Portfolio Concentration

**teenvestor** Tue May 30, 2006 8:13 am

Portfolio Concentration
A few days ago I saw this post on the Motley Fool discussion boards. Readers of this site will know the article was almost 100% the opposite of my portfolio strategy, soI felt complelled to reply, that reply is here:

"The strategy (of portfolio concentration ) we've adopted precludes our following standard diversification dogma. Many pundits would therefore say the strategy must be riskier than that employed by more conventional investors. We disagree. We believe that a policy of portfolio concentration may well decrease risk if it raises, as it should, both the intensity with which an investor thinks about a business and the comfort-level he must feel with its economic characteristics before buying into it."

-Warren Buffett 2003 Letter to shareholders

"We think diversification, as practiced generally, makes very little sense for anyone who knows what they're doing. Diversification serves as protection against ignorance. If you want to make sure that nothing bad happens to you relative to the market, you should own everything. There's nothing wrong with that. It's a perfectly sound approach for somebody who doesn't know how to analyze businesses."

Also Warren Buffett

"If you assume, based on past history, that the average annual return from investing in the stock market is approximately 10 percent, statistics say the chance of any year's return falling between -8 percent and +28 percent are about two out of three.… What do statistics say you can expect, though, if your portfolio is limited to only five securities? The range of expected returns in any one-year really must be immense. Who knows how the crazy movements of one or two stocks can skew results? The answer is that there is an approximately two-out-of-three chance that your return will fall in a range of -11 percent to +31 percent. The expected return of the portfolio still remains 10 percent. If there are eight stocks in your portfolio, the range narrows a little further, to -10 percent to +30 percent. Not a significant difference from owning 500 stocks."

Joel Greenblatt this time

OK now it's my turn.

You say diversification is necessary for good returns - this simply makes no sense what so ever.

For a bunch of different reason first I'll go over each of your different ways of diluting returns, or diversifying.

You say the reason people lost money during the tech bubble was because they were not diversified, this is not true, no matter what you were invested in you lost money during the tech bubble. Even those people who believed there was a tech bubble and avoided tech lost money; money some haven't yet made back. People who thought there was a tech bubble but sought tech companies which were trading under their fair value with good management and a quality business probably didn't lose as much as could have been because they already had a margin of safety.

Also you say people lost money because they were not diversified, is there proof of this or are these just your thoughts? How do you know whether or not they were diversified?

Next you say,"There are still plenty of opportunities in the stock market....you never know what the market, world, or economy is going to throw at you."

This is not true either. Because of the scrutiny a company must go under before an intelligent investor picks it great investors usually can only come up with 6-8 good ideas a year for investments, that is why they spend a lot of time trying to find 'special situations' to use in their portfolio.

I'm not sure what your method is to pick stocks, to me it seems a lot of companies with high growth rates and P/E s under 25 would pass your test. I, and multiple superinvestors (who I will name later), have successfully invested in companies only when the following, plus a lot more things, occur:

-The company is trading at least 50% under its conservatively estimated intrinsic value.

-Financials and footnotes have been analyzed repeatedly for at least ten years of info. People thought Eddie Lampert was crazy when he bought K-Mart, but he was buying $50 in assets for $1 - later his investment went up 300% in one year, that year he reportedly made over $1 billion dollars in fees just from the K-mart purchase.

-Management has also been scrutinized using the numbers mostly - but also using scuttlebutt. Two great investors with opposing views on the subject made great calls on the same company - AutoZone. Eddie Lampert sent an intern around the country for three months to visit thousands of AutoZone's to see how management was at a local level. Joel Greenblatt simply analyzed the financials over and over and didn't buy the company until over two months worth of analysis was done on the numbers to evaluate management.

-Catalyst, this may seem trivial or an element only a growth investor would use, but sometimes it takes years for a company's value to be shown, many value investors now only buy value when there is an attached catalyst to force management to release value.

-Great business, probably the easiest, only buy companies that have great businesses, and competitive advantages that will keep peers at bay.

-Latticework of mental models, this one is extremely hard to understand when beginning, but learn it and investment returns will vastly improve. Started by Charlie Munger in a speech at USC a while ago – this speech is available at Whitney Tilson's web site somewhere. To simplify it a lot you cannot only have investment knowledge in anything, you must also acquire knowledge from multiple subjects, and use this to your advantage when investing. Mohnish Pabrai has done a great job securing 30% annual returns over the last seven years using this method when analyzing companies.

Next, I can't find where you mentioned it but diversifying among sectors within a portfolio. This is hogwash. A value investor must use up down analysis (find the company and analyze don't look for macro-economic factors that will make an industry fly) but when a whole sector is found to be undervalued the great investor will take advantage of this.

In the mid 1990's many people were thinking outrageous thoughts about the future of cable TV, many thought satellite would take over TV. Businessweek spurred it all when a cover story in 1996 claimed cable didn't have a chance. This story sent the price of the whole cable sector down.

But, Superinvestor Glenn Greenberg saw things a different way; satellite TV didn't have local TV yet, installing a satellite was extremely hard and expensive and dense urban settings did not get good reception at all, Greenberg thought the two would co-exist.

Also, cable companies were starting to introduce phone services , broadband Internet connections and other profitable areas that could isolate them from satellite TV should it actually take over the world. Greenberg noticed all of this and took advantage, he avoided cable companies that were part of bigger schemes or had loads of debt, in stead he picked well managed, quality cable companies and by the end of 1998 he had 40% of his fund in cable. Since then their annual returns have eclipsed 25% annually – including the bubble.

Soon I may make the decision to put over 25% of my assets in coal I do not see this as a bad element or risky. I look at the coal industry's cycles and see that whenever they enter and up cycle it goes up for at least 8 years, sometimes 15, after it starts, this has been proven with historical returns. The coal industry's up cycle has just began and I expect it to go up for at least five more years, but this is not the only reason I may be invested in two key coal companies I believe will produce great returns.

-International Coal (ICO) – Wilbur Ross heads ICO, a billionaire 'vulture' investor who turns crappy companies into good ones. He made over $4 billion for shareholders in his last venture – a steel company. Also the company is undervalued because of selling pressure from the officers of one of the companies, which was merged to create ICO, and because of the Sago mining incident. I can get into how the legal fees for the incident will be well lest than profits, but put simply ICO trades at half the multiple of competitors with worse management.

- James Rive Coal (JRCC) – James River is a coal company that has refused to return value to shareholders, and this is a good thing … because recently an activist got involved, and the company will now most likely return a great amount in a short period of time. For more info on this investment, read this post.

I'm sorry but your notion of diversifying among size also seems delusional to me. Micro caps and small caps aren't as risky as bigger names, in fact they are less risky. Thought they are volatile over short periods the only people who would be affected by this shouldn't be invested in stocks unless they have years of experience. Back to why it's less risky bigger companies are followed by many different analyst, I won't go over the whole advantage with buying small caps I'm sure you've read the 3 a week promotional Hidden Gems articles on the home page of the site. But basically when as many analysts follow these big companies they may be coaxed into 'adjusting' earnings a little bit because of the daily pressure they face. Smaller companies may do they same thing but it is less likely and great investors can easily find small overlooked companies, which are undervalued, and have trustworthy management, these smaller companies will rise faster.

Though small caps are advantageous at whole, any time you find an undervalued opportunity with a high probability of it delivering high returns it needs to be purchased. Only six of these are found a year and all of them being small, or big, should not matter.

Few, we're on the last one now. I won't go through the 'it's dumb thing' I'll go right to why it is dumb. Though there are complicated ways to use closed-end fund arbitrage to take advantage of over or under valued companies, diversifying among countries is a waste of time. You said there are always opportunities, if so why is it needed to go offshore to find companies that do not report the same way, may be adjusting earnings, may have disagreeable government impossible to predict, etc. Basically don't invest in foreign securities unless they are no longer foreign and you have visited the country, and know how the company works.

Risk is reduced not by diluting returns by diversifying and looking at beta; it is reduced by only buying quality companies with a margin of safety.

I wrote this not just to argue, or put you down, but because I feared long-term returns may be in jeopardy. With all the different ways of diversifying you have mentioned here, one would need to own over 100 companies from different countries to be fully 'diversified'. Returns would not be good long-term they would be less than that of an index because one could not keep up with this many companies from this many countries in this many industries all at the same time, especially if he has a job during the day.

A simple way, but rewarding, way to develop a portfolio without having to own a Russian telecommunications company would be to own the following:

- 2 or 3 great quality companies with the intent of owning them forever. These are not easily found and will not be found more than once per year, probably not for a long time.

- 5 to 7 companies trading for less than half of their conservative intrinsic value (be this by way of multiples, earnings power, assets, etc.) with a foreseen catalyst that leaves the potential for a 100% return in two years or less.

- As many special situations as you can find, or you can follow at one time.

Oh yeah, I promised a list of fund managers who concentrate their investments I don't have time to go over all of them now, but go here.

For more on concentrating your investments go to Focus Investor and Right Price Investing the latter is run by yours truly ;-) any opinions of it are welcomed.

**blast_investor** Tue May 30, 2006 10:24 am

Excellent write up on diversification issue.

Warren Buffet's past word on diversification is clear and striking.

Joel Greenblatt' own approach is focused approach. But his "Magic Formula" is index-type approach with fully diversified portfolio of 25 stocks.