The Free Capital Blog Digest

The following is a digest of posts from Guy Thomas’s Free Capital blog from Feb 2011 through Jan 2012.  Each post provides a link to the parent article with bullet-pointed lists of key-takeaways from each. For the complete discussion by the original author, please click the link to the parent article.

How important is analytical intelligence in investing?

  • Equity trading is not as reliant on raw mental strength (IQ, analytical ability) as fixed-income trading; instead, equity trading is more dependent upon mental characteristics such as:
    • Actively seeking information from dis-confirming sources
    • Adjusting for one’s biases
    • Accepting uncertainty for long periods
    • Deferring decisions for as long as possible
    • Calibrating your certainty to the weight of evidence
    • Responding unemotionally to new information
    • Indifference to group affiliation
  • The mental characteristics which are helpful in investing are not universal positives and may be useless or negative characteristics in other endeavors

Max, min and average payoffs

  • Most activities can be categorized as max payoff, min payoff or average payoff
  • Max payoff means the activity is “positive scoring”, your payoff is your highest or best result and failure carries no lasting consequences
  • Optimal traits for max payoff are:
    • high energy
    • irrational optimism
    • persistence
  • Examples of max payoff activities include:
    • selling
    • leadership
    • most sports
  • Min payoff means the activity is negative scoring, your payoff is your lowest result and even a single failure may have lasting consequences
  • Optimal traits for min payoff are:
    • meticulous care
    • good judgment
    • respecting your limitations
  • Examples of min payoff activities include:
    • flying a plane
    • driving a car
    • performing brain surgery
  • Average payoff activities combine elements of both max and min; investing is an average payoff activity, with particular emphasis on the min aspects
  • A lot of success in investing comes from simply avoiding mistakes (min payoff)

Discussion of diversification (posts 1, 2, 3 & 4)

  • Diamonds and flower bulbs
    • Diamonds are companies with exceptional economics and long-term competitive advantages that you’d be happy to hold if the stock exchange closed tomorrow for the next five years
    • Flower bulbs are companies which are cheap at the moment but which have no exceptional business qualities (they often make a good quantitative showing but not a strong qualitative one); they can usually be counted on to bloom but should be bought in modest size because they require liquidity to get back out of the position and realize the value
    • Which should you buy? Diamonds are exceptionally rare and require outstanding foresight of long-term durability; flower bulbs are more common, simpler to spot and merely require patience and a strong stomach
    • “Investing is a field where knowing your limitations is more important than stretching to surpass them”
  • How many shares should an investor hold? Some theory…
    • The optimal number of stocks to hold, N, is a function of…
      • quality of knowledge about return dispersions (decreasing)
      • $ size of portfolio (increasing)
      • volatility of shares (increasing)
      • capital gains tax rate (decreasing)
    • Exceptional investors with exceptional quality of knowledge should hold a concentrated portfolio; Buffett from 1977-2000 appears to have held approx. 1/3 of his portfolio in his best idea and changed it annually
    • With a small portfolio, liquidity is not a concern but as your portfolio scales a large number of holdings becomes optimal to maintain your liquidity which enhances your optionality by giving you the opportunity to change your mind without being trapped in a position
    • If the companies you target have highly volatile share prices, it becomes attractive to switch frequently so that you can “buy low and sell high”, thus you want to restrict your position sizing (higher number of positions) and maintain liquidity
    • If the capital gains rate is high you are penalized for turnover so you want to keep your total number of positions low and hold them for longer
  • How many shares should an investor hold? Some practicalities
    • There is clearly a trade-off between the number of positions you have and your quality of knowledge
    • A portfolio which is higher in diversification may hold many lower quality businesses (flower bulbs) but the certainty of the analysis of each might be significantly higher than a concentrated portfolio of several high quality businesses (diamonds) whose analysis is extremely sensitive to long-term forecasting accuracy
  • Concentrated investors often “come a cropper”
    • Many investors eventually disappoint because they have concentrated their bets on companies the world turns against
    • This has happened even to great investors like Warren Buffett (ex., WaPo, which now looks like a horse-and-buggy investment)
    • The danger of concentration is that nothing grows forever, and concentration + illiquidity often make it hard to escape mistakes

Meeting management

  • Opportunity cost of time: is it better spent speaking to management or investigating other ideas?
  • Getting an edge: sometimes speaking with management helps to understand the picture in a way that gives you an edge
  • Buffett: if you need to talk to management, you shouldn’t own the stock
  • Don’t be schmoozed

Analytics versus heuristics; why I don’t use DCF models

  • Time is precious and DCF models take too long
  • A good buying opportunity shouts at you from the market; if you need a calculator, let alone a spreadsheet, it’s probably too close
  • Robustness is more important than refinement; it’s easy to find apparent discrepancies in valuation, but most are false– it’s more important to seek out independent insights which confirm or deny the discrepancy than to calculate its size; when info quality is good, focus on quantifying and ranking options, but when it is poor, focus on raising it
  • Non-financial heuristics are often quicker and sufficiently accurate to lead to correct decisions; you may make more errors than the rigorous analyst but you can work much faster and evaluate many more opportunities which is usually a good trade-off
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Thoughts On Diversification & Ideal Portfolio Management: Why Are You Diversified?

I’d like to talk today about diversification as a strategy within the theory of portfolio management.

What is portfolio management?

In portfolio management, you have two possible extremes between which most actual portfolios lie– own one thing, or own everything.

The classic example of a person who owns one thing is the owner of a small business, of which the proprietorship makes up his entire personal equity capital in relation to the total investment universe. Most people wouldn’t even consider this person to have a portfolio because he holds nothing else. His business is his portfolio.

Consequently, portfolios imply diversification, and vice versa. The moment you take equity in more than one venture, you have created a portfolio and you are simultaneously diversified. This is the mild hypocrisy of people who warn against diversification (calling it “deworsification”) and counsel investors to maintain a concentrated portfolio. A portfolio may be concentrated to a small number of holdings (let’s say, five or less to pick an arbitrary point of distinction), but this is not a non-diversified portfolio– the very fact that it is a portfolio implies it is diversified.

The standard argument for diversification

Proponents of diversification (or, what we might term “portfolioization” to come up with an even more complicated and hard to speak/spell nomenclature for the phenomenon) argue that diversification is a way to limit risk in equity ownership. It is the “multiple egg baskets” theory, the idea being that if you drop one basket you only lose the eggs inside of the dropped basket, whereas if you carry all your eggs in one basket and drop it, there goes dinner.

But it’s a bit of trickery, because risk can’t be eliminated, only exchanged. In effect, as you diversify (portfolioize), you exchange business risk for market, or economic, risk. The larger your portfolio becomes in terms of total positions, the more it comes to resemble the total universe of equity opportunities in its performance.

With diversification, you are not limiting risk, you are exchanging it. You’re determining how much of your equity will be exposed to each kind of risk in existence, not how much risk you will be exposed to in total (that question is settled by what particular risks you do put into your portfolio).

To summarize, two risk equations:

  • business risk vs. market risk
  • which business risk?

Standard counter-arguments to diversification (or, why it’s really deworsification)

The case for diversification isn’t complicated and neither is the case against it. There are two main points to consider:

  • diversification limits exposure to particular risks, but also limits potential rewards (no free lunch)
  • diversification may introduce an altogether separate risk– lack of focus

The first point is fairly self-explanatory. If you only invest X% of your portfolio in a particular risk, you ensure that your maximum loss is never greater than X%, but you also ensure that your maximum gain is never greater than X% * Y, Y being the return of the underlying investment.

So, if you invest 20% of your portfolio in ABC Company and the stock falls by half, thanks to the magic of diversification, you actually only lose 10% of your portfolio (-50% * 20% = -10%). On the other hand, if the stock rises by half, thanks to the magic of diversification you actually only make a return equal to 10% of your portfolio (50% * 20% = 10%).

There’s no free lunch. You only would get to capture the full 50% rise if you had the full 100% of your portfolio exposed. You essentially provide yourself downside insurance because, while your overall gain is capped, your overall loss is capped as well as it can never be higher than the 20% you exposed (provided you aren’t using leverage or shorting).

Perhaps more nefarious, some investment thinkers point out that by diversifying your portfolio, you spread your attention thin and could end up not understanding the individual risks your various positions hold as well as you might if you had one position (or two, or five…) and so, in a quest to limit business risk you actually enhance it because the quality of your analysis falls. Similarly, if you do poor analysis, you might be more prone to rationalize it because, “Oh well, ABC didn’t work out, but I’ve still got bets on DEF and XYZ, I’m sure they’ll turn out okay and make up for the loss– I’m diversified!”

The scarcest thing most investors have is attention they can devote to their investing, not capital.

Is one ever justified in diversifying?

Diversification by itself is not a terrible thing. As discussed above, it really doesn’t confer any advantages beyond the psychological– diversification by itself can’t improve the absolute returns of your portfolio, on net.

It also doesn’t have to be a purposeful strategy. Diversification can happen “by accident” in the following scenarios:

  • it would be inappropriate to invest 100% of your capital in a position due to market cap constraints
  • you have received new capital inflows following commitment of 100% of your previous capital
  • the market moves against you in the middle of taking a position

In the first case, imagine an investment opportunity in a company with a market cap of $100M, in which case the maximum appropriate position one could take without “bidding against oneself” is $5M, but one’s full capital represents the amount of $10M. In this situation, you would only invest half your capital in the idea because investing any more than this might destroy some of the value available. Diversification would be a natural consequence of a situation like this, whether diversification itself was desired or not.

In the second case, imagine you have $10M of total capital in period 0, which you fully invest in X. However, some time later, in period 1, you receive additional inflows of capital of $1M (perhaps you have earned a 10% dividend on your earlier investment in X). Unfortunately, the price of X has risen in the interim and no longer represents the value proposition it once did, although you’re still happy to have your earlier capital invested at the price available in period 0. In this case, you might invest the $1M in opportunity Y and, again, diversification would occur as a natural consequence of these developments whether it itself was desired or not.

In the final case, imagine you have total capital of $10M and have found an investment opportunity which could utilize your entire capital. However, you plan to accumulate in blocks because the investment is not liquid enough to take the $10M at once, and you do not want to make it obvious what you’re doing. You begin by investing $2M. Unfortunately, shortly after you do so a big-mouth blogger lets the whole world know about this great opportunity and the price of the investment opportunity rises to the stratosphere, pricing you out of any meaningful additional accumulation. You’re stuck with 80% of your capital uninvested and must look elsewhere. Again, diversification has occurred as a natural consequence even if it has not been actively sought after.

Ideal portfolio management implies no intended diversification

We’ve seen that diversification can result of two different catalysts– an investor can purposefully seek diversification in order to make a tradeoff between business risk and market risk (to self-insure his own decision-making process by giving up total return potential), or diversification can occur as the natural, unintended consequence of the general investment process.

Ideally speaking, the best situation for any investor to find themselves in is having one idea that has so much return potential relative to risk, that they are so confident about, that they are able to invest 100% of their capital in the idea, thereby avoiding diversification, or portfolioization, entirely. Ideally, one would have all their money at any given time in one idea and only one idea, and when that idea had either fruited, or a more profitable opportunity had arisen elsewhere, the investor would then sell the entire position and look to his next opportunity.

Outside of this ideal, portfolioization may occur inadvertently in pursuit of these very circumstances, in which case there is nothing to be upset over or critical about.

However, if diversification is pursued as a purposeful strategy outside the context of an individual contending with liquidity constraints (ie, perhaps investing 100% of capital in his best idea would put him in a bad position if outside demands for this capital, which are unpredictable, would require him to liquidate at an inopportune time), it stands to reason that an investor might ask himself, or be asked by another, “Why are you investing in something you’re not completely confident about in the first place?”

In other words, perfect confidence is unachievable (although it is the ideal), but it is hard to imagine why an investor would be justified in spreading his bets out across things he was less than as-confident-as-he-could-be about and consoling himself that he was doing well to mind risk thanks to diversification, when he could instead wait for an opportunity where his confidence about the risk-reward picture was as-confident-as-he-could-be and then invest all his capital in that one idea.

And of course, as almost always, I’d be wise to consider and hopefully even heed my own advice!