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Thoughts on Diversification


Viking
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I continue to think about diversification and what has worked for me in the past and what I want to do moving forward. 

 

Lets say that in the current environment, FFH moves to $220 Canadian (at $0.90 to US) = $198 US

 

Given what I know of FFH I would be comfortable putting 50% of my net worth in the company.

 

Are there any small business owners on this site? Is my proposal above any different that a business person who has most of their net worth tied up in a small business?

 

Regarding timing, I am not suggesting a holding period of forever. Rather, may experience has been that within 2 to 4 months the stock appreciates substantially.

 

Yes, there is a chance the company could blow up (earthquake etc)... less than 2% probability

Or they deliver between 10 and 20% ROE... most likely... 60%

or they underperform with <10% ROE...  25%

or they outperform with >20% ... 13%

 

What do others think? Reckless?

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It's not reckless but I wouldn't do it with a company that had  a 2% chance of blowing up.  That means over a 50 year investing career if you always have 50% of your net worth in one company than one year/morning you're going to wake up 50% more poor.  If the 7 lean years and near failure wouldn't have happened (it wouldn't be a $250 stock though would it) than I would probably think differently.  The insurance/underwriting/reserving risk is not one that I can grasp being outside the company.  Prem is probably the only one that can and I'm glad he's comfortable with it!

 

I would do it with a company that had a .5% chance of blowing up or the blow up would be good for the rest of the world and my holdings (ex: finding a better, cleaner source of energy than petro to a petro company). 

 

At $100 U.S now, I would feel comfortable with 33%40%, maybe more.

 

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Guest kawikaho

Buffett proclaimed he would bet 100% of his net worth in WFC at $10/share.  And, to most people at the time, and even now, WFC had a much greater than 2% chance of blowing up.  Infact, the CDS market was pricing for atleast a 25% chance of this happening back then.

 

I would bet 100% of my portfolio on BRk-A at $60k, MSFT at $10, GE at $5, etc...  no hesitation.  And my portfolio is well into 6 figures.  If FFH went to 100, it's all in for me.

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The better quote that I found on diversification and focus so far is one from Buffett. Here it is:

 

"Focus investing creates wealth. Diversification protect wealth".

 

It's actually more complex than that, but it's a pretty good summary.

 

Small business owners have overall far more chance of failure than if you have a diversified portfolio of very solid companies like MSFT, BRK, etc., but when they build from scratch a small business that his succesful over time, the return on their investment can simply be mouth watering. Something you could not dream of with Berkshire and Microsoft at their present size.

 

Regarding focus investing in stocks, I say when you've fund a given investment that has very strong odds of sucesss and a decently small chance of failure, a fat pitch if you prefer, then a good thing to do is to slam big.

 

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Viking,

 

Prem himself has 95% of his net worth in Fairfax, and most, if not all on this board, would say that he is smarter than I or anyone else on the board! As Yogi Berra has said "You can observe a lot just by watching"! Buffett has 99%, and Munger 90%... these guys are what the board is named after so we must think they are pretty smart!!!

 

Prem has built a fortune by owning for 20+ years the same company and having a large percentage of his wealth tied to this company. If you look at the Forbes 400 list or any other wealth list, it has been done by most the same way.. owning a concentrated portfolio of good businesses over the long term.... seems to be a huge disconnect between how the richest in the world got there, and how most people with anything to do with investing think, speak and act.

 

Is it better to get 100 Wayne Gretzkys versus 1? Well, yes of course but that is difficult.. I do not recommend owning one company (even though again, some of the Forbes list has done this!) but do recommend owning a concentrated portfolio of the best companies that you can find. Very difficult to find more than 10-20 Wayne Gretzky type investment opportunities in my view.

 

Up for debate on these points though... I will answer one answer before hand though... When Markel execs were asked the question what they would do different if they were running money privately they answered that the answer to that question should be "NOTHING".... so I understand that volitility can suck if running anopen ended fund, but let's forget about that debate point as it really has no merit for value investors... as they should not be worrying about the institutional imperative

 

I am interested to see what others think, so please let me know. Got to avoid gamblers ruin, but still have to be concentrated enough to actually move the needle when right.

 

 

 

 

Fact that thought would be of interest to most:

 

If a person had invested in six 'jockey' companies(without even caring about if they were cheap or not) 10 years ago they would have had over a 12% return versus the S&P which was negative! Would have been in the top of the fund managers!! (Fairfax was trading at like 4-5x book then as well!) This is in hindsight, but would not surprise if next 10 years were no different.

 

(LUK, MKL, FFH, BRK, BAM, L bought in May 1999 to May 2009)

 

 

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I am not a fan of large diversification: things need to move the needle, good ideas are not that frequent and we have so much time. Although, I have a hard time understanding how someone interested in investing cannot find 5 to 10 stocks with similar upside potential or undervaluation. If they have been researched properly, then you should be confident in their own merit and prospects. If that is the case, I would say that you will have a hard time overweighting significantly in any one of them.

 

If you consider Fairfax like a hedge fund or mutual fund and don't want to continually look/find individual securities, then putting 50% of your assets in it may make sense, but if you are an investor then its merit should be assessed against all other available opportunities.

 

If Fairfax is already a core position and represents 10 or 20% of your assets, I would suggest that you buy calls if a large stock price discontinuity occurs. In other words, the price moves so much that it increases the upside potential quite a bit vs your other stocks. So instead of going "all in" and abandoning other excellent opportunities, buy calls to effectively overweigh your position. Your risk will be much less, you will sleep at night and you will benefit the same way if things work out as you think. The market is not that dumb. Give them a year and they will jump in to if the value is truly there.

 

If options are not available, then you can sell your other companies to buy more, but you have to be extra careful because sometimes it is your analysis that is flawed and you are averaging down into a loser. It has happened to me a few times on companies that I was "sure" of my thesis. It has also happened a few times that I did not invest my full "quota" to see the price significantly appreciate.

 

Cardboard

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Keep in mind that you can diversify across several stocks OR you can buy a conglomerate stock which itself is somewhat diversified. To combine the two, you are getting a double whammy of diversification, which doesn't sound too hot.

 

E.g. say you own Berkshire Hathaway, you already own a very diversified stock, so if you now go out and buy 10 other stocks, you have really way too much diversification.

 

On the other hand if you buy a "single" service or product business, then you could buy 3-5 of them to be diversified. I think owning more than about 3 stocks is silly, but those 3 have to be VERY carefully selected.

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Scorpian, GE is nearly as diversified as it gets as well and someone who put a large amount of their worth in GE a year or so ago would be down over 60%. There are not any conglomerates that are anywhere near risk-free.

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One might argue if GE was properly diversified when the financial product division began to overshadow the industrial business. If you strip the financial business of GE from the industrial business, I would argue the latter would have been fairly well diversified and is as low-risk as you can find short of some fixed income investments yielding next to nothing. The moral of the story, if you mix a good business with a bad one, the bad one can taint the whole company.

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I continue to think about diversification and what has worked for me in the past and what I want to do moving forward.   

 

Lets say that in the current environment, FFH moves to $220 Canadian (at $0.90 to US) = $198 US

 

Given what I know of FFH I would be comfortable putting 50% of my net worth in the company.

 

Are there any small business owners on this site? Is my proposal above any different that a business person who has most of their net worth tied up in a small business?

 

Regarding timing, I am not suggesting a holding period of forever. Rather, may experience has been that within 2 to 4 months the stock appreciates substantially.

 

So basically, you are thinking of putting half-your net-worth into a 2-4 month hold. Forget that it's FFH. You're looking to daytrade or market-time 50% of your net worth?

 

I'm following up on this thread because I am a small business owner and you asked for our input.

 

About four years ago I put everything I had into buying out my partners. It was the single greatest investment I've ever made. My normalized net earnings have met or exceeded my purchase price of the company every year since I bought it. I retired all the debt financing it in 16 months. I'm a happy guy.

 

I was comfortable doing that deal because I lived and breathed my company and knew it inside out. The level of knowledge a small business owner has into his business will (or should) always exceed what any outside, passive investor could possibly gain into any public company. Even FFH, even BRK.

 

If you aren't rich, and you want to get rich, don't put half your net worth into any public company and hope it does the work for you. Fact is very few people become wealthy from investing in stocks. The number 1 road to wealth and financial independence is business ownership. So if this is your position, I wouldn't put 50% into FFH, I'd go out and buy a business. (The other thing is this: your business can make investments! Since I bought my company I have less personal investments, just enough to max out my RRSP allowance every year. The bulk of my investment I do from within my businesses. I like to view it as my own little micro-Berkshire or Fairfax :-P )

 

If you are already wealthy, I wouldn't be putting 50% into a 2-4 month play in anything. Especially the months we've been having around here lately. I think FFH is a pretty good place to park a sizable chunk your wealth and have minimal downside risk from here and a lot of upside over the long hold.

 

Also, just so I can become known on the board as "that crazy USD crash guy", you're assumptions to the downside are pretty mild. Over the next couple years  I think we'll all get off very lucky if we just see a  CDN at .9 USD or even a USD at .9 CDN.

 

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Agree completely with Mark Jr.

 

A few additional points

 

1. Buffett when he was running his partnership never had more than 40% of the portfolio in a single asset. Only after he was in control of Berkshire that he put his net worth into it.

 

2. This is what He said on this subject

 

Charlie and I operated mostly with 5 positions. If I were running 50, 100, 200 million, I would have 80% in 5 positions, with 25% for the largest. In 1964 I found a position I was willing to go heavier into, up to 40%. I told investors they could pull their money out. None did. The position was American Express after the Salad Oil Scandal. In 1951 I put the bulk of my net worth into GEICO. Later in 1998, LTCM was in trouble. With the spread between the on-the-run versus off-the-run 30 year Treasury bonds, I would have been willing to put 75% of my portfolio into it. There were various times I would have gone up to 75%, even in the past few years. If it’s your game and you really know your business, you can load up.

 

I do not think anyone can approach the level of intensity and focus and depth of understanding that Buffett brings to an investment. So for us mere mortals it would not be prudent to assume that we would have the same level of understanding that Buffett has on any investment. The thing to worry about in investing is "things that we do not know that we do not know". These kinds of surprises are far too common.

 

3. I would look at Klarman sizing and he generally had a 10-15% sizing on his top investment. This is I think a reasonable position for a very high probability, large margin of safety and with low probability of large loss. A larger position would be reserved for truly once in a lifetime, 20 punch rule kind of picks. Even in this case I would limit it to say 20-25 of Portfolio with maybe an exception for Berkshire, since it is managed with the understanding that several owners might have 100% of their net worth in it.

 

4. A wide variety of business lines might reduce some kinds of risk but a single business is exposed to certain risks that cannot be eliminated like litigation, rouge employee acts, etc.

 

5. My estimate for a blowup (defined as permanent loss of 30-40% or more of IV) would be something like 5% of more for FFH. That is we can expect one such event every 20 years. So this is not something that I would be comfortable putting anywhere near 50% of total portfolio.

 

Vinod

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Fact is very few people become wealthy from investing in stocks. The number 1 road to wealth and financial independence is business ownership.

 

Investing in stocks is business ownership, only on a fractional basis.

 

 

In theory, theory and practice are the same.

In practice...they aren't.

 

-mark

 

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You diversify because you either have (1) a fidicury duty, or (2) you don't really understand what you've got, or (3) you're not very good at hedging your risk. Because you may not be good at it, limiting your exposure to any one investment has long been recognized as the time-honoured mechanism by which to limit your screw-ups.

 

Small businessman get to be successfull because they've fully understood how their business makes its money, what its threats/opportunities are, & have learnt how to control their risks by adjusting the appropriate variables specific to that risk. The forecasts, budgets, product costs, minimum volumes, demand curves, etc are constantly getting updated in their heads - & they act swiftly as new information comes to light. The size of the business is irrelevant. On main street we call it control; on wall street we call it risk management and return optimization.

 

As investor; my risk management tools are essentially investment training, management assessments, financial analysis, critical thinking, option use familiarity, and tradeable positions. Liquidity & financial tools, versus the more direct 'control' of the small businessman - but the same result. 

 

If you hold more than 2-3 equities you're probably overdiversified.

 

Definately not MPT, but effective!

 

SD

 

 

 

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Always a fun discussion, to diversify or not?

 

Buffet reversed his position a few years ago. He used to tell the public "20 punchcards, use each one wisely".  But since then he learned that inexperienced people were taking him up on it, and then he's started saying "if you know nothing, diversify widely with a low cost index fund, if you are an expert you don't need to hold more than 6 positions".

 

Remember, Buffet's mentor Ben Graham, who's method Walter S. followed, was an advocate of wide diversification.  I think he held 100 or more securities at times. Apparently this was one of the sticking points when they discussed collaborating on an update of the Intelligent Investor.  Buffet ended up just writing the preface since they couldn't agree.

 

Royce also follows a high diversification model, but part of that is their large asset bases and small cap focus.  Walter S. did, and so does Tweedy and Browne, both Graham followers.  Fairholme, Klarman, Sequoia, Longleaf, and Buffet go for the less diversified model.

 

Personally I think that the more control you have over the business, the better it is to be concentrated.  Mark Jr has a huge degree of control over his own business, so it makes sense to go all in.  That said, I'm not sure I buy the comparisons when it comes to people like Watsa, Buffet, Gates.  The truth is that any one of them could lose all their money in FFH, BRK, MSFT and still have enough money to live the rest of their lives without working.  They each have millions outside the company stock, so the number and risk is a lot less relevant.  They aren't relying on their stock for their retirement really.  That's not the case for me, so going all in doesn't make sense.

 

Speaking of GE, and the Financial services bringing the whole thing down.  What if we get another Katrina, or two, plus an earthquake?  How badly would that hurt FFH?  I imagine they have reinsurance in case of such an event, but I don't know enough about their insurance to know for sure.  Also if you get one of these 1 in a 100 years disasters, what is the counterparty risk on the reinsurance?  I agree that FFH is diversified both because it is an umbrella company, and it has a portfolio of other companies, but the 'fat tail' event prevents me from making it a super oversized position.  it also prevents me from putting too much money in the cat-insurance sector.

 

Just my 2c :-)

 

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Fine discussion, but I couldn't let this slide:

 

Fairholme, Klarman, Sequoia, Longleaf, and Buffet go for the less diversified model.

 

Klarman????  I think you do not follow his methods closely.  Rarely will he ever put more than 5% in an idea.  His SEC filings as an example aren't even that concentrated, and they are roughly 20-40% of his asset base (if that).

 

He is far from concentrated at least in the definition used on this board and in most investing circles.

 

Ben

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Is there any other strategy besides these?

 

- concentrated investment in a single company well researched and meeting Fisher's GARP (growth at a reasonable price) criteria.

- statistical value investing where many bargins are bought with a net positive expectation but any which may blow-up.

 

 

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Mark Jr, I appreciate the comments. Regarding the holding period, to clarify, should FFH sell off dramatically, I do not expect the stock to appreciate in 2 to 4 months. Rather, that has been my experience of what has actually happened the past 6 or so years that I have been closely following the company. I would not have a set holding period.

 

Regarding understanding the company, I probably understand FFH better than any other company out there given the years spend following the stock, reading ALL quarterly filings and others opinions and observing management (and learning about competitors) etc. However, my understand would not be close to that of a small business owner of their own operation.

 

Question: when you made the plunge, how much of your net worth was tied up in your company? And for how many years?

 

My guess is it was well over 50% (perhaps closer to 80 or 90%). Is it really all that much different than what I am proposing?

 

Bargainman, great post. Actually, I think a bad catastrophe year would actually work in FFH long term favour. Right now many of their (and ORH) competitors have little 'wiggle room'. Investment losses that past year have cause large write downs and eroded capital. Interest income is anemeic (given low bond yields). Underwriting is OK. Many companies have also in the past year released a disproportionate amount of prior year reserves (in what appears to me) to help underwriting results. Capital markets are still not open for insurers. FFH, on the other hand, has been building excess capital the past two years (ORH alone has $550 million), interest income is very high compared to peers (given tax free munis etc) with OK underwriting. My guess is they have also been very conservative with underwriting losses (given the investment gains they had no reason to dip into prior year reserves to pad earnings). If we have a bad catastrophe year, FFH will survive and we will have the mother of all hard markets. The only question would be how much excess capital they would still have to write new business...   

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Mark Jr, I appreciate the comments. Regarding the holding period, to clarify, should FFH sell off dramatically, I do not expect the stock to appreciate in 2 to 4 months. Rather, that has been my experience of what has actually happened the past 6 or so years that I have been closely following the company. I would not have a set holding period.

 

[snip]

 

Question: when you made the plunge, how much of your net worth was tied up in your company? And for how many years?

 

My guess is it was well over 50% (perhaps closer to 80 or 90%). Is it really all that much different than what I am proposing?   

 

Hey Viking, apologies if I did a misread on your meaning.

 

I think the key difference is going all-in or 50%-in on your own company vs. somebody else's. All the value-investing legends we follow here are near fully invested, with seemingly little diversification in their own companies or conglomerates, everybody else is along for the ride and taking a leap of faith, albeit a fairly well educated one in a lot of cases here.

 

As was pointed out in another post, if BRK went to zero tomorrow, Buffet has enough outside of it to live comfortably. Same is likely true for all the rest. So yes, they are concentrated, but they are probably also diversified enough to survive a catastrophic implosion of their babies without having to get a job at Starbucks afterward.

 

Since I took over my company one of my goals has been to diversify outside of it. I frequently ask myself if by diversifying my outside investments I have sacrificed growth within the primary company. It is possible. But my business is the internet and there is not much of a historical track record in my industry to gauge how things will go through various long economic cycles.

 

The whole thing could blow up around noon today and civilization would somehow muddle through if nobody could send email or surf the web anymore. Most of this stuff didn't exist 15 years ago and we got this far without it. In my mind, it means the "moat"  around my entire industry is pretty narrow.

 

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What he probably means is that a startup can have 1000% returns in a very short period of time, very unlikely to find that in the stock market in a short period of time. On the other hand, it is said 95% of small businesses fail so 1000% * 95% failure rate = 50% return which may be comparable to buying a big public company that has a failure rate close to zero.

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Nothing is correct when viewed in a vacuum.  Diversificiation is dependent on the investor's abilities and emotional constitution, thus it isn't a one shoe fits all type of question.

 

The other issue of Prem and Warren having 90%+ of their networth in one business is also erroneous.  The 10% of Prem's net worth that isn't in Fairfax would be about $50M...that's a hell of alot of money to live on even if Fairfax implodes in the worst case scenario.  In Buffett's case, 1% of his net worth is $500M, or Prem's entire net worth!  If Berkshire collapses tomorrow, Buffett won't be standing in any bread lines, neither will his children, grandchildren, great-grandchildren...well you get the point!

 

Diversification changes with age, temperament, abilities, constitution, the construct of the holdings (inside a corporation, retirement plan), etc.  For myself, I have no problem holding just one investment at any given time, but I doubt I could do that over many, many years, unless it is my own company.  Even if I have my whole net worth in say Berkshire, there will come a time where I will say to myself that perhaps the stock is overvalued and market risk could be mitigated by moving it to undervalued ideas.  It doesn't negate the long-term prospects of Berkshire, but I would simply be acting in a prudent manner.

 

Now you can't do the same thing with investor capital, because each partner will have a different mindset.  If you go through a period such as we have, you will get some investors who become very afraid.  Unless you have liquidity, you will have to sell to meet redemptions, thus you cannot stay fully invested in one single stock...especially if it isn't liquid.  The only way you could so, is if you do what many other hedge fund managers do, and lock in your partners, close the fund, or only allow redemptions once a year.

 

The end result is that diversification cannot be viewed singularly or in a vacuum.  There are many aspects to why someone should or should not be diversified.  And safety of capital isn't one of them...just ask Bill Miller!  Cheers!  

 

 

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