General ThoughtsInvestment PhilosophyInvestment QuotesWalter Schloss

General Thoughts on Portfolio Management and Diversification

“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:

  1. The closing of the gap between price and value
  2. 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:

  1. You have to be very precise in your estimate of value, because the business won’t “bail you out” by growing over time
  2. 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”.

Predictable Businesses

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 maintain comfortable levels of diversification. But I think owning say 5-8 great businesses and in addition maybe a few special situations or bargains that occasionally pop up provides plenty of diversification without diluting your best ideas.

To Sum It Up

As I finish up my Value Line project, I’ll begin discussing some of the businesses on my watchlist. I think if you build a watchlist of 50-100 good companies, there are almost always a few opportunities at any given time for one reason or another.

To take a lesson from Schloss, I think it is imperative that each investor develop a strategy that a) works well over time (value investing generally does) and b) suits their personality and maximizes their strengths. I sleep better at night owning good businesses. I like to feel comfortable that my portfolio of businesses will do well over time regardless of what the near term outlook for the stock market is, what interest rates will do, or what’s in store for the economy in the next year. Some of these things can make or break certain companies—so I find it more comfortable to look for durable businesses that can withstand a variety of these tests. These tend not to be the cheapest P/B stocks that Graham and Schloss would have liked, but they also tend to grow value over time, which gives me a much appreciated tailwind.

These companies don’t often become undervalued, but you also don’t need that many of them to collectively create a massive margin of safety for your portfolio—and this is a margin that will grow over time.

While it’s true that life and business are often unpredictable, and sometimes disaster may strike the land, I think diversifying into a handful of high quality “ventures” ensures your twofold goal of shipping your grain safely across the sea and achieving an adequate return on your investment.

———

John Huber is the portfolio manager of Saber Capital Management, LLC, an investment firm that manages separate accounts for clients. Saber employs a value investing strategy with a primary goal of patiently compounding capital for the long-term.

I established Saber as a personal investment vehicle that would allow me to manage outside investor capital alongside my own. I also write about investing at the blog Base Hit Investing.

I can be reached at john@sabercapitalmgt.com.

13 thoughts on “General Thoughts on Portfolio Management and Diversification

  1. Hi John,

    Thanks for the article, I agree with all of it.

    You mentioned you have a list of 5-100 business which you would like to own if the price is right.

    Do you use any unconventional methods – such as a stock scanners to prime further investigation?. If yes what metrics do you rate most highly – my guess would be return on assets?

    Thanks
    B

  2. Hi John,

    the subject of diversification is a tricky one and will always follow an investor.

    I am a great fan of Graham’s and Schloss’s strategy (although not following it slavishly), but not so much of Schloss’s diversification strategy. I’m more of a focussed investor.

    Based on the observed behavior of money managers, it seems to me that the majority reasons that if diversification is a good thing, then more of the same must be better. They fail to recognize that they are maximizing instead of optimizing their portfolios.

    However, as with most things in business and life, the law of diminishing returns applies also to diversification. Overdiversified manager’s appear to be ignorant to the fact that the bulk of diversification benefits is achieved surprisingly early (20-30 stocks).

    They also neglect the negative effects brought about by overdiversification, i.e. increased operating costs and”dilution” of manager attention and cognitive resources, to name just a few.

    Wishes

    O-tone

    1. The law of diminishing returns is something that isn’t brought up enough in my opinion. I’d go even farther than you and say the vast majority of the diversification benefits are achieved with a 10-15 stock portfolio. Below is a study that found the standard deviation difference from a 20 stock portfolio to a 1,000 stock portfolio only decreased 0.8%.

      http://www.lazardnet.com/us/docs/sp6/3048/LessIsMore-ACaseForConcentrated_LazardInvestmentFocus.pdf?pagename=Financial+Advisors

      1. Thanks for sharing that link Travis. I’ll check this out. And yes, I agree with you. I think in general, you achieve nearly all of the diversification benefits with the first 8-10 uncorrelated positions. #11, 12, 13, etc… doesn’t offer much incremental diversification benefits, but does add real costs that are hard to measure such as maintenance (time spent researching and maintaining the position). This can create some risk as it’s harder to know each position well the more positions that are in the portfolio.

        I think investors can thoughtfully disagree on whether a 6 stock, 10 stock, or 15 stock portfolio is best. And I think part of it depends on what type of investments are being made. But there is no question that if you get above 20, you really are just diversifying for no extra benefit.

  3. Do you think of MKL in similar way to BRK? Amongst all the Berkshire pretenders he appears, to me, to be the closest in investment approach (Fairfax is too macro) and with a proper insurance business meaning the elephant in the room of free leverage of float. I read a piece noting that Buffett’s investments have compounded at 12% since inception, versus 9% S+P meaning the extra 8% (to get to BRK 20% annualised return) was benefit of the float. It seems to me that even now after all the books on Buffett people misunderstand that the bulk of the alpha was structural, not picking Wells fargo and drinking Cherry coke!

    1. Yes I like MKL the best among the insurance conglomerates that get compared to BRK. Nothing is as good as BRK in terms of an insurance machine, but MKL is a very good business. I’ve written about MKL here in case you’re interested: http://basehitinvesting.com/markel-mkl-a-compounding-machine/

      Also, I’d love to see how they came up with 12%. I think the equity portion of Buffett’s portfolio for many decades (30-40 years) compounded at over 20%. In recent years, the operating businesses began earning more and due to the massive $100 billion+ size of the stock portfolio, there is no chance it does much better than the S&P, but in the early to middle years of BRK, Buffett’s stocks did much better than 12% annually.

      But it’s an accurate point to say that BRK’s insurance business is a huge (and probably underrated) driver of value for the firm.

        1. hey Jonathan,

          if I interpreted correctly, the 12% refers to Berkshire “stock” price. Not Berkshire stock portfolio “investment”. Berkshire “stock” compounded in the region of 20% (after tax) since Buffett took over. If Berkshire is not taxed, that would be roughly 30% compounded (as in the source).

    1. Yeah I have a number of different watchlists with stocks in different categories, but I often put stocks on the list just to begin tracking the business more closely. But my objective is always to build my “main” watchlist of great businesses that I understand well. If that list can provide one or two ideas a year, it’s a very valuable list.

  4. I implement a similar strategy in that I combine compounders with special situations and bargains. Probably the opposite allocation to the major categories.

    I have a printout with probably 20 different situation categories where I physically write down ticker symbols after coming across them from various sources. Would recommend this organizational tool. This ranges from distressed to NOL shells to REIT and mutual conversions to compounders.

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