As a value investor I've always struggled with how diversified or concentrated my portfolio should be. I've followed both approaches -- imperfectly -- over the past 12 years. Much of the problem stems from the fact that I'm a big fan of both Warren Buffett (who favors concentration) and Benjamin Graham (who generally favored diversification).
Excellent books I've read over the past year have simultaneously clarified and exacerbated this confusion: Warren Buffett's Ground Rules by Jeremy Miller, Deep Value by Tobias Carlisle, and Concentrated Investing by Allen Benello, Michael Van Biema, and Tobias Carlisle. I also recently discovered a superb blog site, Base Hit Investing (BHI) by John Huber and Matt Brice, that has added greatly to my knowledge of return on invested capital, return on incremental capital, and the impact of portfolio turnover on overall returns. BHI has been pulling me toward the concentrated approach.
In an effort to capture the best of Graham's mechanical cigar butt approach and Buffett's more subjective concentrated approach, I've decided -- for the time being -- to go with a quantitative approach that tries to identify undervalued, unleveraged companies with high returns on incremental capital and/or invested capital. I'm using these return on capital metrics to try and avoid cigar butts (similar to Joel Greenblatt's approach). Below are the notes I made to justify this decision -- I often do this to steel myself from my own emotional and return-damaging whims:
- The problem with concentrating in select positions is that you get too emotional and you end up making dumb trades that hurt returns (motivated by fear, greed, etc.). Concentrated positions often lead to second guessing (due to the exposure that comes with a large bet) and overly aggressive, unnecessary buying and selling. It’s better just to equal-weight your positions and hold enough positions that you don’t mind taking a bath every once in a while. Good diversification and a clear sales trigger reduce dumb, unnecessary trading.
- Based on experience and the literature, you can reliably make good money with a diversified approach (occasionally great money). On an averaged, portfolio basis you'll always own a group of undervalued, unleveraged, well-run companies earning attractive returns on incremental capital and/or invested capital. Some picks won’t work out, but on average things should work out well. This is the big advantage of a diversified portfolio strategy: with a diversified strategy it’s not as important to be right about each pick (like you have to be with a concentrated approach) — you just have to be right on average.
- A diversified, group approach allows you to buy smaller, more volatile companies and accept more stock-specific uncertainty, which can then drive higher returns. It also relieves the pressure to predict the future or know every single thing about a company/industry. By staying diversified you can use an easy, quantitative approach, make a few mistakes, and still get good results. And the companies you choose don’t have to be cigar butts with declining businesses — you can use return on incremental capital and return on invested capital to identify well-managed companies that are growing in a smart way. Smart companies don't just grow earnings — they grow earnings at a rate that’s attractive relative to the incremental capital required to support this growth.
So that's my investing approach, at least for now. I've also noticed a side benefit of diversification -- fewer stomach issues.
The author is not an investment advisor or CFA and readers should consult an investment advisor before buying or selling any publicly traded stock. The views expressed in this article are the author's personal opinions and should not be construed as investment advice.