value and opportunity

Especially among active Value investors, there is a big debate about diversification or concentration of portfolio investments. Within the comments we were debating this already quite intensively, I also commented on Stephan’s blog why I think 30% of the portfolio in three Greek stocks is too much.

I would divide the the argument into two camps:

1. The “Buffet / Munger camp”: If you have a good idea, you should invest as much as possible into those 3-5 ideas. Reader Setla provided as proof Berkie’s balance sheet from 1995, where the top 5 investments made almost 100%.

2. The “others”, like Graham, Walter Schloss, Klarman, FPA, Tweedy etc. which usally construct portfolios with 20-50 stocks, in the case of Graham and Schloss sometimes even more.

My view on this is the following: There is no right or wrong, position sizing depends on many factors. Some of the more important ones are:

A. Type of stock

It makes a big difference in my opinion if you prefer “bufffet” style shares like Nestle, Coca Cola, Gillete etc. or small caps like SIAS, Installux, Poujoulat or Hornbach.

Nestle and Coca Cola for instance are global companies active in almost every part of the world and in different segments. If one country or even a continent doesn’t perform you still have the other 4 continents. So they are stocks which are already diversified theselves.

If I look at my portfolio, my small cap stocks are not divdersified at all on a stand alone basis. SIAS for instance only runs Northern Italian motorways or Poujoulat is highly dependent on French wod pellet heating. So those stocks are not diversified at all but have very specific risks.

The same applies for Graham/Schloss type of Net-Nets or other “deep value” stocks where on an individual basis a lot could go wrong, but within a diversified portfolio you could expect significant outperformance.

It would be therefore financial suicide to invest only into 3 or 5 of those small cap stocks as very singular events can wipe out significant amounts of the portfolio.

B) Control position

Many investors who try to invest like Warren Buffet, forget one important thing: Buffet is always in some kind of control position.

Either he is actually a direct control investor (GEICO, Iscar etc.) or he is the largest investor in a public company. You can imagine, if Warren Buffet calls Coca Cola, he will not be put into the endless phone loop but transferred directly to the CEO.

So if he has tied up a lot of money in one stock, he can influence the company to a certain degree if he doesn’t like what they are doing. And make now mistake, Warren seems to be a nice guy on the outside, but he can get quite nasty if things don’t go his way.

Other examples for less diversified control investors are for instance private equity funds which usually invest into 5-10 control investments per fund but with full control over management.

As a private investor, one is definitely no control investors. I personally do not trust ANY company management enough to put a very large amount of my hard earned money into it.

C) Personal risk tolerance

One thing: Not every investor has the same risk tolerance or risk preference. Making money in the stock market long term means that you have to be able to stay in the game.

If you are very young and run a small portfolio (say a couple of monthly salaries), you can always get back into the game by saving part of your salaries and start over again. A pensioner who relies on his portfolio to generate a large anount of his income does not have this “luxury”.

For someone too rich to bother (Warren, Charlie ?) the same applies as for the young guy. He/She can take more risk.

For me personally, the approach of investing a max of 5% of the portfolio has worked quite well in the past. I also found it helpful to start with a “half” position of 2.5% first and then increase if things go fundamentally the right way. I have no problem, letting the position grow due to performance up to 10%, by then I will decide if I take some money of the table.

Cash Quota

There are as many opinions on cash as there are investors. Interestingly Warren Buffet of course is famous for holding always cash to be prepared for crisis investments, as well as very clever investors like Seth Klarman or FPA (Bob Rodriguez) which hold large amounts of cash if they think the market is generally overvalued.

For me, a “general” target cash quota of 10% has worked quite qell in the past. Due to my investment style ( inc. Special situations ect.) I normally have continuous cashflows into the portfolio. On the other hand I have usually some stocks in my watchlist in which I want to invest at a certain price without having to sell one of my other position.

So effectively, my cash quota is “oscillating” around 5-15% depending on specific events and valuations.

I think a certain cash quota is necessary to remain flexible. Howevr one should avoid increasing or reducing cash based on one’s market expecation. At least in my experience I am not able to add value consistently through this kind of “tactical” asset allocation.

Summary:

I think both, for position sizing and cash quota, there is no “one fits all” strategy. In my opinion, many value investors make the mistake trying to apply the principles of one very succesful “guru” to any situation. It might also be difficult to copy any “Guru” because the “Guru” might have a very different kind of risk tolerance and risk capacity than the ordinary investor.

I do not want to give explicit advice, but most investors should NOT try to construct 3 or 5 stock portfolios without cash reserves as the probability of NOT SURVIVING the next crisis is quite high, no matter how “safe” the stocks look like.