor is reluctant to realise a loss and hangs on in grim hope that the original cost price will be attained again. This is an investment sin. A second type might be “stale” stocks. A stale stock is one that has failed to meet expectations and probably should be sold, but it is cheap and there is a reluctance to sell at an unsatisfactory price. You might have paid 60c thinking the shares were worth $1.00.Something goes very bad and the shares are worth say 40c but the shares are selling at 30c. I tend to be guilty of having one or two of such investment failures linger in the portfolio. Money has a time value. A stock can be cheap (under priced) for years and keeping a disappointment there for year after year is a mistake.

There are many ways to skin the investment cat. On the subject of diversification, different degrees of diversification are appropriate for different styles of investing. It is common sense really, but as they say, common sense is not common.

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