I am thinking about concentration vs diversification. On the one hand, I don’t want to own a bunch of cheap stocks that aren’t very good businesses. I will own a few with asset backed protection, but I will diversify in these cases. I would be willing to concentrate my portfolio (10, 15, or even 20%) into one stock if I truly understand the business and I determined that it had a competitive advantage and a durable position in the market place (think Coke or Berkshire Hathaway). These are compounders that will be here in 10 years, 20 years, or longer. These are stocks I’d hold for a long time if I could buy them at a decent price. And the only time I’d concentrate that much is when:
- I understood the business and the competitive advantage
- The stock is trading at a price where my future estimated returns will be above average (15% or higher)
It’s very, very rare that a compounder of this quality trades down to that kind of level. Occasionally they do, and in that case, you can buy and hold for a long time, or at least until the value begins to exceed intrinsic worth.
So if you don’t see opportunities to take large positions in franchise businesses then you better own cheap stocks, and you better be diversified. It’s not as good as Buffett’s forever idea, but it’s the next best thing and it can yield incredibly high long term returns for the patient, emotionally disciplined practitioner.
I do own some franchise businesses currently, but they aren’t large positions. I’m just discussing concentration vs diversification here… the only stocks I’d concentrate my portfolio in are stocks of high quality at fair prices. The rest of the time I want to own a basket of above average stocks at below average prices, and also a small basket of cheap stocks relative to net tangible assets. I’m also looking at a 4th category lately involving special situations like spinoffs and merger arbitrage situations.
Buy Cheap and Good Companies
The foundation of my portfolio consists of buying numerous above average companies at below average prices. These stocks provide a margin of safety via their valuations, and some of them will turn around and provide fantastic upside. In my favorite cases, I’m able to buy a stock that is cheap that has some sort of upside that I don’t have to pay for. I’ve found that often the upside materializes more often than the market expects, and thus you get fantastic returns in those cases, but you don’t have to rely on that happening.
If you overpay for a franchise business, you have to rely on that company to continue to grow and continue to generate high returns on capital. It may work, but I’d rather buy a basket of cheap and good stocks whose prices reflect poor outlooks and difficult business conditions. These stocks tend to have minimal downside because if the business doesn’t perform well, it was already priced to reflect those poor results; but if the business does better than expected, the stock gets revalued significantly higher.
So I’d rather invest with these odds:
- Buying a basket of stocks that represent a margin of safety and little downside as a group, with tremendous upside potential if things work out better than expected.
As opposed to these odds:
- Buying overpriced franchise companies that may turn out to be decent investments, but are priced for perfection. These stocks have limited upside, but larger downside if things don’t work out as well as expected.
Concentration or Diversification?
In the end, concentration comes down to the ability of the investor to be able to value the business and understand the risks inherent to that business. If you are going to concentrate, you need to be a good security analyst as well as a good business analyst. This is a difficult job, and one that many do not succeed at.
Many value investors these days talk about their willingness to “concentrate their portfolios on their best ideas”, of course modeling themselves after Buffett. I don’t begrudge them if they can do it. But many who try to mimick Buffett end up getting mediocre results (average index like returns) because they don’t have Buffett’s ability to match security analysis (determining if a business is undervalued) with business analysis (being able to judge the economics of the business as well as evaluate the quality of the management). This marriage between security analysis and business analysis is an art form that very few have the ability to do. It is much easier to simply be a security analyst that looks at the quantitative side of the equation with just a few cursory inputs on the business side. Many disagree with me on this, but I feel it’s the safest way to manage capital, meaning the best combination of protection (margin of safety) on the downside and potential for above average returns on the upside.
Margins of safety can come from buying high quality stocks or from buying cheaply priced stocks. Of course, combinations of these can be good as well. But if you concentrate your holdings, you better be concentrated in high quality businesses at a fair cost. This is Buffett, and it’s hard to do, especially if you are entering at today’s prices. If you diversify among cheap stocks, you get a margin of safety through paying low prices for these stocks. Buying a basket also shields you from company specific risk. So you’re buying above average businesses at below average prices, and you’re shielded from company specific risk.
Investing is an art form. Buffett has mastered it (obviously) better than anyone else. The rest of us can try to emulate him, but we can also emulate Schloss or Graham, and have much better odds of success. Over time, we will naturally increase our skill at evaluating business, and over time our methods might evolve. At least that’s my plan.
I have a lot to learn, but investing is a lifelong journey. It’s an art form that is dynamic and difficult to master, but can always be improved.