Excessive Diversification Leads To Mediocre Performance

ValueWalk’s Raul Panganiban interviews Shree Viswanathan, founder and sole employee of SVN Capital. In this part, Shree discusses his background and what led him to investing and finance, his investment philosophy, his sandbox approach to finding companies, deloying capital for a full business cycle, and excessive diversification would lead to mediocre performance. Full interview link.

Get The Full Series in PDF

Get the entire 10-part series on Charlie Munger in PDF. Save it to your desktop, read it on your tablet, or email to your colleagues.

Q3 2020 hedge fund letters, conferences and more

If we can just begin with your background and what led you to finance and investing?

Sure. So I'm actually an immigrant from India. I came to the US as a graduate student pursuing graduate studies in accounting of all subjects back in the late 80s. And and I finished my CPA soon after, and I was actually working in an insurance company in Des Moines, Iowa. I know what you're thinking at this point in this guy's life be any better than just watching grass grow, and counting, the more in insurance. But for an immigrant like me at that point, it was a fascinating platform, learnt a lot made a lot of good friends. But I distinctly remember in August of 1995, my cube was right next to the investment teams queue. And they were talking about how one was Warren Buffett had made this phenomenon. This was the second tranche of Geico that he had acquired, which I learned later on. But somehow that started that sort of, you know, instigated a, an urge for me to search a little bit beyond what I was doing just in the county.

How Warren Buffett Uses Discount Rates To Value Stocks

Berkshire Hathaway Warren BuffettWarren Buffett has never detailed the process he uses to value the businesses he acquires for Berkshire Hathaway. However, over the years, he has provided some limited insight into his methods. Q3 2020 hedge fund letters, conferences and more Based on these comments, it is widely assumed that Buffett uses a discount cash flow model Read More


So that pursuit sort of led me to business school at the University of Chicago. I went there to be an investment banker, because I was so enamoured by capital markets, was an investment banker at Alex brown in Baltimore, and then moved to Thomas weisel. Doing tech m&a in San Francisco for a variety of different reasons. I left investment banking to do mergers and acquisitions for a bank. And fortunately, in 2005, I had an opportunity to come back to Chicago to set up a small hedge fund focused on financial services, investing in banks, insurance companies and stuff like that. And although since then, I've been involved in a couple of different very storied platforms, value investing platforms in Chicago advisory research first, for about 10 years or so. And then, right before I launched SVM capital, I spent a couple of years at Keeley asset management. And then, in 2018, I launched this SVM capital With the primary objective of sort of investing in a global market with the intent of doubling capital or a business cycle, doing all that by avoiding many of the ill effects of traditional Investing Options, you know, I decided to do it with a very concentrated portfolio. I'm sure we'll go into all these details later, but concentrated long term, patient, global portfolio with a very equitable fee structure, particularly the partnership structure that I just launched this year, there is no management fee, only performance fee. So that's a sort of a little bit about connecting the three dots a little bit of what I did in the past, what I'm doing now, and what I would like to accomplish over the future.

How would you describe your approach or how would you describe your investment philosophy?

Sure, um, I'd say there are three important tenets to my investment philosophy. You know, I'll go into each one of them in a little bit more detail. But concentration is number one, on time horizon is number two. And global approach is number three. Now, when you look at the index, and s&p 500, as a good proxy for market, now, it's done approximately somewhere between eight and a half to 9%. Depending upon which time frame you choose, going back in time. If my objective is to sort of have a portfolio that does a lot better than the benchmark, I'm of the opinion that I have to do something different. And what is what does that different mean? Oh, um, first of all, Zig Ziglar, big philosopher, author, you know, back in the days, he said, if you don't have an objective, you will hit it every time. And so my objective is to have a portfolio that doubles the capital or business cycle, in dative terms that translate in a business cycle is typically about five to seven years, even though the most recent one that ended in March of 2020, was a little longer than that. But quantitatively, that translates into somewhere between 10 to 15% per year, obviously, not every year, not in a linear fashion. But so that's the that's the objective.

And how I do that is, is by concentrating the portfolio, while concentration by itself does not guarantee positive returns, I believe that excessive diversification will most likely result in mediocre performance. At SVM capital. It's a one man Investment Committee. And so I believe in this concentrated portfolio of about 10 to 15, well researched securities, that give me the best opportunity over a long time horizon. Long time horizon, that's the tenant number two, and are to hit my objective of this odd performance or a business cycle. I'm looking for certain special tools to help me accomplish that. And one of them is actually the power of compounding. Allow me to digress a little bit here. If you actually take a penny, and doubled it every day, if it's a penny yesterday, 2 today, 4 tomorrow, 8 the next day, by the 30th day, it actually becomes $10.7 million. That's a very powerful compounding force, or the punch line here is, what is it on the 29th a day, it's half of that it's about 5.4 million, I'm rounding the numbers here, about 5.4 million.

So you know, that sort of gives you a couple of different very important points, you know, the power of compounding, you know, a penny becoming 10.7. But also that power of compounding is sort of backend, heavy. If you were to draw it on a piece of chart, it would be more like an asymptotic curve. So, you know, my objective is to, you know, limit the impact of transaction costs, taxes and turnover to create value. And the third tenet is the global approach. You know, while us is still the largest and the deepest equity capital market in the world, um, perhaps it's because of my immigrant you know, in the immigrant background, I do see opportunities, wonderful opportunities, even outside the US. And in fact, you know, that sort of geographical diversification acts as sort of a natural hedge. Um, but when I say global, and I want to be sort of careful in how I define global, not picking any country, for that matter.

And as Warren Buffett has said, many times in the past, accounting is the language of business. And as a CPA, I'd like to understand the language through a couple of different methods, either us gap, the company that is fired, that I'm interested in needs to be filing their statements using us gap, or IFRS, International Financial Reporting Standards are currently about hundred and 40 countries follow IFRS. So that's still a fairly large number of countries and companies. But and so I sort of overlay my own corporate governance, my own understanding of corporate governance in those countries. And then finally, I want the filings to be in English, and are if they file in their local more local language, I don't want to spend time translating that using Google Translate or whatever, back into English. I generally find even though Japan is a very attractive market, I generally find this to be a problem there. Were many companies fail in English. So those are the tenants, you know, concentration, long term and global.

So when you when you look for companies, what do you look for to try to find business quality that will garner that 10 to 15% per year over that business cycle that you're looking for? Or do you try to find undervalued companies that will achieve that long term goal?

Yeah. So it's actually a great question. Um, you know, I was trained in the traditional method of value investing by Mr. David Heller, the founder of advisory research, where I've spent about 10 years you know, the traditional method, meaning in a look for a cheap stock, and trying to and then try and understand what the business model is, over time, in my own, in my own understanding, and as a part of my own evolution, I've sort of flipped that order. Um, I asked the question, if the business is of good quality, and I can define quality, or define quantity in a second. And then and then ask if the particular business is available at a reasonable valuation. You know, it may appear as just a simple flip, but it actually opens up enormous doors, enormous number of doors, in terms of business models and quality of businesses. And so that's the approach I take.

To answer your question, in a very specific methodology, I'd say, I sort of think of my portfolio as as sort of a sandbox with each corner of the box, representing as a security question that needs to be answered affirmatively. I consider the sandbox to be a sort of a dynamic system. As you know, in any dynamic system, if you have too many moving parts, there's a higher likelihood of things going wrong. moving parts here in this context would be buying and selling. So I try to keep the sandbox with as minimal buying and selling as possible. But that said, I know. The the four corners of the sandbox the questions would be the first one is, you know, is it a business that I can understand is that the business within my circle of competence? When Michelangelo was asked how he created David, that I didn't create David, you know, I just removed all the unwanted pieces, and the resulting stone was there. And so I think of my sandbox as a sort of a portfolio where I keep away many businesses, sectors industries that I don't understand or that I don't like and that way I'm sort of you know, focused on a very select number of companies. Now what do I keep away keep outside of the sandbox? But in a Bitcoin is a is a rage at this point. biotech pure energy exploration, production companies, mining companies, and even retail for that matter. Um, you know, those are businesses that I sort of keep away.

Unfortunately, to really create wealth, I believe we just need, you know, a select few businesses that I can understand very well. And, you know, we have innumerable number of examples, the quote, in terms of how that approach can create serious work. So that's number one. Number two, is the point about your question about quality. Now, that's where I try and understand the quality of the business. I come at this from a variety of different angles. You know, if I'm, if my objective is to have less trading within that sandbox, I need to be able to do a lot of diligence work up front. And so one of the points I'm trying to understand there is, can I seriously envision this company continuing on doing whatever they're doing for the next 10 plus years, which means I need to have a good view of how the company has performed over the last 10 years or so. Again, you know, quoting Winston Churchill here, you know, the farther back you can look, the farther forward you're likely to see. So I sort of spend a lot of time on the historical financials, the business that returns the capital needs, quality of the balance sheet.

I generally don't like financial leverage, I don't like acquisition of growth, you know, what's the free cash flow generation free cash flow, conversion to net income, things like that, so that sort of all that, so it gives me a good picture of the quality of the business, obviously, the quality of the business has to go hand in hand for me with quality, the management team, you know, looking for management teams that have good skin in the game, in terms of owning the particular business, have a reasonable compensation programme, have a very attractive incentive programme. And I'm trying to understand a little bit of the culture part of it through my diligence, I'm sure will come come to that later in this conversation. And then finally, I'm looking to pay a reasonable price in terms of valuation, what you pay for the business is absolutely important. You know, but at the same time, that kind of quality businesses that I'm looking for, generally trade at a different valuation spectrum relative to the so called cheap, you know, value investments. So looking to pay a reasonable valuation. off these four, I find myself spending a lot more time on order number two, which is the quality of the business in corner number three, which is the quality of the management team.

I forgot to ask in regards to the time horizon there over the business cycle. When you construct your portfolio, do you try to have certain timeframes that will overlap together? Or do you try to layer them in a way so that way, that five to seven year for each idea can stretch out, I guess, how do you think about that part of your portfolio?

So you know, when I'm, when I'm about to deploy capital into a new name, I'm generally thinking about a full business cycle, at least a five to seven year period, it doesn't mean that at the end of that cycle, period, I am absolutely going to get out, you know, if the business is actually performing well, I would love to continue to hold on to it. And so and that goes back to that power of compounding, you know, allowing the business to allowing the management team to execute allowing the business to perform, if it is happening that way, you know, might as well continue on. And your question, sort of, you know, covers the portfolio management aspect of how I think about correlation between different businesses. And am I right, in understanding that request? Yes. So yeah, it's a very important aspect.

Years ago, some time back, you know, I've sort of evolved from where I used to be in that regard as well. You know, given my financial background, I used to do acquisitions in the past. Services area and add a small financial services focused hedge fund. It was easy for me to get concentrated a little bit on some of these financials, which ended up being sort of a rate sensitive collection of businesses, which was fine until and our rates started going down. And looks like crates will continue to remain low for a long period of time. I'm always looking out these days. And in addition to that, you know, I also ended up having a little bit more exposure. In travel related names. I'm always constantly looking to avoid those types of concentrations and specific factors or variables. My Portfolio these days are fairly well diversified, both from a sectoral standpoint, and from a geography standpoint, currently have about 12 businesses within the portfolio. Eight of them trade in the US or outside most, or Western Europe, one in Eastern Europe.

Interview with Shree Viswanathan

And then I know you mentioned earlier that excessive diversification would lead to mediocre performance, why is that?

Sure. Um, you know, again, goes back to my starting objective, or doubling capital over a business cycle 10 to 15% return per year, I combined that desire for high return requirement with my desire to keep the turnover low, admittedly as sort of a steep herd to help generate that kind of healthy return the underlying business or businesses, they need to be able to generate no 15 plus return 15 plus percent return on capital. Now, one thing we know about business in general is reversion to mean this is generating a very healthy return. We know competition comes into the space and essentially, arbitrage has that excess return away. Fortunately, there are some businesses that are able to avoid such reversion to mean or at least defer that reversion to mean time period, into the far into the future. Those that are in are able to avoid or defer such reversion are companies that have a dominant position in whatever they're doing?

You know, they tend to be monopolies or duopoly, is, in fact, you know, Peter Thiel actually made a presentation to Stanford students in 2017. He titled it, competition is for losers. It's actually worth a listen about 40-50 minutes or so fantastic. programme about how he thinks about competition, that sort of, you know, gels well with how I think about adding businesses to the portfolio. You know, when I think about Porter's analysis, for example, the barrier to entry, the competition part is one of the most important aspects of, you know, what I'm looking for. So, my focus in identifying these types of dominant businesses, and which sort of protects them from this reversion to mean, investing in those businesses allows me to kind of avoid the mediocre performance. You know, then, so that's the underlying business of the, of the underlying Return of the business itself, in terms of excess of diversification, and why that leads to mediocrity and what is appropriate number of securities in a portfolio and up at University of Chicago, where I graduated, you know, it's the citadel of this capital as a as a pricing model. And Eugene fama got a Nobel for coming out with that theory a few years ago.

But, you know, a number of different studies have tried to answer that question with with precision. But the one that I thought came close to identifying the ideal, the appropriate number of securities in a portfolio is, is actually Joel Greenblatt, you know his book. You can be a stock market genius, classic. In there, he sort of answers it explicitly, he says, You know, with 8 securities in a portfolio, you actually get about 81% of the benefits of diversification. But 16 securities, you get 93%. The benefits of diversification beyond that, the benefits start plateauing. In fact, in my mind, as you go beyond that, it becomes more detrimental to the portfolio because you now have to spend a lot more time following businesses and moving variables and stuff like, so. You know, for me, investing is a is an individual sport. And at SVM Capital, I have an investment committee of one, I want to concentrate my efforts on a few businesses that meet my investment criteria, which I believe will give me the best chance for superior wealth creation.

More from the interview.