Friday, March 21, 2014

Diversification..again..

I often get asked the question "what are your thoughts on diversification?"  Someone asked me recently and I thought that newer readers might appreciate my thoughts on it as well.  I wrote about this a year and a half ago, the post generated some lively comments, and I expect this one will as well.

Before I begin in I want to set out a few points accommodate those who are too lazy to read the post, but will post comments anyways.  I have heard that Warren Buffett says that only the ignorant diversify.  I have heard that I'm diluting my returns by investing in anything beyond my ten best ideas.  I've heard that what I do is just mechanically investing based on math, or formulas.  I'm already well aware of all these things, no need to refresh me.

It's surprising but I actually believe in concentrating one's resources into a single investment if the circumstances are appropriate.  If an investor has control over the investment, and can make decisions about the company's strategy, future direction, and capital allocation I think it makes sense to concentrate resources on that investment.  I think it makes so much sense that if you're in this position it might make sense to focus all of your money, time and effort on the particular investment.  I think concentrating in a position also makes sense for hedge funds and mutual funds in similar positions.  If they have the ability to control or influence the outcome of an investment it makes sense to concentrate their capital where they are spending a lot of time and energy.

There's a story floating out there where Charlie Munger talks about owning a small town restaurant, hardware store, gas station, and hotel.  He says he'd feel adequately diversified with that portfolio.  I would as well, the reason being that in the analogy I would own and control those properties.  How would the story change if I owned a tiny little sliver of each and a faceless manager 800 miles away who I couldn't get on the phone was making the decisions?  Would I still feel diversified?

There's a famous Buffett quote that's often used to bludgeon investors who concentrate their portfolios: "Diversification is nothing more than protection against ignorance."  This quote describes me and my investing perfectly.  When I look deep inside, no matter how much research I do I am still ignorant of the companies I'm investing in as an outsider.  I laid out my thoughts for that in this post, one that many of you skipped.

As outside investors we can't know everything about what's happening at a company.  If we think we do we're deluding ourselves.  I worked at a startup out of college that was in many ways run on a shoestring and a lot of hope.  We had outside investors who were blissfully unaware of what was actually taking place day to day.  At one point we had a massive system crash that destroyed all of the company's data, intellectual property and software.  Our core system had died suddenly without a backup.  Thankfully a coworker was able to engineer a solution and numerous hours later business continued as usual.  Customers knew there was a massive disruption, and employees knew without our co-worker's creativity unemployment would have been our future, but investors receiving quarterly statements they never knew they were hours away from losing everything.  Unfortunately many companies are run in the same haphazard way, and we as investors never have any idea.

I diversify my portfolio to avoid disaster, but that isn't the only reason, or the main reason.  The theory for concentrating is that no one is bothering with investments that will only return 50%, rather many only invest in companies that double, triple or quadruple in two or three years.  Why settle for a measly 50% return when you can search harder and find the 400% return?

If I could find five stocks that I knew would all quadruple in three years I'd bet the farm on them as well.  The concept sounds great.  The question I have is where are all the funds and investors doing 100% compounded?  Compound capital at 20% for a decade or more and suddenly you will be a 'guru'.  Why is there such a gap between what investors are looking for and what happens?  Many shoot for the stars investments fall flat.  A few do make it to space, but their gains needs to be spectacular to negate the losses for the rest of the investments that blew up.

The problem is consistency.  It's hard to consistently invest in companies that return 200%+.  To understand why think of baseball.  It's easier to consistently hit singles verses consistently hitting home runs or grand slams.  A grand slam is possible under the correct circumstances, but a single is possible every time the batter steps to the plate.  In theory a hit is a hit, but that's not true.  A pitch needs to be thrown just right, and the bat needs to hit the ball with enough power at the right place for a home run to occur.  Players who can consistently get on base are more valuable than the power hitter who makes a great highlight on ESPN, but mostly strikes out.  I think of Walter Schloss, an investor enthroned in value investor lore who consistently hit investing singles.

If a company meets my minimum criteria for an investment I'm likely to take a position.  It might be a small position, but it will be added to the portfolio.  It's important to note that not every position gets some pre-set mechanical sizing.  If a company is unusually cheap, or there's some other special characteristic I will size the holding larger.  Sometimes I'll increase a position if the company becomes cheaper, or if I become more convinced about their potential.  I have averaged down on holdings, but I've also averaged up.

Whereas sometimes I'll take a larger positions, I've also taken many small positions.  My holdings in community banks are a great example of this.  I have a general profile for a cheap bank that I look for.  If a bank meets my criteria I will take a small position.  There have been a few of these banks that after researching I end up liking and take a larger position.  In general most are tiny positions.  In the aggregate my exposure to small community banks is greater than 10% of my portfolio.

A great criticism might be to ask why I don't just invest in an index of banks.  The problem is there is no index that does what I want.  There are no indexes that invest in banks with $9m market caps, or $150m in assets.  I don't know of an index that has criteria that says if a Chairman and CEO are in their 70s it will buy more.  If there were an index that did some of these things I'd probably consider purchasing it.  I enjoy investing, but it isn't like I couldn't find something else to do with my time either.

I know my approach isn't for everyone.  It's probably not for anyone.  It works for me though, it's something I'm comfortable with and lets me sleep well at night.  I'm going to continue to hit singles and doubles and let the rest of you hit the home runs.

26 comments:

  1. Same thing for me. I own about 30-40 stocks typically. Many positions are quite small, because some stocks are statistically cheap, but I don't feel, I can possibly know enough about them to risk a large position. Banks are a good example - there are lot of them, often with very similar valuation. Some would say, why buy them at all or buy the one that seems best. For me at least, I prefer to buy a bit of all of them, if they meet my value criteria.

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    1. Yes, I own about 60 positions, although some are small. I probably have 40 'major' positions, and then 20 minor ones.

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  2. "I don't know of an index that has criteria that says if a Chairman and CEO are in their 70s it will buy more"

    I am a bit interested in your reasoning. I presume its because the CEO will most likely retire or die soon and new management is more likely to be a catalyst....Is that it?

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    1. Yes, a catalyst. I am usually buying closely held companies, and when the Chairman passes away or retires it opens up the company to new management, or the possibility of being sold.

      If a founder has a number of children or grandchildren who are in line to inherit some of the company it's easier to distribute the company as cash rather than divvy up management.

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  3. Excellent post. Looks like you get a lot of grief on posts like this. I am a big fan of Buffet and Munger and have attended their meetings and read all the books. I dont agree with Buffet's 20 punch rule. I think on the topic of diversification they may have led the investing public down the wrong track. I agree with your post on this topic.

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    1. I agree with you, I think Buffett is maybe mis-interpreted with this. His company itself has 40 subsidiaries and at least 14 equity positions, that's diversified to me.

      Joel Greenblatt is touted for concentrating as well. He used to hold five or six positions, yet now he's running a firm that owns hundreds if not thousands of positions. That's quite an about face.

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    2. Yeah, some of Greenblatt's motivations might be a function of ability to sell a product broadly. You'll recall that Greenblatt tried to write "You Can be a Stock Market Genius" for the average investor. It's one of the best investment books ever written but it's admittedly not a beginners book. He had to dumb it down pretty materially with the "Little Book" series to reach at broader audience. Point being that there's some marketing reasons behind his switch from concentration to diversification. I'd imagine it's easier to sell a 100 cheap/high quality stock fund than a 5 highly asymmetric stock fund.

      I fall on the "concentrate on your best ideas" front, but I'm realistic about it. The Kelly Formula maintains that you should bet big on highest probability outcomes. The reality is that investing in stocks have wide bands of outcomes. So Kelly shouldn't be taken too literally, i.e. you should ratchet concentration down to account for the uncertainty regarding distribution of outcomes.

      Michael Price gave a very worthwhile lecture a while back (https://www.youtube.com/watch?v=Nph-sDz1EtA) where he talks about a hybrid portfolio approach that has elements of concentration and diversification. I generally gravitate towards this school of thought whereby you have layers within a portfolio.

      Thanks for the post. Keep it up.

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  4. No need to worry about what others think, Nate, you're clearly on the right track for you. For what it's worth, Buffett was mostly much more diversified in his early days, when investing in a Graham-like fashion. I think it's fair to say that your investing style is more like 1950s Buffett than 2010s Buffett (and I mean that as a complement). When Buffett did a bit of Graham-like investing in recent years, such as his foray into Korea 10 years ago, he diversified. It's the right approach to take to areas of statistical cheapness but wide outcome uncertainty, like the small, illiquid stocks you focus on. Keep up the good work.

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    1. GB,

      Thanks for the comment. If I were worried about what others were thinking I wouldn't be posting here.

      I appreciate the comparisons to Graham or Buffett. I'd like to think of myself as taking the parts of them and others that I like and growing from there.

      Keep reading! Thanks,
      Nate

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    2. Hi!
      Great post Nate.

      But GB, are you sure he was mostly much more diversified?

      Cause, I thought has always been a more concentrated investor?

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    3. GB,

      I think your comparison is incorrect. When he ran his partnerships he altered Grahams strategy and invested very concentrated. However, by doing so he actually proves Nate's point because he took huge positions and often got a board seat. See Sanborn Maps or Dempster Hill. He definitely could force the valuation gap to close more quickly.
      I would actually go so far to say that he is much more diversified now than in his early days. Sure his top four security holdings and drivers to operating earnings are big, but his stock portfolio contains 10+ positions and he has more than 70 subsidiaries.

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    4. Nice post Nate. As for Buffett, he was very concentrated in the 1950's, at least at the top of his portfolio. In 1951 he made 75%, and owned 6 stocks, with Geico being 65% of his portfolio. He averaged 50%+ for 6 years before starting his partnership in 1956. In his first or second letter, he describes his investment in Commonwealth Bank which he had a 25% position, that he was comfortable getting as large as 35%. Like Nate said, he did control positions so that reduced his risk. Many know about Amex, which he put 40% of his assets into. So he took very large concentrated positions at the top of his portfolio. In the early 60's he mentioned he owned around 40 stocks, but most were smaller and he had the majority of his portfolio in his top ideas in the early days of his partnership. Munger was the same way and crushed the averages. Munger put everything into one stock very early on. Schloss achieved a great record using an opposite strategy-one I would say is similar to Nate's, and produced incredible results for 47 years.

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    5. I ended my comment last night without really finishing my thought. After watching 5 hours of basketball and fitting in family time, nieces and nephews, and inlaws, and then fitting in some late night reading, I think I actually dosed off as I was typing the comment from the ipad. Thus, the topic of diversification/concentration was the last thing on my mind last night.

      But basically, I really respect Nate's strategy of diversification, even as it goes against the more modern style made so famous by Buffett, Munger, others... I've given the topic a lot of thought myself over the years. I think a Schloss type strategy can be incredibly successful for a few reasons. One, buying cheap stocks works over time. In 1972, Schloss said his goal was 15-20% per year, which he surpassed. Second--an underrated consideration of investment strategy is longevity... Schloss lasted 47 years, and said he never "was stressed out". He compared himself to Lynch, who made fabulous returns for 13 years at Magellan, but burned himself out. So measuring performance over 47 years, I can only think of one person that beat Schloss--and that of course is Buffett--but even then, not by a landslide.

      So longevity matters.

      Third, is lifestyle. Diversification helped Schloss do the things he enjoyed doing in life. Family, the arts, and other interests. He loved investing, but he wasn't consumed by it.

      Now, some might say managing 60 stocks would add MORE stress because of the maintenance requirements of tracking that many businesses. So others might feel that they can maintain a longer career by concentrating on a select few investments. So I've heard it both ways. Some think diversification is easier to implement, others feel a concentrated portfolio is easier to maintain.

      The level of stress might seem like an irrelevant topic when it comes to returns, but I think an investment style that is easier to follow will be one that provides longevity, and with it, better overall returns over the long run.

      Of course--this assumes that either strategy is founded in logical principles and sound reasoning. I'm assuming a Schloss/Graham strategy vs a Buffett/Munger type strategy. Either can work, both have worked for a long time.

      It depends on the practitioner. One must know oneself.

      Nate clearly has a handle on his own personality and emotional makeup, and it works for him.

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  5. Good post. While I don't personally diversify as much as you (or perhaps as much as I should), I certainly see your point regarding downside protection due to information that an outside investor simply will not have. I'm curious though, have you always spread your risk over many companies or has your style evolved over time?

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  6. Well written article. I am probably in between concentration and diversification depending on the quality of stocks I can buy.

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  7. I agree but I think it would be interesting to see what you could do with a more concentrated account. It might be interesting to go back and see what your performance has been when you had a lot of conviction on something and took a large position.

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  8. Buffet has said that he would add a position if he believes it's better than the least favourite stock in his portfolio. That's a good guideline for me and usually works out to 15-20 stocks for me.

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  9. I just thought about this last week and came to a similar conclusion. While many say that you should use the Kelly Formula to size your holdings, which often leads to positions >20%, i found a lot of arguments against that. The Kelly Formula was for independent binary bets where you have a bankroll which is only used for this one bet. But what we do as investors is like playing 20 or more bets parallel, its like playing n cardgames parallel. And as as card player you probably would just split your bankroll over all parrallel games if your edge is nearly identical everywhere.

    So the more investments with the same or identical conditions we hold, the more the real investors edge will shine through. Investing in single investments on the other hand are nearly pure luck. So in the end the more diversified you are the more the rule of large numbers is working for you.

    Because of this and some other factors (like momentun and my inability to detect the best bets) i have decided to equal weight on cost my holdings. ( My best performing stocks where always the ones where i had the least amount of money in. :( )

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  10. Thank you for independent pov on your investment strategy. Many who start out in investing follow a investment hero mantra like a religeon.

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  11. Personally I prefer a concentrated approach, but am considering a 'basket of stocks' approach if I cant find enough high quality companies to buy. The problem is time. How on earth do you keep track of 40-60 stocks? Do you still have a day job?

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  12. Hi Nate,

    I think to diversify or not really depends on industries.

    If you invested in the likes of MICROS systems (hotel management software), D&B (business information), H & R Block (tax adviser) then diversify within the same industry has little purpose. This is because the dominant player has the most market share, brand and financial power than inferior competitors which diversify might increase risk as oppose to reduce risk. Also, I think invested in upstream and downstream of a supply chain (eg. equipment rental & mining, apparel & retail) does not serve the purpose of diversifying.

    However, if you invested in the likes of IT service, restaurants, community banks where the market is inherently fragmented then concentrate is like a suicide. DWS Limited appears to be a decent IT service firm in Melbourne, but certainly there are many decent firms based in Brisbane, Sydney as well as Melbourne. To bet on DWS Limited alone is just silly.

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  13. Hi Nate,
    Thanks for your thoughts, thought I'd chip in with a few of mine.

    'Protection against ignorance' is one way of describing diversification, but just as well it's protection against overconfidence. I remember reading 'The Dhando Investor' by Pabrai and he was talking about holding only 10 or so stocks, and preferring concentration. Subsequently, he ended up with a few of his holdings not doing so well, and I think I recall seeing some commentary about how he has reevaluated his views.

    To make concentration work, you need to 1) have the confidence and 2) be right. Plenty of people have 1), not that many have 2). When you consider that even the biggest-name investors make missteps from time to time, you have to think 'What is the likelihood that I might have missed something/something might go wrong that I can't predict/getting blindsided?'

    You can afford a few losers with diversification. If you are concentrated you have less of a buffer. That said, I will occasionally double/triple up on those holdings where I have a greater level of confidence. Overcoonfidence? maybe, but I've done better than worse in those instances, although I recognise the sample set isn't that large.

    Cheers for the blog

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    1. Pabrai actually has stated that he probably changed from a concentrated portfolio to a more diverse portfolio at perhaps the worst time (market lows) and has since gone back to his original ways. Also despite having at least one position that became a zero he has still been able to compound at slightly less than a 26% rate.

      About 42 minutes in is information on this and also general talks on concentration and diversification:

      http://www.youtube.com/watch?v=GBXRNH9VfhA#t=2624



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  14. Jean-Marie Eveillard said something great about diversification. When asked about diversification he said, he " Number one, because I’m not as smart as Warren Buffett. And number two, because truly, people say, “Well, why don’t you just invest in your best ideas?” But I don’t know in advance what will turn out to be my best ideas. So, that’s why we’re diversified."

    Jean-Marie had a remarkable track record at First Eagle funds with a widely diversified portfolio.

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  15. 2 things: 1) w/in Berkshire itself, it's very diversified. The largest single position in probably BNSF/Geico (BNSF was worth $40B when WB bought it out), which is what, 10% of assets only? So Berkshire itself is very very diversified. 2) On the other hand WB is not himself diversified in that almost all of his wealth is in 1 company (over which he has control)...BRK; even then by WB's own admission, BRK would've gone Chapter 11 without government intervention in 2008...so his entire life's work would've gone up in smoke...an argument in favor of diversification.

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  16. Right, I'm getting sick of all the standard comments like "you need to diversify", also I'm getting sick of the same standard counter arguments.

    In my view all those comments make assumptions that people actually have enough money to diversify, buy big stock loads of companies or a combination of both. Now let's assume poor people also invest, sure you have indexes, mutual funds or what ever. Now this goes against the diversification effect, since that is based (in my view) on choice. Something earlier named type of companies don't have or have it extremely limited.

    So, let's look at it in a entirely different way, I'm assuming people wan't freedom and are poor, just like me. I own 20 shares of ONP and 10 shares of INTC, that's my entire portfolio. For me the option of "traditional" diversification simply is non existent, so creativity is the way to go.

    I actually do diversify just not in the traditional view, through my holding's I'm globally diversified. INTC, my company, has global operations, ranging from countries like China to the USA, their in Joint Ventures and have divisions within computing technology market. Those divisions are in in my opinion basically companies with in one company. So this one company can get loans on a global scale, they have divisions, Joint Ventures and much more. This means, I own several companies directly in control and out of control of the mother company. From my point of view, I had the freedom to choose a good consisted cash cow and own a diversified company. While being insulated from possible horrible catastrophes, since they just could spin-off divission, take out a loan to fuel expansion for all or simply use the proceeds from a other division. This means, a lot of possible options to act up on, when things go south and down under.

    Before purchase I had the choice of the level of diversification, own more than 1 company, while being lazy and just buy shares of INTC. Through this way, I achieved diversification with a lot less money. Sure this looks like a index, how ever it's more an conglomerate.

    With this way of thinking, I achieved in my opinion both goals, namely diversification, freedom of choice and protection in the form of option(not the contract type). This is something that combines the best of both worlds, It's concentrated yet at the same time diversified.

    kind regards,

    -Rens

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