There are not many things as divisive in the investing world as the term diversification. The opinions range from concentrating in a few best ideas to owning the entire market, and everything in between. There seems to be an unwritten consensus that the best value investors hold concentrated portfolios, and to do otherwise would be return destroying. I've also seen a second trend where people talk about a guru investor's holdings and how they purchased a "basket" of stocks. Monish Pabrai bought a "basket" of Japanese net-net stocks, and other gurus have purchased other baskets. Calling a dog a duck doesn't make it a duck, it's just a dog with a funny name. In this post I want to discuss a few myths on diversification, so the next time an investor wants to add one more stock to their portfolio they don't feel ashamed. Maybe we can eradicate the investing world of baskets..
Warren Buffett says to concentrate
It is apparently well known that Buffett believes in a concentrated portfolio. Googling for this returns 3.59m results, but no direct quote. If there is a direct quote maybe a Buffett groupie who reads the blog can leave a comment.
Warren Buffett also recommends that most investors should put their money in index funds. There is actually a quote for this one "A very low-cost index is going to beat a majority of the amateur-managed money or professionally-managed money" (source) My guess is most readers aren't heading off to their brokerages to dump their stocks and buy index funds. So why pick and choose what Buffett says to do when creating your own portfolio?
As David Merkel notes Warren Buffett is different than the rest of us. I would submit to readers that Buffett's idea of concentration is a bit different than is commonly accepted. Berkshire Hathaway's website lists 50 independent subsidiaries. The annual report shows 14 major equity positions. It seems to me that owning 64 different companies in a variety of different industries is the very definition of diversification.
Only invest in your best ideas
The saying goes "Why invest in your 11th best idea when you can put money in your top ten?" This sounds great, but let's just take the question to the logical conclusion. Why invest in your second best idea when you can put all your money in your best idea? If as an investor you really have the ability to know your absolute best investment idea why waste money in anything but the top idea? The problem is we think we might know our best idea, but we really don't. My two best investments where companies that I thought at most could double, I just held and they became 10-baggers. I waffled on buying one of them, and I almost sold the other the day it doubled.
Diversification is protection against ignorance
This is another Buffett quote where he states that "Diversification is nothing more than protection against ignorance." Now I recognize in comparison to Buffett I am ignorant, I'd venture to guess most investors are. Not all of my investments go straight up, and I make plenty of mistakes. I would rather be ignorant, and understand my weakness than suffer from over confidence. I look for a large margin of safety when I invest because I know that it's easy to make a mistake. Buying with a bigger discount allows me to make more mistakes and avoid losing money. I'd prefer to never make a mistake, but that's just a dream, and nothing more.
My returns will be ruined if I spread my bets
This is my favorite myth, and one that I feel is misunderstood, just like how average companies are good investments. When I invest in a company at the point of purchase I look for a 25% discount to tangible assets (for a 50% return), or a 10-15% return hurdle. Why the 10-15% range and not something higher? Some companies growing at 6% might also be selling at 35% of book value, I'm happy to take the lower ongoing return for a bigger asset discount. Likewise some companies are selling close to book or above book, so I look for a higher earnings yield.
Every stock I add to my portfolio has the same return characteristics, either a 50% upside or 10-15% ongoing growth, or both, or both and more. Some companies have higher earning yields, but they might be less stable than a lower yielding company. As long as every company I add to my portfolio meets my minimum return potential how does adding one more company dilute my returns? It doesn't.
At this point some readers will point out that searching for stocks that match strict criteria such as profitable net-nets lowers my investable universe. This is true, but there are still plenty of very cheap stocks. As an example this weekend in Barrons there was an article that mentioned there are 183 small cap Japanese stocks selling for less than net cash. Putting a profitability filter on those stocks might reduce the set to 100; why not just buy them all? It would be hard to imagine an investor having trouble building a portfolio from 100 companies all selling for less than net cash and not earning a positive return.
What it all means
I think most investors would agree that extreme diversification is pointless unless it's the goal, such as in an index fund. Paying a manager to mimic an index is akin to throwing away returns. As a value investor the money is made at the time of purchase. As long as I stick to my process and look for a solid margin of safety, a tangible asset discount, and a discount to earnings I don't see how adding one more company that fits my criteria can do anything but help my portfolio. I doubt this post will change anyone's mind, but it might make people think a bit deeper about their style and assumptions.
Talk to Nate about diversification