Someone who reads the blog sent me this email:
"I have been thinking about portfolio construction lately.
…due to the strict standards you have, I thought it was very natural to just hold mainly four stocks…unfortunately, this method has shown its short comings lately. Both because of (your) mistake in picking CLUB/WTW instead of the other winners discussed in Avid Hog/Singular Diligence, and also because I am currently getting in touch with a lot more very cheap opportunities in the Asia region…I have also been rereading Buffett's partnership letters and was reminded he once held like 40 stocks. Even though he concentrated at his top several positions sometimes and also he sometimes put 30% to 40% of his portfolio into the workout category, he did say they usually have fairly large positions (5% to 10% of their total assets) in each of five or six generals, with smaller positions in another ten or fifteen. (This) of course is a far cry from the 20%/25% position sizing we usually talk about…
What are your thoughts? Is it actually better to spread our portfolio a bit more?...I am getting more and more the feeling that finding the right stock is not the most important part, but picking the right ones to actually put money in is the key. Would (being) willing to spread a bit more make this key job easier? The very cheap stocks I am finding these days may not fit something you will invest in as they are likely not good buy and hold investments. Yet they are also not exactly like cigar butts, i.e. not of very, very low quality stuff. Is it wise for me to ignore them in my personal portfolio and just pick those that are more like the buy and hold category?"
I hold 4-5 stocks because I find that is most comfortable for me. You want to combine an approach that makes enough objective sense to work for anyone in theory with an approach that makes enough subjective approach for you to carry it out in practice. I found owning 20 stocks was not practical for me. I spent more time watching what I owned than coming up with a good list of new stocks to research. I didn’t spend enough time focused on what I was buying. When I owned 20 stocks, I spent too much time on the HOLDING and the SELLING and not enough time on the BUYING. It’s no accident that the only thing we do for Singular Diligence is tell you which stock to buy. We never revisit it. We never tell you to sell. It’s all focused on a one-time buy decision. I think that’s the decision that really matters. If you get that moment right the next 5 years or more will take care of themselves. There’s just a heck of a lot of time spent on stuff other than worrying what to buy next when you have 20 stocks. When you have 5 stocks, you can spend all your time thinking about what you want to buy next. I don’t want a situation where someone asks me “So what stocks do you own” and I go: “Oh, let me just check this list here.” That’s a problem unless you choose to embrace almost total neglect of what you own. I think Ben Graham mostly did that. It’s okay to own a lot of stocks if once you buy them you just forget about them. It’s not okay if you spend a lot of time wondering whether you should sell. And if you own 20 stocks, there will always be one or two you’ll be thinking you should probably sell because their price has risen so much or something has changed. Pretty soon you are thinking as much about selling as stock picking. I don’t like that.
At many times, I held many more stocks than I do now. These were usually special situations, micro-cap value stocks, etc. I find the experience less comfortable for me. For many other people, the reverse is true. They prefer holding more stocks. I think that is fine.
I don’t think the big issue is whether you HOLD a lot of stocks or HOLD very few stocks. I think the issue is whether you BUY a lot of stocks in any one period.
Most people I talk to could benefit from higher selectivity and lower activity.
Some of these people buy 12 stocks a year and sell 12 stocks a year. That means they are making a buy or sell decisions once every 15 days or so. That’s a lot of work. It is too little thinking and too much acting.
On the other hand, you can own 30 stocks and be relatively inactive. Let’s say you own 30 to 50 stocks and you hold a stock for an average of 5 years. If you hold 30 stocks for an average of 5 years, that means you only need to buy one new stock every 2 months. That is more manageable. And you can eliminate the sell decision by just waiting 5 years and then selling.
So, let’s say you own 30 stocks and hold each for 5 years and then sell. Now, every 5 years all you have to do is make 30 buy decisions and no sell decisions. That is just one decision every 2 months.
The benefits of diversification beyond 30 stocks is minimal. The dangers for holding a stock for too long when you sell automatically in 5 years is low. So, I think you can be a selective stock picker who holds 30 stocks. The way to do that is to forget about selling. And to hold stocks for 5 years.
Let’s take an example of a stock I’ve been “stuck” with. George Risk. The business has done fine. The stock was cheap - on an EV/EBIT basis - when I bought it. It is still cheap today. This is the classic example of a no catalyst stock. It is dead money. But, otherwise it was not a bad stock pick. I was not wrong about the business’s future. I did not overpay. It was safe when I bought it. It’s safe today. So, it is a financially strong company selling at a cheap price. This was true then and now. But, as many were right to point out when I bought it - there’s no catalyst.
I've held George Risk shares for about 5 years. It paid some dividends during that time. Let’s go back exactly 5 years - not the precise date I bought, but it works well for this example. George Risk stock is up 80% over those 5 years. The S&P 500 is up 92%.
So, George Risk underperformed. This can be a selection problem. Maybe the lesson is never to buy a stock without a catalyst. Don't buy a stock where management is piling up cash year after year after year. Or it could be a matter of luck. Maybe George Risk is the kind of stock that will have a catalyst if I bought today and held for the next 5 years - but it didn't for these 5 years. Obviously, if the family chose to pay a special dividend or sell the company or something - the return would be big and instant. This is an $8 stock with $6 in cash.
Diversification can fix this problem. You find maybe 5 stocks like George Risk - I’m not sure there are 5 stocks like George Risk, but let’s pretend that's not the problem - and you split your money between them. If you want to hold say 25 stocks, then you simply diversify by putting 20% of your portfolio into “George Risk type stocks” rather than putting 20% of your portfolio literally into George Risk.
I think that’s fine. I even think it’s a good idea. I think any time you can find 5 stocks of a certain “type” it is a good idea to split your money between them.
Right now, I own:
- Babcock & Wilcox
- Ark Restaurants
- Weight Watchers
- George Risk
I could easily own something like Tandy or Ekornes instead of one of those stocks. See Quan’s post on “Stocks Picked and Lessons Learned” for details of the stocks that we picked for Singular Diligence and therefore could be in the portfolio.
Quan broke some of those stocks down by category. I think it’s a wonderful idea to diversify by category. So, if you really like net-nets and you really like franchise (wide moat) stocks and so on you divide your portfolio not in stocks - but into categories.
You can do the same thing with countries. A lot of countries move together though. So, I don't think this provides as much diversification as the financial press and mutual fund marketers would lead you to believe. If you own Dow Jones type companies in the U.S., U.K.., France, Japan, etc. I am not sure you get that much diversification aside from currencies. And it’s a lot of work for you. And you don't know the cultures. And you don't speak the language. And there are different laws. And your selectivity could suffer.
But, I think it's a wonderful idea for an investor to split his portfolio into half domestic and half foreign. So, if you live in France keep half your portfolio in Euros and half in Pounds and Dollars and Yen and so on. This gives you some diversification away from your currency. It gives some diversification against the risk that your specific country at this specific time is in a bubble or something and you don't see it.
So, let's review. I think a half and half diversification among foreign and domestic is good if you can do it. And I think a 5 instead of 1 diversification by category - net-net, growth, franchise, value, turnaround, etc. - is good. When Quan and I were looking at Carnival, I wanted to invest in Carnival because I believed that oil prices - which were then close to $100 a barrel for the Brent type stuff Carnival was buying - should tend to be priced around $60 or so in the future. I looked at oil and said I can see the sense in $30 prices and the sense in $70 prices. There's no sense in $100 prices. And so I was eager to buy Carnival because it was in a business with durable demand in terms of volume and it had a good cost structure when you took out fuel. But, notice, you could have said the same thing about Southwest. A lot of the arguments against Carnival and Southwest were that their costs weren't good when you included fuel and that they weren't cheap on recent earnings. Also, their ROEs were low. But, if the price of oil falls from $100 to $50, then suddenly their costs are better, their ROEs are good, and their P/Es are nice and low enough. So, Carnival and Southwest were in the same category. And I see no problem with saying instead of putting 20% in Carnival you put 10% of your portfolio in Carnival and 10% in Southwest and say it's one 20% bet that will go wrong if oil never plummets.
We can do the same thing today with Progressive (PGR), and Valley (VLY). We did a Singular Diligence report on Progressive. We mentioned how we thought future earning power would be higher because their investment assets which are a lot of short-term government backed debt pay next to nothing now but will pay more in the future. Let’s say they are mostly in two year notes that yield 0.5% right now. Well, in normal times, the yield on that same debt would be 5.5%. The long-term history of Progressive's investment portfolio is about 5.5% returns or something like that. You'd expect 5% to 6% returns. And yet you have some people looking at the stock and saying the portfolio may only make 2% a year till rates move. So, why invest now?
Valley National has the same problem. If you read the Morningstar analysis - for instance - they complain that Valley's efficiency ratio is not good anymore.
The problem with the efficiency ratio as used in banking is that it is a ratio of expenses to revenue. It is not a ratio of expenses to assets. Nor is it a ratio of expenses to deposits.
Really, the cost side of banking should be the ratio of expenses to deposits. Deposits may be liabilities but they are the ultimate source of all earning power. This is the same way that float is the ultimate source of all of Progressive's investment earning power.
The efficiency of Progressive’s investment business should be judged by the cost of its float - not the investment income generated by the assets it finances with float. Likewise, Valley's efficiency or lack of efficiency should be judged by its cost of deposits not its expenses divided by revenue. Valley does not control its revenue - which is set mostly by interest rates - any more than Progressive controls its investment income.
So, here we have two stocks - Valley and Progressive - that aren't cheap on today's numbers. But, if we imagine interest rates of 6.5% on the 10-year bond instead of 2.25% today - you have a different earnings picture on the same dollar amount of loans.
Therefore, Progressive and Valley are both part of the same category of stocks that would be cheap if interest rates were “normal” but are not cheap today. So, just like you could split your money into Carnival and Southwest and admit the risk - that oil prices would never plunge - was the same in both stocks, you can buy both Progressive and Valley today and admit the risk - that interest rates will never “normalize" - is the same in both stocks.
So, I would endorse that kind of diversification. I would endorse putting 10% of your portfolio into Carnival and 10% of your portfolio into Southwest instead of 20% into only one if you felt oil prices should drop by half and the stock market price for oil consuming companies didn't reflect this.
I would also endorse putting 10% of your portfolio into Progressive and 10% of your portfolio into Valley instead of 20% into only one if you felt that interest rates will skyrocket from here and the stock market price for interest collecting companies doesn't reflect this.
Just recently, we published a Singular Diligence issue on Swatch. Swatch is the cheapest really good watch company. It has a huge business in China. It is big in the actual production of components for watches. It is a manufacturer - not an assembler. Movado is the opposite. It is not as high quality a business as Swatch. But it's an even cheaper stock. It is big in America and small elsewhere. It has a big licensed brand business. It is an assembler - not a manufacturer. It is not big in components like Swatch is.
I think both Swatch and Movado are good long-term values. They both look like excellent relative values.
So, if by diversification you mean instead of something like a portfolio that includes this:
- Carnival: 20%
- Progressive: 20%
- Swatch: 20%
You want a portfolio that looks more like this:
- Carnival: 10%
- Southwest: 10%
- Progressive: 10%
- Valley: 10%
- Swatch: 10%
- Movado: 10%
I think that's great. I think you are still making the same bets - oil prices will fall, interest rates will rise, some watch companies are too cheap - without putting as much money in any one stock.
But, there's also a selectivity element here. I only approve of this kind of diversification because Southwest has a similarly excellent 30 year past record as Carnival. Because Valley has a similarly excellent underwriting record as Progressive. Because Movado - although a one brand company plus licenses and big only in the U.S. - has great mindshare where it does compete. In its price category and country (the U.S.) the Movado brand is actually much stronger than anything Swatch sells here.
So, I don't think the deterioration in quality - the compromise brought on by less selectivity - is high in picking both Carnival and Southwest instead of just Carnival, or both Progressive and Valley instead of just Progressive, or both Swatch and Movado instead of just Swatch.
But, let's stop now and talk about an instant where the compromise in quality was great and the results of diversification dangerous.
We made a mistake buying Town Sports (CLUB). Quan and I both bought this stock. And both of us have since sold it. We also wrote a Town Sports issue for Singular Diligence. So, our subscribers suffered as well.
We actually picked two gym stocks for Singular Diligence. One was Town Sports. The other was Life Time Fitness. You can read about those two gym stocks in Quan’s blog post.
For Singular Diligence, we made a diversified mistake. Town Sports stock did very badly. Life Time Fitness did well. At the time Quan wrote that blog post, Town Sports was down 41%. Life Time Fitness stock was up 46%. The net result of those two picks is bad. If you put $5,000 in Town Sports and $5,000 in Life Time Fitness – you did badly.
But some of our subscribers did worse. They bought Town Sports but did not buy Life Time Fitness. Quan and I did the same. We bought Town Sports. We did not buy Life Time Fitness. Actually, Quan owned Life Time Fitness at one time. But, that’s not relevant to this discussion here other than to show he was smarter than me in recognizing the virtues of Life Time Fitness but not smarter in recognizing the vices of Town Sports.
Now, we could say this is a diversification problem. Subscribers who put even amounts of money into all our newsletter’s picks would do better than those who bet only on Town Sports but not Life Time Fitness. Buying an even amount in every stock we pick gives you safer results.
But there’s a problem. Quan and I bought Town Sports but not Life Time Fitness. We did that with our own money. We also wrote about both Town Sports and Life Time Fitness in Singular Diligence. So, we – by diversifying – gave our subscribers the opportunity for better net results than we ourselves got. They could put one egg in each basket. We picked the bad basket for ourselves.
Here’s the catch. If you had told either Quan or me that we could pick only one gym stock for Singular Diligence – we both would’ve answered: “Life Time Fitness”. If we could only ever buy and hold one gym stock – there’s no question we would’ve said “Life Time Fitness”.
So, you have three different ways of selecting. When given the “Punch card” rule of having a card with only 20 punches for a lifetime of investing – we are forced into the stock that did better. If we had only one “punch” to use on a gym stock – we’d use it for Life Time Fitness. Life Time was the better buy and hold than Town Sports. We knew that even when we picked them both.
So, too many punches can results in picking one good and bad stock versus just one good stock. If we were “stuck in one gym stock forever” we would make sure that gym stock was Life Time Fitness. No doubt about that.
But then why did Quan and I buy Town Sports?
We focused on the upside. In our own portfolios, we looked at the highly leveraged and very cheap Town Sports and the anti-leveraged (they actually owned a bunch of land that wasn’t fully mortgaged up at the time) Life Time Fitness and we chose based on upside potential. We were greedy. We weren’t fearful. Fear would have forced us into Life Time Fitness. Greed lured us into Town Sports.
So, what’s the lesson?
If you think in terms of which stock in an industry would you pick if you had to buy and hold it forever – you would be more likely to pick a stock like Life Time Fitness.
If you think in terms of diversification – you’d pick both Life Time Fitness and Town Sports.
If you think in terms of immediate upside potential – you’d pick Town Sports.
In our own portfolios, Quan and I applied Warren Buffett like levels of concentration. Yet, we included a stock Buffett would never pick. Might he own Life Time Fitness? Maybe, I guess. Might he own Town Sports? No. Definitely not. Let’s put it this way: if Warren Buffett was ever going to buy a gym stock – and I’m not at all sure he ever would – there’s no doubt that gym stock would be Life Time Fitness.
So, maybe greater diversification is the safest bet. Or, maybe greater selectivity is. Certainly, thinking in terms of moat and financial strength and which stock would you rather own forever leads to safer stock picking. Focusing on the upside adds risk. Focusing on the downside lowers risk. Focusing on the short-term adds risk. Focusing on the long-term lowers risk. Diversifying waters down risk and return. So, it reduces risks that you take that the rest of the market doesn’t.
Let’s look at our other disaster: Weight Watchers. This is a debt story. If you asked Quan and I what weight loss company would we buy if we had to hold it forever – we’d say Weight Watchers. If Warren Buffett had to buy one weight loss stock, which would it be? No doubt. It would be Weight Watchers. Now, he might never buy any weight loss stock. That would make perfect sense. But, if you are going to buy a weight loss stock the only claim any of them has to any sort of moat or franchise is Weight Watchers.
Buffett would certainly never have bought Weight Watchers when we did. It was up to its nose in debt. That was our mistake.
Quan and I both still own Weight Watchers. We like the business better than Town Sports. We did when we picked those stocks. And we still do now.
Weight Watchers has done horribly as a stock though. The business has done badly. The stock has done worse. You can read Punch Card Investing’s post in August of 2013 to see how right Punch Card was and how wrong Gannon and Hoang were on Weight Watchers.
That’s a mistake. We’ll make them. We’d make them whether or not we diversified. As we’ve said on the blog before – Quan and I certainly regret picking Weight Watchers for Singular Diligence. You can’t have a stock down 75% or more and expect subscribers to stick with it. We both still own the stock ourselves though. If we thought Weight Watchers was a mistake to buy in our own portfolio – you might guess we’d sell it by now. We haven’t. I won’t say that means we don’t think it’s a mistake. But, I would say we consider our error in buying Town Sports to be clear in a way our error buying Weight Watchers was not and still is not. Town Sports was a much worse mistake than Weight Watchers. This is from our perspective. For the market result, Weight Watchers was a truly terrible error.
Diversifying can reduce the loss in something like Weight Watchers. If you owned 20 stocks instead of 5 – you’d cut a 20% stake in Weight Watchers to 5%. If you had a 75% loss in Weight Watchers you’d lose 15% of your portfolio in a 5 stock portfolio and just 3.75% of your portfolio in a 20 stock portfolio.
The truth here is pretty simple. Avoid making 75% losses. The way to do this is easy. Don’t buy stocks that are leveraged at like 5 times EBITDA. If you buy stocks with no debt – you aren’t going to lose 75% on the stock if you are at all good at picking the company. The reduction in Weight Watcher’s enterprise value is a lot less than the drop in its market cap. This was a highly leveraged stock. Buffett would never, ever buy something with so much debt. We shouldn’t have picked a stock with so much debt for Singular Diligence. In the future, we will never do that. You’ll never see as highly leveraged a stock as Weight Watchers be a Singular Diligence pick in the future.
Town Sports also had a lot of operating leases. Rent expense is what has sunk that company. So, the lesson from both Town Sports and Weight Watchers is probably avoid companies with debts and leases. Don’t buy leveraged companies.
Is there a lesson about diversification in there somewhere?
I don’t see it. If Weight Watchers had been debt free when we bought it, we’d be holding it quiet calmly right now as I hope most of our subscribers would. It’s the debt that worries us with Weight Watchers. With Town Sports, we have a direct comparison. Town Sports had a lot of rent expense. It didn’t own any of its properties. There is one exception. Meanwhile, Life Time Fitness owned its properties. Its real estate portfolio was very, very safe. So, we had one unusually high leverage gym stock in Town Sports. And we had one unusually low leverage gym stock in Life Time Fitness. If there’s a lesson there – it’s a lesson in leverage, not diversification. Quan and I should have eliminated Town Sports because of its leverage. And we should have – in our own portfolios – preferred the no leverage stock to the high leverage stock. We should’ve thought about downside instead of upside. We should have thought about the long-term rather than the short-term. Long-term we knew the downside in Life Time Fitness was lower. If the long-term downside in a stock is lower – that’s probably the stock you should prefer. We didn’t. We picked the highly leveraged, cheaper stock. A lot of value investors do that. A lot of big value investing losses come from very highly leveraged stocks with low multiples.
If you want to avoid something like Weight Watchers, there are three ways. One, you can diversify. This can turn a 15% of your account loss into a less than 4% of your account loss if you just expand your portfolio from 5 stocks to 20 stocks. This may work fine for many people. I won’t condemn it. Two, you can avoid an industry like gyms all together. Many of our subscribers did this. We published issues on Life Time Fitness and Weight Watchers and Town Sports. And they responded by saying: “I’m not going to buy any weight loss business or any fitness business. They’re too faddish.” So, maybe you can avoid fads by ignoring an entire industry. There is a good logic to this. Weight Watchers and Life Time Fitness and Town Sports all have very high customer attrition rates. They lose 30% to 50% or more of their customers every year no matter how good a job they do. People just quit on self-improvement a lot. That will always be the case. It’s better to sell junk food and cigarettes and alcohol than to sell weight loss and fitness. It’s easier. Products in the first group are a lot more compelling. You don’t exercise on impulse. So, you can stick with the sin stocks and avoid the self-improvement stocks. I actually think there’s a lot of logic to that. I would tend to favor that approach over diversification. Stick to stocks that retain their customers. Avoid stocks that depend on people’s willpower being strong for them to stay a customer. That’s great advice. It applies to Weight Watchers, Town Sports, and Life Time Fitness. The third way to avoid a Weight Watchers type disaster is to look at the balance sheet. Just don’t buy companies with that much debt.
A separate question here is whether it’s okay to own a lot of stocks simply because you have a lot of ideas. My answer to that is yes. If you have a lot of equally good ideas – spread your money around evenly.
But are the ideas actually equally good?
My test is whether I can or can’t discern between the quality of the stocks involved. It’s a subjective and personal test. I know I can’t exactly predict which of 5 possible good ideas will work best and which will work worst. That’s predicting the future.
And that’s not what I mean. But, in our Swatch issue we mentioned 6 companies. We mentioned Swatch (obviously) which trades at about 11 times EBIT. We mentioned LVMH which trades at 15 times EBIT. Richemont trades at 17 times EBIT. Fossil at 8 times EBIT. Movado at 7 times EBIT. There are 3 Japanese watch makers. We mentioned only two. They trade between 10 and 14 times EBIT.
Now, if you said you’d like to diversify by buying all the Japanese watch makers – I’d say fine. I don’t particularly like any of them at today’s prices. But if I did like one – I’m not sure how different I’d feel about Citizen, Seiko, and Casio. So, if you wanted to diversify among those 3 - that’s fine. I’d pass on all 3. I’m not sure I can choose between them.
Likewise, if you said you wanted to buy Richemont and LVMH – I can see how you might think they are similar. I’m not sure I’d agree. And I would spend more time looking at those companies. They really aren’t that similar. And they are expensive.
The 3 watch companies I think it would be okay to diversify among are Swatch, Movado, and Fossil. I’m not sure I like Fossil as much as Swatch or Movado. Fossil relies a lot on Michael Kors. It’s an unusually hot watch brand. It also skews incredibly female. So, a really big portion of Fossil’s profit comes from sales of women’s watches under the licensed name: “Michael Kors”. That’s unusual for a watch company. A watch brand is usually not as young as Michael Kors in terms of its history. Most watch brands are really old. Some licensed brands aren’t. But – putting aside Michael Kors – each licensed brand for Fossil and Movado is normally quite small. No one brand matters that much other than the owned brand that the company has. In the case of these two companies that’s the Fossil and Movado brands.
I think a basket of Swatch, Movado, and Fossil would be fine. I don’t think I’d want to buy Fossil alone. But, maybe Fossil will be the best performer long-term. Fossil is strong in licensed brands. They can be the best home for a lot of licensed brands in the future. So, they can win licenses that eventually become hits. And we can’t predict what brands those will be. But Fossil is in a good position to get them. So, while I consider Fossil more speculative than Swatch and Movado – I wouldn’t blame anyone for creating a basket of all three watch companies.
So, let’s say instead of putting 20% of your portfolio in Swatch you put 6% or 7% in Swatch and 6% or 7% in Movado and 6% or 7% in Fossil.
That kind of diversification is fine. I’m all for that. On an after-tax basis (Swatch pays low corporate taxes) they are all nice and cheap. If you imagine a one-third and one-third and one-third blend of those 3 companies – you’re getting a high quality, low priced watch stock with little debt. And by dividing 20% of your portfolio into equal parts and putting it in these 3 companies you are relying less on Michael Kors than a 20% bet on Swatch would. And you are relying less on China than a 20% bet on Swatch would. Swatch gets a huge amount of its profit from China. Most of the company’s growth has come from Asia for a long time now. Swatch doesn’t get a lot of sales from the U.S. and licensed brands while Fossil and Movado do. So, that’s a very nice form of diversification. And you are still paying a mix of a high single digit EV/EBIT by our calculations for all 3 companies. That’s a good kind of diversification. But, notice that I excluded Richemont for being way too expensive. I also excluded all the Japanese watch makers because I think their business quality is not high and their stock prices are not low.
So, I still took about 7 watch companies (Swatch, Movado, Fossil, Richemont, Casio, Seiko, and Citizen) and narrowed them down to just 3 acceptable buys (Swatch, Movado, and Fossil). Personally, I like Swatch and Movado and think Fossil is a bit speculative due to Michael Kors. But, if someone asked me “Should I buy a stock basket of equal parts Swatch, Movado, and Fossil?” – I’d say yes.
So, in that sense, I’m in favor of diversification. Watches have good product economics. These 3 companies are good relative bargains when you consider their high quality and low price. If you buy a basket of these 3 and promise to keep them for 5 years – I think that’s wonderful. I think the average investor might do better in a combination of all 3 than in just one. They – like I did with Town Sports – might otherwise pick the wrong stock in a group with one or more good stocks in it. Most importantly, lots of people feel safer having 7% of their portfolio in Swatch, 7% in Movado, and 7% in Fossil instead of 21% in one of them. If that feeling of safety makes them a longer-term investor, then I’m for diversification.
The other obvious time to diversify is when you are a quantitative investor like Ben Graham. Warren Buffett isn’t normally. I’m not normally. But, when Warren Buffett bought stocks in Korea he diversified widely. He told a group of Kansas University students:
“My broker at Citigroup told me to look through this Korean version of the Moody’s guide. He said it would look just like 1951. He was right. I began flipping through the pages and found a lot of good companies trading at very low multiples. In 5-6 hours I put together a small portfolio of 20-25 stocks – about $100 million total. One example was DaeHan Flour Mills. It has a 25% market share in wheat flour in South Korea. Book value was 206,000 Won and the company had 201,000 Won in marketable securities and was trading at 2x earnings. The market is clearly not efficient all the time. There are certain opportunities that can make you fabulously rich.”
So, he put about $5 million into about 20 companies. When I looked at Japan a few years ago, I was originally going to find something like 20 stocks. That was my plan. But, then I winnowed a list down and came up with two groups. One, was net-nets that had been consistently profitable for a while. There were about 15 of these. I sold a report on the blog with those 15 net-nets in it. The other group was stocks with negative enterprise values that had been consistently profitable for 10 straight years or so. That was a sub group. Maybe 5 of the 15 stocks were in that group. So, I had to decide do I buy a big basket of say 30 or whatever stocks in Japan that are really low priced “value” stocks. Or, do I stick to just 15 net-nets with no losses in recent memory. Or, do I pick from this even smaller group of maybe 1 out of every 3 of those net-nets that actually have a negative enterprise value.
I decided I would put only 50% of my portfolio in Japan, because I didn’t want more than 50% of my portfolio in the Yen. It was an overvalued currency at the time. And I wasn’t going to hedge. That was fine. These stocks were cheap enough that if the Yen fell – and, in fact, it did fall – the U.S. dollar returns were still going to be fine. And the returns were fine.
I think they would’ve been fine any way I did it. I think picking those 15 net-nets I put in the little statistical report would’ve given you a fine portfolio. I think that the stocks Nate at Oddball Stocks wrote about and bought did absolutely fine. And I think that if you hedged the Yen you did well obviously. But, if you didn’t hedge the Yen your returns in dollars were also just fine. And these little Japanese net-nets didn’t behave like the stocks most people have in their portfolios. And obviously the Yen moving against the dollar doesn’t have all that much to do with the average American investor’s portfolio. So, you had a nice basket that was a diversified value investment. And I think you would’ve had that basket if you hedged or didn’t hedge the currency and if you picked 10 or 30 net-nets or just the 5 negative enterprise value stocks with 10 straight years of profits that I settled on. Basically, Japanese micro-cap value did fine for a few years. And it did fine in Yen. But it also did fine in U.S. dollars.
So, should you have diversified or not?
I knew nothing about Japanese companies. I was never going to pick just one stock. Many didn’t have information in English. And that doesn’t even matter that much. I read reports in English from Japanese companies – and I still don’t feel I understand them well enough to buy them alone. If I was going to buy Nintendo then I would’ve bought just Nintendo. But, I wasn’t. I was doing a Ben Graham type operation. It was similar to what Graham did all his life. It was similar to what Buffett did in the 1950s in the U.S. and again in Korea in the 2000s. And it’s what I did in Japan. Like I said – it’s also what Nate at Oddball Stocks did. I’m sure my results weren’t better than his. And he may have diversified way beyond 5 stocks. So, there was no real harm in diversifying in Japanese net-nets.
Oddly, Mohnish Pabrai didn’t really make money in Japan. I still have no idea what that was about. I think that might have been more of an attention deficit disorder issue on his part than anything to do with selection. He wanted to put bigger sums to work. And he seems to have bought and sold faster than I did.
In fact, I have a very small position in one Japanese net-net left over. I wrote the “Buy Japan” blog post on March 16th, 2011. So, it’s been over 4 years now. And these Japanese net-nets are up a big amount. And yet I still have a really small piece of one of them I never sold. I was going to sell it to buy something else and then I never got a good price for it in Japan. So I just held on to it. One day, the stock will pop again and will sell it. It’s such a tiny position because I was able to sell most of it at the price I wanted. It’s just illiquid. And so I didn’t get the price I wanted after that. My point is that I’m not in a real hurry to sell a stock. I’ll just leave it there doing nothing for a long time. I don’t know exactly how Nate at Oddball Stocks runs his own account. But, I think it’s also a bit less actively than Pabrai might have been in Japan.
So, I think it’s fine to own 100 stocks, 50 stocks, 30 stocks, 20 stocks, 10 stocks, or 5 stocks. If the stocks you own seem equally good to you on the criteria you use to buy them – then your portfolio works for you. If you look at your portfolio and realize that 5 of these 25 stocks you have are much, much better companies than the other 20 – then I think you have a problem. I think you are watering down your stock picking.
But, if there had been 15 stocks in Japan with negative enterprise value and no losses in the last 10 years – I would’ve bought 15 stocks instead of 10. I mentioned George Risk earlier. I bought George Risk at around net cash. You paid for the $4.50 or $4.75 or whatever the cash per share was and then you got the business for free. The business is a good one. It makes money every year. It would have an unleveraged ROE of over 20% year after year if the company didn’t hold all that cash. So, you had a box of cash and investments – it’s actually a mix of equity mutual funds, cash, and municipal bonds – and then you had the business. If I could find stocks in the U.S. that were consistently profitable – like, they made money every year for 15 years and their pre-tax ROC was like 15% a year or something – trading for their net cash per share, I’d buy every single one of them. If there were 30 companies that were like George Risk in the sense they were consistently profitable businesses trading for their net cash position, I’d buy every single business that met those criteria.
If you can find profitable, negative enterprise value stocks in Asia right now that you don’t think are frauds – then just buy them. Buy them all. If there are 50 of them, put 2% in every stock. If there are 10 of them, put 10% in every stock. Don’t buy anything else. Don’t be picky. A profitable company selling for net cash is a bargain of a lifetime. Buy it. And don’t judge between them.
But, in normal times in the U.S. I don’t find any stocks like that. You don’t normally find even one. It’s often zero. That wasn’t true when Buffett was investing in the U.S. in the 1950s. It wasn’t true during Ben Graham’s career. But, I was born in 1985. It’s been true for most of my life. There are brief crisis moments where it’s not true. And sometimes some micro caps get neglected. And specific countries – not the U.S. – sometimes end up with a lot of very, very cheap stocks. But, remember, Japan’s economy and stock market had done pretty badly for about 20 years when I found those net-nets. That’s why they were there. Business was going sideways for 20 years. And then they were just paying down debt and piling up cash over a couple decades. And nobody in Japan really noticed or cared or saw a catalyst in the stocks. And they were tiny stocks. So, they get neglected. If you can find 50 stocks like that instead of 5 – you have my blessing. Buy all 50 of them. It’s fine.
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