Value investor Warren Buffett famously said, “Diversification is protection against ignorance. It makes little sense if you know what you are doing.” At the same time, no matter how confident you are in your investment thesis, it is good to recognize your limitations in common stock analysis. Today, I explore how to build a reasonably diversified portfolio based on a value investment approach.
From a value investment standpoint, there are three reasons to diversify, which I will discuss in order:
1. A diversified portfolio can help you avoid a significant loss should one or more of your investments go wrong.
The first reason is based on the limitation of common stock analysis from a purely scientific approach. Although value investing is the most scientific approach to analyzing securities from a long-term perspective, it’s subject to variables that cannot be forecast with scientific precision. In other words, the forecasting part of security analysis, such as earnings forecasts and industrial trend forecasts, is subject to human misjudgments. In order to mitigate such flaws, Benjamin Graham recommended two principles in his book, Security Analysis.
- Principle for the untrained security buyer: Do not put money in a low-grade enterprise on any terms.
- Principle for the security analyst: Nearly every issue might conceivably be cheap in one price range and dear in another.
In Cabot Benjamin Graham Value Investor, I tackle Graham’s first principle by screening out stocks with risky balance sheets and unpredictable earning streams. (Though I might, on occasion, take such risks but only if I believe that the company has a great probability of turning around.) I apply Graham’s second principle by screening out stocks with unreasonably high valuations.
2. Because any individual stock can take longer than expected to reach its full value, a basket of diversified stocks can give you the patience to wait it out.
The second reason for diversification is to account for the factor of time. Although a stock’s price generally tends to follow the intrinsic value of the security, no one can say with certainty how long it will take for a stock’s full value to be reached. It could happen the very next day or after a prolonged interval of time. Diversification, in Ben Graham’s terms, is an investment operation that can help reduce the pain of waiting (even though a value investor, by definition, has a great deal of patience).
3. When a particular industry is relatively undervalued, you can mitigate individual stock risk by buying a group of undervalued stocks in that industry.
The third reason for diversification can be applied when an analyst’s thesis relies on a top-down forecast rather than a bottom-up valuation. In other words, if you believe the market is undervaluing a particular industry, you can invest in a group of undervalued securities in that industry. For instance, as of Q3 2017, the airline industry is trading at 12 times its 12-month earnings while S&P 500 is trading at 22 times its trailing 12-month earnings. If you believe that the airline industry will grow at par with the economy with no great advantage to a single company, you may select a few reasonably valued and competitively positioned companies in the industry.
How Much Diversification do You Need?
Modern portfolio theory, in contrast to value investment theory, puts great emphasis on the correlation of a stock’s price history to arrive at an optimally diversified portfolio with a highest possible risk-adjusted ‘expected’ return. Relying on such a statistically oriented theory with precise guidance for diversification leads to a great amount of satisfaction for a risk-averse investor. Unfortunately, such a theory, including its statistical components such as standard deviations, beta and correlations, has no theoretical merit in a value philosophy.
Statistics based on the price history of an instrument are technical in nature, and such information is irrelevant from a value standpoint. Lack of reliance on such readily available information leaves little room for a value investor to make a satisfying diversification theory.
One of the fundamental beliefs of a U.S. value investor is confidence in the American economic system. Any long-term investor would have gained significantly over time by investing in any large U.S. indexes (compared to returns from bonds). Passive investors can take advantage of America’s economic engine by buying a low-cost exchange-traded-fund of a large diversified index like S&P 500—there is no security analysis required for such an investment. However, an active investor who bets on a few undervalued securities to get a superior return has enough reason to worry about the diversification of his portfolio.
An active investor under such a circumstance may allocate his portfolio based on his level of confidence in his investment thesis. Unfortunately, there is no easy way to measure your own confidence. Having said that, the benefit of diversification cannot be quantified without looking at two opposing forces.
- The more stocks you own, the less you’ll be hurt if one falls apart.
- The more stocks you own, the less you can truly know about each one.
Balancing these two opposing forces is the challenge. If an analyst can focus on 10 stocks with great diligence, he can be confident in his selections, though his diversification will be limited. On the other hand, an analyst with 100 stocks will have greater diversification but will reap less benefit from his stock selection ability due to his limited ability to focus on his stocks.
“My view is that an investor is better off knowing a lot about a few investments than knowing only a little about each of a great many holdings. One’s very best ideas are likely to generate higher returns for a given level of risk than one’s hundredth or thousandth best idea.”—Seth A. Klarman, Margin of Safety.
I tend to follow Seth Klarman’s logic, and you can see the results in Cabot Benjamin Graham Value Investor, where I have recently taken over the duties of Chief Analyst and am shrinking the previously heavily diversified portfolio down to a more manageable size.