“Ship your grain across the sea; after many days you may receive a return. Invest in seven ventures, yes, in eight; you do not know what disaster may come upon the land.” –Ecclesiastes 11:1-2
Investors have always discussed and debated the merits of diversification—apparently even as far back as the days of King Solomon (although his definition of diversification—7 or 8 “ventures”—might not sit well with modern day portfolio theory and mutual fund managers who often hold 30, 50, or 100 of such ventures).
Over the weekend I happened to reread this article on Walter Schloss, which got me thinking about portfolio management a bit. Schloss is an investor I’ve talked about on the site before. He’s one of my favorite investors—not necessarily because of his strategy, but for his simplistic view of investing. To Schloss, investing was simple. It involved buying stocks that were cheap relative to easily identifiable net asset values, or low P/B stocks. He set up his business in a way that suited his personality and maximized his strengths—and it led to incredible results. His strengths were his patience, his discipline, and his ability to not be influenced by others’ opinions.
A friend and I were talking this week about portfolio management, and I thought I'd write down a few miscellaneous comments on the topic. This topic (portfolio management and how many stocks to own) is a question I get often from prospective investors, and so it seems to be of interest to many readers.
Schloss ran a very diversified portfolio. He bought many different cheap stocks. He didn't talk to management. He relied on numbers, probability, and the concept that when taken in the aggregate, buying stocks at cheap prices relative to their book values will work out well over time.
How much diversification is necessary?
I prefer to focus my investments much more than Schloss did, but the answer is it depends on a few things—namely the type of investment approach that is being implemented. An investor buying cheap stocks of companies with little to no earning power is probably better off using a more diversified basket approach. Ben Graham—who Schloss learned from—also used this approach. Both did quite well—averaging around 20% per year for decades.
How were they able to continually achieve such great results? Because it's not easy buying the stocks that these guys owned. As Schloss says, sometimes:
“these companies and industries get into disrepute and nobody wants them, partly because they need a lot of capital investment and partly because they don't make much money. Since the market is aimed at earnings, who wants a company that doesn't earn much? So, if you buy companies that are depressed because people don't like them for various reasons, and things turn a little in your favor, you get a good deal of leverage.”
This style of investing worked for Schloss because his personality and skillset was geared for it. Although I also like cheap stocks, I find more safety in building a portfolio filled with durable businesses that can compound earning power and value. To paraphrase something Bruce Greenberg once said, I want to feel perfectly fine in the event of a 1987 style stock market crash—stock prices will go down, but the underlying businesses I own—as a group—won't be permanently impaired.
Now, I think there can be a place in the portfolio for bargains and special situations, and not all investments fit neatly into a specific category. I've talked about how investors shouldn't focus on categorizing investments, but focus on understanding them. Forget about style boxes and whether an investment fits into your pre-defined strategy—just look for great value.
As Alice Schroeder said about Buffett (paraphrasing): “If someone gave him a dollar bill and asked for two quarters for it, he'd immediately take it. He wouldn't say, ‘Well, that dollar bill has no moat'”.
Focusing on a Few Good Businesses
The other side of the coin is to own a select few high quality businesses that do a lot of the heavy lifting for you (i.e. they compound value over time). I also think that collectively, the margin of safety is much greater in owning good companies—those well-managed, durable businesses with predictable earning power. I've written a few posts on the concept of return on invested capital (ROIC), and why this is an important driver of value.
Buying these businesses at a discount to their fair values provides two sources of potential return:
- The closing of the gap between price and value
- The growth in earning power over time
So if the value gap takes a year or two to correct itself, then you also benefit from the business having a higher earning power and higher intrinsic value than it did when you first bought it, giving your investment return an added kicker.
The opposite occurs with cheap stocks of mediocre or lousy businesses that have declining earning power and shrinking intrinsic values. It is possible to make money buying these companies at a discount—after all, almost every stock has some intrinsic value that is greater than $0, thus in theory it's possible for any stock—regardless of how good or bad the business is—to become undervalued and a potentially attractive opportunity for bargain hunters. But I see two general problems with most bargain situations:
- You have to be very precise in your estimate of value, because the business won't “bail you out” by growing over time
- There is a tricky element of timing involved—if you buy a declining business below intrinsic value, you have to sell it fairly quickly before the intrinsic value falls down to your purchase price
In other words, good businesses bought at a discount have a margin of safety that increases over time. Bad businesses bought at a discount have a margin of safety that shrinks over time. As cliché as it now is in the investment community, the following remains as true as when Buffett first said it: “Time is the friend of the wonderful business”.
There is also the element of predictability. Many of the stocks Schloss and Graham bought had future prospects that were somewhat unpredictable:
“The thing about my companies is that they are all depressed, they all have problems and there's no guarantee that any one will be a winner. But if you buy 15 or 20 of them…”
So you need diversification with this approach to capture the benefits of the law of large numbers—you don't know which stocks will work, but as a group, the portfolio will do well–similar to the concept of insurance underwriting.
Owning carefully selected high quality businesses is a different approach.
I think because of the higher level of predictability in some investments means that you need fewer of them to remain adequately diversified. Berkshire Hathaway is a company I discussed recently, and this is an example of a company is very diversified. It's also very predictable that earnings will be much higher in 5-10 years than they are now. You don't need 10 BRK's to have a diversified portfolio. Other stocks (most other stocks) are much less predictable and maybe you need smaller position sizes and more of them to