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Thoughts on Diversification vs. Concentration

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.

6 thoughts on “Thoughts on Diversification vs. Concentration

  1. nice post. i think diversification is great as long as their is a decent velocity of ideas and the ideas themselves move towards fair value pretty fast – a few months to three years. peter lynch approach can work. schloss approach can work. many different ways.

    in my opinion, diversification versus concentration should also be contrasted depending on the cheapness of the market itself. if there is a paucity of ideas with mutli-bagger potential, then it makes more sense to concentrate.

    1. Thanks for the comment Bob. Yes, I view my portfolio as dynamic. It’s a synthesis of ideas that I’ve taken from others such as Schloss, Graham, Buffett, Greenblatt, Pabrai and others… it’s easier maintenance to own 8-10 stocks that are high quality companies at very attractive prices (ideally). This will allow you to buy and hold them for a long time while the businesses do the work of compounding for you. Cheap stocks require higher turnover, need more diversification, and thus more maintenance, but can also yield high long term returns.

      Generally speaking, the longer you hold an asset, the lower the returns are likely to be. Buffett turned the Washington Post investment into a huge return over the years, but compounded it was about 13% per year, which was far below the average investment return. The big deal was it was $10 million to $500 million over a multidecade period. And obviously once the investment was made, it required basically no maintenance. Plus taxes are deferred by not selling. So it’s an outstanding long term investment, but not as striking as many might have guessed.

      Schloss on the other hand treated his investment portfolio like a grocery store…. buying inventory with the intent to resell at a profit.

      I like to think of my portfolio of having different business lines (cheap stocks, cheap and good, franchise businesses and special situations)…

      Thanks for reading!

  2. Nice topic! Most parts of investing is goal driven: retirement monthly income 25 years from now, income streams for a child’s college tuition 15 years from now, etc. As a person who also investes in non-tax defered accounts, I feel that one advantage that the franchise compunders offers us investors is best described by Charlie Munger:

    There are huge mathematical advantages to doing nothing.
    Munger: Another very simple effect I very seldom see discussed either by investment managers or anybody else is the effect of taxes. If you’re going to buy something which compounds for 30 years at 15% per annum and you pay one 35% tax at the very end, the way that works out is that after taxes, you keep 13.3% per annum,
    In contrast, if you bought the same investment, but had to pay taxes every year of 35% out of the 15% that you earned, then your return would be 15% minus 35% of 15% – or only 9.75% per year compounded. So the difference there is over 3.5%. And what 3.5% does to the numbers over long holding periods like 30 years is truly eye-opening. If you sit on your ass for long, long stretches in great companies, you can get a huge edge from nothing but the way income taxes work.
    Even with a 10% per annum investment, paying a 35% tax at the end gives you 8.3% after taxes as an annual compounded result after 30 years. In contrast, if you pay the 35% each year instead of at the end, your annual result goes down to 6.5%. So you add nearly 2% of after-tax return per annum if you only achieve an average return by historical standards from common stock investments in companies with low dividend payout ratios.

    Thanks for your sharing your perspectives.

    Achit

    1. Great points Achit. I just made a comment to a different poster that you can read similar thoughts I have. I view the portfolio as a dynamic group of a few business lines. Franchises, Cheap and Good stocks, Cheap stocks, and special situations (arb, spinoffs, etc…).

      Franchises require the most conviction, but the least maintenance. (i.e. buying and holding Teledyne or Berkshire would have made you very rich without much maintenance). Cheap stocks require more of a basket approach to allow for specific company risk. The idea here is to become the insurance company. Diversification, or better described as a multiplicity of transactions, allows your end result to equal your expected results as the number of positions increases.

      The best absolute performance in investing is likely to come from concentrated portfolios (30-50% annual returns). But like Schloss and Graham proved, it’s possible to run a diversified portfolio and make 20% per year also.

      The grocery store inventory can increase turnover and returns if the stocks purchased are cheap enough (i.e. buying a 50 cent dollar over and over again can result in very profitable returns, even after taxes, as the profits are reinvested back into more opportunities). But as you say, buying and holding compounders puts time on your side, and allows you to let others carry more of the workload.

      It’s dynamic. At this point, I use both general ideas in my own portfolio. Depending on opportunities, the weights of these strategies fluctuates…

      Thanks for reading!

  3. Some excellent points both in the article and among the commenters. I especially like the idea of a portfolio containing different business lines. It helps to make the idea of value investing businesslike and acknowledges that more than one value orientated approach could and should be utilised.

    1. Yep, “Investing is most intelligent when it is most businesslike”- Ben Graham…

      Thanks for the comment David.

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