Concentration vs. Diversification

They used to say in the industry that Peter Lynch never met a stock that he didn’t like, he had hundreds of stocks in the Magellan Fund despite his boss, Mr. Johnson, telling him to buy just a few. Charlie Munger is very harsh on excess diversification calling it something like “a cure for ignorance” (or something like that). That two such experts have such divergent views merits examination. Can they both be right? Their returns say that, yes, both work, if you know what you are doing. Understanding the differences will enable you to pick the right one for you.

One thing that Lynch and Munger agree on is that you must know your stocks. At Berkshire-Hathaway they have a very lean staff, Charlie and Warren doing the heavy lifting. Lynch had a large staff of analysts at his disposal at Fidelity. If you are an individual investor with no staff and limited time, you just don’t have the resources for running a widely diversified portfolio. We haven’t even looked at the benefits of each approach and already an adequate approach is taking shape!

The Magellan Fund under Peter Lynch had a huge number of stocks but what most people don’t realize is their distribution. It was NOT an “index” approach. Magellan had a core of (relatively) large positions and a long tail of ten-bagger wannabes. Lynch believed that ten-baggers could add a lot of performance to a portfolio. This was not traditional diversification.

Excesses are dangerous, too much on one stock is risky and too many stocks lacks depth which leads to lackluster performance. From what I have read, somewhere between 12 and 20 stocks is sufficient to get the benefit of diversification. I aim for a dozen. I never had too many stocks but at one time I let one position surpass the 50% mark. But it was not out-of-pocket money, the stock just grew like a weed and I let it grow until I sensed that the story changed. Despite selling at about half the top price, this stock still produced an IRR of 43% over a four and a half year span. (If it weren’t for some stupid mistakes, I’d be a rich man!)

With all the tools available, one can have concentrated diversification! Currently I have ten positions with four making up 50% but two of those positions are ETFs which hold 132 high tech stocks between them. The ETFs are a new addition to my portfolio and I plan to grow them by dollar cost averaging (buying more quarterly).

Denny Schlesinger

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Lynch!!

A P.S.

yeah, when you at Lynch you have to realize a few things:

*there is a line in the book about insurance CEOs spending a week with him teaching him the industry and what to look for; most of us mere mortals don’t get this sort of access, but there is no reason we can’t pick up the phone and call investor relations after we’ve read the financials and done our homework.
*mutual funds by definition limit concentration; he mentioned in his other non-concentrated portfolios the returns were higher
*this was an open-end fund and Lynch and any mutual fund manager had to worry about redemptions
*Lynch had a personal rule of thumb that he would talk with a representative of each major industry group once a month, and this was in the world before Reg FD fair disclosure
*in Beating Lynch mentions that of the 900 stocks he had in 1983, 700 were less than 10% of total assets; he kept secondary positions so he’d be forced to keep regular tabs on them or because he couldn’t get more shares

Lynch wrote that: A foolish diversity is the hobgoblin of small investors.

He wrote that you should own as many stocks in situations where a) you’ve got an edge, and 2) you’ve got a prospect that passes all the tests of research (and by the way it was HIS standard of research)

who was it that said this?

if you are successful, concentrate
if you aren’t, don’t
but you have to know beforehand

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700 were less than 10% of total assets;

The long tail…

Denny Schlesinger

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Currently I have ten positions with four making up 50% but two of those positions are ETFs which hold 132 high tech stocks between them.

Wow. What are the other two? Let me guess – ROST and…AMZN?

Bear

I guess I was not clear enough: my top four positions are all individual companies.

Denny Schlesinger

One thing that Lynch and Munger agree on is that you must know your stocks.

For sure. I used to go out to Lynch, but now I stay home and play Munger Games instead.

Pete

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I agree with what Warren Buffett had to say about diversification.


“We think diversification, as practiced generally, makes very little sense for anyone who knows what they’re doing. Diversification serves as protection against ignorance. If you want to make sure that nothing bad happens to you relative to the market, you should own everything. There’s nothing wrong with that. It’s a perfectly sound approach for somebody who doesn’t know how to analyze businesses.

But if you know how to value businesses, it’s crazy to own 50 stocks or 40 stocks or 30 stocks, probably because there aren’t that many wonderful businesses understandable to a single human being in all likelihood. To forego buying more of some super-wonderful business and instead put your money into #30 or #35 on your list of attractiveness just strikes Charlie and me as madness.”

  • 1996 Berkshire Hathaway Annual Meeting

“Of course, some investment strategies - for instance, our efforts in arbitrage over the years - require wide diversification. If significant risk exists in a single transaction, overall risk should be reduced by making that purchase one of many mutually-independent commitments…Another situation requiring wide diversification occurs when an investor who does not understand the economics of specific businesses nevertheless believes it in his interest to be a long-term owner of American industry. That investor should both own a large number of equities and space out his purchases…On the other hand, if you are a know-something investor, able to understand business economics and to find five to ten sensibly-priced companies that possess important long-term competitive advantages, conventional diversification makes no sense for you. It is apt simply to hurt your results and increase your risk. I cannot understand why an investor of that sort elects to put money into a business that is his 20th favorite rather than simply adding that money to his top choices - the businesses he understands best and that present the least risk, along with the greatest profit potential. In the words of the prophet Mae West: ‘Too much of a good thing can be wonderful.’”
1993 Letter to Berkshire Hathaway shareholders
http://www.berkshirehathaway.com/letters/1993.html

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Another situation requiring wide diversification occurs when an investor who does not understand the economics of specific businesses nevertheless believes it in his interest to be a long-term owner of American industry. That investor should both own a large number of equities and space out his purchases…

That was 1993. In 2017 you can instead buy the right ETF. While there is an expense ratio (fee) you save on trade commissions by buying one ETF instead of a dozen stocks.

Last December I decided to use ETFs to invest in high tech (semiconductors and small cap IT).

Denny Schlesinger

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Last December I decided to use ETFs to invest in high tech (semiconductors and small cap IT).

denny, I don’t see how you can be comfortable doing that without having some opinion about the ETF’s constituents. So have a feel that semis and small cap IT is actually worth buying right now, or did you base it on past performance, or did you use some other method?

I’m all for ETFs but not sure why you’d want to vary into specific industry ETFs. Just interested in your thinking here.

(fwiw, I bot VFH late last year - lemming that I am)

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Excesses are dangerous, too much on one stock is risky and too many stocks lacks depth which leads to lackluster performance. From what I have read, somewhere between 12 and 20 stocks is sufficient to get the benefit of diversification. I aim for a dozen

You are assuming that the writer of what you read knows anything about making money in their own portfolio or tries to make a living by writing articles and getting paid for them.

I’ve tried diversification and as I weeded down the number of stocks I own, the better results I had. Probably because I sold my poorly performing stocks and added to the better performing ones. My portfolio currently consists of 8 securities that grind out a little more than double the money I spend on all our living expenses including FED and STATE taxes. The excess income above expenses is reinvested in additional shares grinding out additional income. My portfolio growth mostly comes from the reinvested income and doesn’t require capital gains to grow. I find the income to be more stable than the seeking of capital gains that usually require a growing of share prices that may or may not be available from Mr Market at any particular time

b&w

On the other hand, if you are a know-something investor, able to understand business economics and to find five to ten sensibly-priced companies that possess important long-term competitive advantages, conventional diversification makes no sense for you.

BINGO! CAP - competitive advantage period. One aspect of this is brand power, such as Coke, or Nike, or yes, Under Armour (issue with Under Armour would be valuation), or Skechers (issue with Skechers would be valuation as well based upon growth, if any), or network effect with switching costs.

That is all you need to know as a long-term investor. In the market “sensibly priced” does not equate to trailing P/E but future growth combined with duration and relative power of a company’s CAP.

Tinker

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Denny, I don’t see how you can be comfortable doing that without having some opinion about the ETF’s constituents. So have a feel that semis and small cap IT is actually worth buying right now, or did you base it on past performance, or did you use some other method?

I explained it at the NPI board:

A dozen year ago I wrote Good bye Technology! Now I’m saying “Hello Technology!” What changed?

http://discussion.fool.com/hello-technology-32507026.aspx

Denny Schlesinger

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You are assuming that the writer of what you read knows anything about making money in their own portfolio or tries to make a living by writing articles and getting paid for them.

I usually know who I’m reading. :wink:

Denny Schlesinger

Another situation requiring wide diversification occurs when an investor who does not understand the economics of specific businesses nevertheless believes it in his interest to be a long-term owner of American industry. That investor should both own a large number of equities and space out his purchases…

That was 1993. In 2017 you can instead buy the right ETF. While there is an expense ratio (fee) you save on trade commissions by buying one ETF instead of a dozen stocks.

Last December I decided to use ETFs to invest in high tech (semiconductors and small cap IT).

Denny Schlesinger

I agree. I like the Schwab ETFs. Extremely low expense ratios on their index ETFs.

http://www.schwab.com/public/schwab/investing/accounts_produ…

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