The Group Approach, Part II

A concentrated, Buffett-style investor will sometimes look at a Graham-style, cigar butt investor and say: "You're making valuation decisions based on over-simplified metrics like PE or price to cash flow or price to book when the true value of a company is the sum of discounted future cash flows. Your selection criteria are too superficial."

Pure quant, Graham-style value investing might be too superficial to justify heavy concentration in an individual stock, but it can work well when funds are equally divided among a large group of stocks. The prudence of a particular investment strategy often depends on diversification. Healthy diversification helps minimize the impact of Black Swan events.

Buffett-style investors think it's okay to concentrate, and prudent to do so, because they know a lot about their individual holdings -- they've done DCF analysis, have studied the company and its competitors, and feel certain in their assessment of the company's long term competitive advantage. Yet future events can still surprise. Every so often a famous value investor suffers a large, unanticipated, Black Swan loss from a concentrated, "sure thing" investment. Bill Ackman's loss in Valeant Pharmaceuticals comes to mind. No matter one’s confidence, heavy concentration entails outsized exposure to large Black Swan losses. Unless you're a business conglomerate with an indefinite lifespan -- Berkshire Hathaway for example -- big losses are hard to recoup.

Charlie Munger has talked about the remedy for concentrated investments and unexpected Black Swans. He advises value investors to buy a small basket of stocks and then "watch that basket closely." Vigilance helps, except when a concentrated investor makes more bad decisions that magnify the original loss. With Valeant Pharmaceuticals, Ackman and other well-known value investors bought more Valeant stock as the company declined, increasing their losses. Averaging down makes sense when a stock declines for no reason, but in Valeant's case the decline was justified. 

I don't know if value investors like Ackman failed to cut Valeant losses because they fell in love with the company or because they were unable to see or acknowledge their mistake, but the moral of the story is that concentrated investors watching the basket closely can still make costly mistakes. Concentrated investing makes it more difficult to stay rational and unemotional, increasing the odds of misjudgments.

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.