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Diversification and the Value investor


Guest longinvestor
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Guest longinvestor

For a value investor's portfolio,

 

1) how many 15% ideas?

2) how many 10% ideas?

3) how many outlandish/wild card ideas?

4) should there be a limit on total # of holdings?

 

A question that keeps coming back again and again to me and I thought of starting a thread on this.

 

Ever since I got into value investing in 2001, I've narrowed mine to 3 stocks, fewer and fewer mutual funds, now down to 2, cash and a short position on the market. I've wondered about diversification but have been lazy to do anything especially since FFH and BRK which I consider to be 15% ideas, keep dipping down for me to buy more. The 3rd stock is LVLT which is an absolute mistake from an opportunity cost perspective but am still holding since I dont see it going to zero in the next 5 years. I suppose it is a wild card idea for me.

 

How do you approach these ?s, not my stock ideas but the number of holdings in your portfolio.

 

 

 

 

 

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A value investor can have 3 or 100 stocks in it's portfolio, that doesn't change the fact that he's a value investor or not to me, but the first would prefer focused portolio management and the other would prefer diversified portfolio management.

 

That being said, that concept goes further to me. To own Berkshire Hathaway is far different from owning a phase 2 unique product pharma company. One has very diversified streams of operational cash flows while the other is surviving on hope.

 

And when you think about it, most of active business men have an extremely focused investment portfolio. A lot of them own only stocks in 1 company (their own) that is generating operational cash flow in just 1 industry.

 

Cheers!

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Buy as many companies as you can find and do sufficient research on that fit your level of value/potential/margin of safety requirements.

 

Never buy or hold more companies then you can keep track of in the way that they should be kept track of.

 

For me this usually means holding less then 10 positions because of how many I can find, research and keep track of.

 

beyond that I don't think that there is any rules in my book.

 

I would personally love to be more diversified but I will never diversify for diversity's sake if that means not understanding the businesses I am investing in.

 

SmallCap

 

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Guest longinvestor

Buy as many companies as you can find and do sufficient research on that fit your level of value/potential/margin of safety requirements. Never buy or hold more companies then you can keep track of in the way that they should be kept track of.

For me this usually means holding less then 10 positions because of how many I can find, research and keep track of.

beyond that I don't think that there is any rules in my book.

SmallCap

 

How I got to my 3 names from many. I now wonder why not just 1? That way I have all the time in the world to not keep track of stuff. Now that is the real non-diversification for you! When it is more than 1 it is diversification, not matter if it is 3 or 10 or 100. But why? how? This is what I am hoping we can discuss in this thread.

 

Just curious, your "less than 10 positions", did it come from having 10 hours a week to research or something like that? And have these been different 10 positions at different times during the past decade? Mine have been the same 3 over the past 10 years and like I posted before, it took some mental adjustment on my part to move my other mutual funds etc into these 3 names. Mr (stupid) Market allowed me to do this often, as I am hoping it will again in the coming months.

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I have tried to be more focused. I have tried to keep # of holdings to less than 10. I think having 1 or 2 would be too little-I probably do not enough confidence to choose the right security-though I would be comfortable holding security like BRK, FFH, LUK.

 

Trying to be more focused has forced me to be more selective, more critical of any particular idea. I ask myself if any particular security is better or cheaper than what I already hold before buying.

 

Did WEB not say that we should have a very limited # of ideas during are lifetime. He talked about having a card with only so many hole punches that we can use to make selections.

 

Don t put all your eggs in one basket vs Have less baskets, but watch baskets very closely.

 

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Guest longinvestor

 

Thanks for that link. It has useful content including the VIC presentation with the exact title of interest to me.

 

Looks like, ultimately, mental make up decides the concentration. I have had to make many mental adjustments, including the one which lead me to post this thread. I have never felt more comfortable than now with concentration, despite uncertain markets and such. I sleep well now. Also my mental make up today is to not be a busybody in the name of "finding" values. My question "how many 15% ideas?" has this in background. Also that value investing is a loose term. Lynch was right, when you take your 15% to the bank it does not matter if it came from 1 or 3 or 100 ideas, it is just greenback. I (we) have been spoiled that for ten long years, FFH and BRK continue to be deep value ideas themselves, making me not work hard at all. I doubt very much that 5 years from now we will see this kind of opportunity, so I am making the proverbial hay now. It does not get better than this. Never-in-history times will be these....looking back from 2020 or later! I have even bought the mythical "$10000 invested in BRK in 1954...." in my kids accounts at these prices. Simply unbelievable!

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Thanks for that link. It has useful content including the VIC presentation with the exact title of interest to me.

 

Looks like, ultimately, mental make up decides the concentration. I have had to make many mental adjustments, including the one which lead me to post this thread. I have never felt more comfortable than now with concentration, despite uncertain markets and such. I sleep well now. Also my mental make up today is to not be a busybody in the name of "finding" values. My question "how many 15% ideas?" has this in background. Also that value investing is a loose term. Lynch was right, when you take your 15% to the bank it does not matter if it came from 1 or 3 or 100 ideas, it is just greenback. I (we) have been spoiled that for ten long years, FFH and BRK continue to be deep value ideas themselves, making me not work hard at all. I doubt very much that 5 years from now we will see this kind of opportunity, so I am making the proverbial hay now. It does not get better than this. Never-in-history times will be these....looking back from 2020 or later! I have even bought the mythical "$10000 invested in BRK in 1954...." in my kids accounts at these prices. Simply unbelievable!

 

I think that the role of emotions in "rational" decision-making is deeply underrated. There are so many factors to consider in even small decisions that if we had to work through them all we would just sit at home considering nuances. Just like ants use pheromones to communicate short cuts, we use conviction, boredom, greed, etc. to guide our logic systems.

 

That being said, diversification is a hedge when the nuances become a big deal, and our decision making framework skips over the difference because of years of success. I would point to Bill Miller with financials, Weitz with Countrywide, and Pabrai with DFC and CCRT and PNCL. It's easy to point fingers at their mistakes, but it's more productive to realize that all those men are very smart and very successful and they still screwed up. My guess is that their past successes produced emotional networks which caused them to feel too comfortable with some risks, and too certain in the face of new information.

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"My guess is that their past successes produced emotional networks which caused them to feel too comfortable with some risks, and too certain in the face of new information."

 

-good quote on Farnham's blog site from Mark Twain:“It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so.”

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A value investor can have 3 or 100 stocks in it's portfolio, that doesn't change the fact that he's a value investor or not to me, but the first would prefer focused portolio management and the other would prefer diversified portfolio management.

 

That being said, that concept goes further to me. To own Berkshire Hathaway is far different from owning a phase 2 unique product pharma company. One has very diversified streams of operational cash flows while the other is surviving on hope.

 

And when you think about it, most of active business men have an extremely focused investment portfolio. A lot of them own only stocks in 1 company (their own) that is generating operational cash flow in just 1 industry.

 

Cheers!

 

 

Profound words of wisdom, Partner 24.  Owning only BRK and FFH,for example, will almost certainly give better returns and lower volatility than owning a diversified portfolio.  Not to mention, much lower risk of permanent loss of capital. ( Subject to review of course because of change )

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Guest longinvestor

And when you think about it, most of active business men have an extremely focused investment portfolio. A lot of them own only stocks in 1 company (their own) that is generating operational cash flow in just 1 industry.

Cheers!

That is great insight. The most successful, active, business owners like you point out have always focused on the one thing they are good at. A friend of mine who is a local rental property czar is concentrated in that he has a narrow playfield he chose, within a 10 Sq mile area, multi-family housing, demographic pool etc. He exactly knows how and where his cash flow comes in. We, as passive investors, also need to approach our stakes similar to owner-operators.

 

We have to however inextricably place trust in owner operators we align with. They can screw up but I suppose trustworthiness of the owner operators trumps all else. This is a huge factor in my decision to concentrate in PW/WEB...

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Thanks for that link. It has useful content including the VIC presentation with the exact title of interest to me.

 

Looks like, ultimately, mental make up decides the concentration. I have had to make many mental adjustments, including the one which lead me to post this thread. I have never felt more comfortable than now with concentration, despite uncertain markets and such. I sleep well now. Also my mental make up today is to not be a busybody in the name of "finding" values. My question "how many 15% ideas?" has this in background. Also that value investing is a loose term. Lynch was right, when you take your 15% to the bank it does not matter if it came from 1 or 3 or 100 ideas, it is just greenback. I (we) have been spoiled that for ten long years, FFH and BRK continue to be deep value ideas themselves, making me not work hard at all. I doubt very much that 5 years from now we will see this kind of opportunity, so I am making the proverbial hay now. It does not get better than this. Never-in-history times will be these....looking back from 2020 or later! I have even bought the mythical "$10000 invested in BRK in 1954...." in my kids accounts at these prices. Simply unbelievable!

 

I think that the role of emotions in "rational" decision-making is deeply underrated. There are so many factors to consider in even small decisions that if we had to work through them all we would just sit at home considering nuances. Just like ants use pheromones to communicate short cuts, we use conviction, boredom, greed, etc. to guide our logic systems.

 

That being said, diversification is a hedge when the nuances become a big deal, and our decision making framework skips over the difference because of years of success. I would point to Bill Miller with financials, Weitz with Countrywide, and Pabrai with DFC and CCRT and PNCL. It's easy to point fingers at their mistakes, but it's more productive to realize that all those men are very smart and very successful and they still screwed up. My guess is that their past successes produced emotional networks which caused them to feel too comfortable with some risks, and too certain in the face of new information.

 

Very insightful!

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Great thread.

 

I tend to vary between 1-5% position size (although 10-30% in retirement accounts).

I find myself not wanting to own something unless I can see myself building 2.5-5% position.

This confidence usually comes down to management's capital allocation, valuation, industry structure/business quality

The 20 hole punch idea is challenging... but a wonderful metaphor.

What do others look at for getting confidence for 5-10% + position size?

 

Great article about Michael Price and how he handles position sizing:

http://www.gurufocus.com/news.php?id=105074

 

"What do we do to give us conviction? 1.) Find compelling bargains, not slight bargains. 2.) Test everything with sensitivity analyses. 3.) Prepare to be wrong. It’s not courage, it’s arrogance, when you buy something, you’re saying you’re smarter than everyone else. We realize we have lots of smart competition and temper our arrogance with humility to realize that many things could go wrong. Our own confidence matters, and we’re highly disciplined buyers and sellers to avoid round trips and take advantage of short term sell offs." - Klarman (May 2010)

 

 

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I like Philip Fisher's guidelines.  See pages 116-127 of Common Stocks and Uncommon Profits.  He suggests you divide your stocks in three groups A, B and C.  A firms are larger diversified firms who have many end users (e.g. BRK-A, IBM, LUK, L etc.).  B firms have a expertise in one or two areas and C firms are the options (you are going to be right or you are going to lose all your money).  He recommends less than 20% for A stocks, 10% for B stocks and 5% for C stocks.  Of course firms have to meet your other criteria as well.  This combined with a Kelly ratio can provide a good starting point.

 

Packer

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I like Philip Fisher's guidelines.  See pages 116-127 of Common Stocks and Uncommon Profits.  He suggests you divide your stocks in three groups A, B and C.  A firms are larger diversified firms who have many end users (e.g. BRK-A, IBM, LUK, L etc.).  B firms have a expertise in one or two areas and C firms are the options (you are going to be right or you are going to lose all your money).  He recommends less than 20% for A stocks, 10% for B stocks and 5% for C stocks.  Of course firms have to meet your other criteria as well.  This combined with a Kelly ratio can provide a good starting point.

 

Packer

 

I didn't understand the comment "less than 20% for A stocks" so I looked it up and added a bit of detail below.

 

Fisher's rough guide for minimum diversification was a maximum of 20% allocation to each "A" type company.  Maximum allocation of 10% to each "B" type company etc.  If you invested only in A companies then you should own 5 or more.  If only invested in B companies then should own 10 or more. etc.

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This doesn't make too much sense to me, let's say Berkshire, when younger was an A or B company, even Buffet was willing to put 100% of his net worth into it, what's the point of having 5 positions of diversified conglomerates? The duplication of values would be so large as to give similar results to owning 1 good one.

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These are initial guidelines for investment (money going in) not guidelines for re-allocation once one of the winners becomes large.  I think given Berkshire's exposure to many segments of end demand (even as a smaller firm via its portfolio) would be considred an A firm early on.  These are conservative guidelines and with the Kelly fromula can reduce your risk of ruin.  If you feel comfortable taking on more risk (you are just starting out and your dowside is limited comapred to your future income) then go for it but just like margins of safety this is diversifiaction margin of safety.  I think most of the value investors we all sudy follow some form of this (I know of very few value investors who put going in 50%+ into one stock - as a result of appreciation this may be the case).

 

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This doesn't make too much sense to me, let's say Berkshire, when younger was an A or B company, even Buffet was willing to put 100% of his net worth into it, what's the point of having 5 positions of diversified conglomerates? The duplication of values would be so large as to give similar results to owning 1 good one.

 

From Buffett's perspective, Berkshire *was* his portfolio at the time (Not true, strictly speaking, but the general principal still holds).  Since he has direct control of the capital allocation at Berkshire, it's just splitting hairs to say he has 100% of his assets in one "investment".

 

I think the 20% principal is just hedging for future change.  Will people *always* be able to trust management at Berkshire?  In 50 years?  100?  500?  I wouldn't even bet that they'd be *around* in 500 years.

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so perhaps an added note can be, if an investor you like and trust allocates 100% of his net worth to a stock, maybe it's worth doing the same. However, I would point out how difficult it is to find out the net worth of somebody in an investment if they don't come right out and say it. Holding data shows only % ownership of a company and does not say how much of that person's personal money (5%, 10%, or 100%) that represents.

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so perhaps an added note can be, if an investor you like and trust allocates 100% of his net worth to a stock, maybe it's worth doing the same. However, I would point out how difficult it is to find out the net worth of somebody in an investment if they don't come right out and say it. Holding data shows only % ownership of a company and does not say how much of that person's personal money (5%, 10%, or 100%) that represents.

 

What happened today with LUK is why I find it difficult to put more than 30% of my networth into an idea. You just cant control black swans.

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