I’ve been having a constructive conversation on the topic of diversification fellow value investor Nate Tobik of OddballStocks.com.
Now, this conversation all started because of an e-mail I sent entitled “why isn’t AAPL cheap?”, the point of which was to discuss the reasons why a company that looks like it is cheap statistically (AAPL has a low P/E, outstanding balance sheet, huge FCF generation, etc.) still might not be. The diversification discussion arose organically and orthogonally. I mention this only because reading Nate’s comments is kind of like jumping into the middle of a conversation– that’s not his fault.
Below, I reproduce several of his e-mails (with his permission) and add my own commentary as well:
The other thing is most companies I end up investing in are small caps and they do one thing. So I can look at a OPST or MPAD and read the annual report in 20m. Keeping up with them probably requires 45m a year and I can explain them quickly. So having a stable of companies like this isn’t really a big deal at all. Contrast that with how much time it would take to look at BAC or AIG, it’s crazy. I can probably look at 15 small caps in the same amount of time as I’d spend looking at AIG.
My comment: In this first quote, Nate is explaining why he feels comfortable having a diversified portfolio. While I am worrying about scaling the number of positions in my portfolio down, Nate admits he is looking forward to celebrating his 50th pick one day.
I think Nate raises a valid point here. A company like BAC or AIG is so incredibly complicated, it’s hard to imagine how you’d have time to analyze anything else you might want to add to your portfolio after researching and fully understanding the risks of one of them. On the other hand, a lot of these net-nets we look at are simple businesses and while they have risks, the risks are easy to understand and keep track of for the most part. This is a fair response to the challenge I raised in my first post in which I suggested that diversification may add risk to a portfolio by creating confusion and dividing the attention of the portfolio manager.
Yeah, I’m not married to the idea of a single best idea, I mean what is that? Well America Movil has grown the most for me so is that my best idea? What about Mastercard a 10-bagger since 2006. Here’s the problem, when I purchased both of those I had no idea they’d do as well as they would, I just figured they were worth more than I paid.
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In my view as long as every position I buy meets my return characteristics buying one more position doesn’t diworsify me because that next stock added has the same potential return as all the others. So holding 200 stocks that I think are all worth 50-100% more, or are compounding at 10-15% a year is fine, I would be happy with that. The reality is that many probably don’t exist.
My comment: This is probably true. But at the same time, there is nothing being added by diversification. The free lunch remains elusive. If you have 20 positions that all have a 15% per annum return potential with similar risk, you really just have 1 position with a 15% per annum return potential.
So if I looked and had to tell you what had the best prospects I really don’t know, and that’s not because I question my judgement, it’s because in my experience it’s impossible to tell. I could tell you what is growing on my basis the quickest, or what is the cheapest, but absolute best idea, I don’t know. I don’t think that’s in my investor DNA.
I’ll say though when I see something crazy cheap I will try to keep buying up to a limit, I’ll usually max out at 5% or so.
My comment: Nate is responding to my argument in the previous post that, instead of diversifying, you should put everything into your “best idea”, whatever that may be at the time (best defined as highest return potential for lowest risk out of all alternatives being considered). And he’s definitely correct that you can’t know ahead of time which investment out of a “crop” will realize the highest “yield” ahead of time. I agree there.
But my point was slightly different– that if you’ve got three different plants, say, and one of them looks the healthiest of the other two, water that one, a lot. Don’t water all three, a little, and see what happens.
I think this is where Nate’s comments on the subject are weakest. I think he’s essentially making my point (one of my points, anyway), for me. In contrast, where I think his comments are strongest are just below.
So here’s my thinking on ‘best idea’ and diversification. There is merit to it with a big “BUT.” So for you, say you take over the business, you have the ability to affect change, to run it as you like. You can only own the one business and nothing else and that’s fine, plenty of business owners do that. In a classic sense you have no diversification but it doesn’t matter because you have control.
I don’t control anything I own, and there is a limited amount someone can know about a business from the outside. So if your business sent me the financial statements I could learn a lot, but I would never know as much as you because you’re inside. Even if you don’t have statements you know more, you see salesmen walking around, you know if they’re selling a lot or not by their attitude. You know if the carpet has been replaced recently or if the furniture is getting old. All those little intangibles add up. I could go visit every company I invest in and try to learn this, some people do. That is the point of the sleuth investor, he gets to know the customers, sleuths the company, gets to know the employees. he basically gets to know everything you can know without being an insider, then he loads up. So the idea has merit.
I don’t do any of that, I’m reading statements from my basement and even when I get involved in a company all I get back is a nice letter saying thanks they’ll look into it. So I need to diversify my ignorance, I have a 5% rule because I initially don’t want to go crazy on a new position. I let positions run, at one point Mastercard and America Movil were 50% of my portfolio. I know the companies, I didn’t care, I’ve sold them down so they’re about 25% now, but still. I like to scale into something as I get to know it better. A company I’ve owned for five years I know a lot better than a company I just researched no matter how much reading I did on it.
My comment: This makes sense. Essentially what Nate is saying is that you’re taking an undue risk putting 100% into a non-control situation. There are probably few and rare opportunities where the situation is so clear cut and the risks of total concentration so minimal that you can get away with full concentration (zero diversification, or “non-portfolioization” as I put it before).
This has me “stumped.” I don’t have a great response for this (not that I need to… this is an argument about being right, it’s a discussion about merits and lack thereof). Intuitively it makes sense because my belief all along has been that the more information you have and the more conviction you have about an idea, the more you should be concentrated in it, with the extreme being 100%. But Nate is pointing out that the only place where you can be “certain” or have full knowledge of the business itself, have full conviction about what the world looks like from the business’s perspective, is if you have control of the business. So, outside of that condition, you should not concentrate 100% in normal circumstances.
As Nate mentioned later in an e-mail, he is a “serial investor”, meaning, he is looking at ideas one at a time and evaluating if that investment meets his hurdle. He is not usually comparing multiple investment ideas at once and then picking the “best idea” of the bunch.
This reminds me of a section from early in The Snowball where Schroeder says that Buffett was typically fully invested but, for the first time in his life in the mid-1960s, he was finding the bargain pool to be dried up and felt forced to sit in cash as opposed to deploying his capital.
I think in that situation, you’re forgiven for “diversifying” into cash. But short of that, this “I am holding some cash ‘just in case'”, where the “just in case” is interpreted as “just in case I come across a great bargain or the market crashes” doesn’t hold water. What if that crash never comes, or the bargains you see right now are as good as they’ll get?
Why be “diversified” in cash at that point?
A House Rises 