Think something that might need to be sussed out is what actual diversification actually means. The hedgefund I was at ran a very concentrated portfolio by industry standards… and that was ~15-20 names.
Even for all Buffett’s quips about diversification I don’t think he believes you should hold 5 companies. He’s always held +10. Believe that’s more of a dig at the ‘active managers’ that have 40-50 name portfolios and are just trying to have a minor tilt versus their benchmark.
Basically, I’m just saying I think we’re all pretty much on the same page here. IMO find several great companies to invest in. If you are spoiled for choice then only pick the best ones (10-15 for me). Can’t find enough good ones? Then maybe sprinkle in some ETFs.
Completely agree with diversification but driven by decent business models, profitability, capital use, and importantly valuation!
For a start, one can identify what the investment objective is to start from there. If you want income, you can’t be buying a bunch of high growth stocks; also look at how diversified across countries, sectors, industries and factors apart from asset classes and markets - what we like to call active detailed global asset allocation!
I think Munger may have said it best (as usual), but I'm not sure of the exact quote. It's something to the effect of: if you want to become very rich, you have to have a small, diversified portfolio, but for most people, this isn't the best strategy. TL;DR: diversification works well for the individual to attain average or slightly above average returns, but if you want to hit a grand slam, you have to step up to the risk plate.
I might push back on the idea of META not having a moat back in 2022, during all that pessimism. I think there's no replacement for Facebook or Whatsapp for lots of folks. IG has a narrow moat, but only because of switching costs for content creators. My 2 cents... but the narrative was uber-pessimistic!
For starters, in theory I agree that it makes sense, but I wonder how many “wonderful businesses” one could truly buy in a given time period, if they are serious about purchasing them at an attractive price. I don’t know the answer, but I think it would be tough to fill a portfolio of 20 stocks of truly incredible businesses that trade below intrinsic value in any meaningful way.
Okay, so why not buy them at “fair” prices then?
The whole idea of buying at “fair prices” always seems fuzzy to me. Sure, Buffett bought Coke for 15x trailing earnings (recalling from memory), but that wasn’t really a “fair” price, as it turned out. I would argue he probably knew it wasn’t a fair price at the time. And if I recall correctly, him and Charlie paid something like 6-7x pre tax earnings for See’s Candies, and bought Apple at ~12x earnings.
He started paying higher multiples of earnings for businesses, that I understand, but Buffett has plenty of cash to deploy into larger high quality businesses that seem to be trading at “fair” prices, yet hasn’t. Even last year in his letter he seemed to emphasize the power of waiting for a fat pitch, making a point that you only need a few really good decisions for things to work out.
The question then becomes, is it better to hold a portfolio of 20 businesses that are high quality but theoretically not as mispriced, or have a portfolio of 8-12 good businesses that you feel are mispriced, in a material way. The cost of the latter may be sitting on your butt for a while and waiting, but are the potential outsized returns worth the time you spent waiting? If you’re wrong, certainly not.
To your point about the issue being that when these great businesses become very attractively priced, they are perceived to be experiencing moat eroding issues, that is ultimately our jobs to discern between perception and reality. Not saying it’s easy, quite the contrary. But you must make assumptions no matter how you slice it. Paying 35x FCF for something can be equally risky in that, assuming your hurdle rate is 12-15% or higher, you are assuming the market is under appreciating either the durability or magnitude of the business’ growth. You may be wrong there as well. Will you lose less money in the former, or latter? Not sure.
Last point, if you are a manager running a small pool of capital, I believe you have more opportunities available to you than just buying wonderful businesses at fair prices. You can be more nimble, fishing in less efficient pockets of the market. One could practice a mixed portfolio of “
1. core investments” that are high quality businesses which have perceived problems or are just overlooked, and therefore are mispriced
2. Special situations.
Now, to your point about this type of portfolio being more lumpy and harder to deal with, I certainly can understand that point. But, this would allow you to pick your spots of only the best (in your mind, not saying it will turn out to be the best) in each respective category and still have a 12 stock portfolio. In theory, if you are a good analyst, this approach may be a good alternative.
Sorry for the lengthy response. Great article overall and I appreciate the thought behind it.
Think something that might need to be sussed out is what actual diversification actually means. The hedgefund I was at ran a very concentrated portfolio by industry standards… and that was ~15-20 names.
Even for all Buffett’s quips about diversification I don’t think he believes you should hold 5 companies. He’s always held +10. Believe that’s more of a dig at the ‘active managers’ that have 40-50 name portfolios and are just trying to have a minor tilt versus their benchmark.
Basically, I’m just saying I think we’re all pretty much on the same page here. IMO find several great companies to invest in. If you are spoiled for choice then only pick the best ones (10-15 for me). Can’t find enough good ones? Then maybe sprinkle in some ETFs.
Don’t buy junk just to add diversification.
Completely agree with diversification but driven by decent business models, profitability, capital use, and importantly valuation!
For a start, one can identify what the investment objective is to start from there. If you want income, you can’t be buying a bunch of high growth stocks; also look at how diversified across countries, sectors, industries and factors apart from asset classes and markets - what we like to call active detailed global asset allocation!
I think Munger may have said it best (as usual), but I'm not sure of the exact quote. It's something to the effect of: if you want to become very rich, you have to have a small, diversified portfolio, but for most people, this isn't the best strategy. TL;DR: diversification works well for the individual to attain average or slightly above average returns, but if you want to hit a grand slam, you have to step up to the risk plate.
I might push back on the idea of META not having a moat back in 2022, during all that pessimism. I think there's no replacement for Facebook or Whatsapp for lots of folks. IG has a narrow moat, but only because of switching costs for content creators. My 2 cents... but the narrative was uber-pessimistic!
Interesting thoughts and I appreciate the post.
A few things come to mind as I was reading.
For starters, in theory I agree that it makes sense, but I wonder how many “wonderful businesses” one could truly buy in a given time period, if they are serious about purchasing them at an attractive price. I don’t know the answer, but I think it would be tough to fill a portfolio of 20 stocks of truly incredible businesses that trade below intrinsic value in any meaningful way.
Okay, so why not buy them at “fair” prices then?
The whole idea of buying at “fair prices” always seems fuzzy to me. Sure, Buffett bought Coke for 15x trailing earnings (recalling from memory), but that wasn’t really a “fair” price, as it turned out. I would argue he probably knew it wasn’t a fair price at the time. And if I recall correctly, him and Charlie paid something like 6-7x pre tax earnings for See’s Candies, and bought Apple at ~12x earnings.
He started paying higher multiples of earnings for businesses, that I understand, but Buffett has plenty of cash to deploy into larger high quality businesses that seem to be trading at “fair” prices, yet hasn’t. Even last year in his letter he seemed to emphasize the power of waiting for a fat pitch, making a point that you only need a few really good decisions for things to work out.
The question then becomes, is it better to hold a portfolio of 20 businesses that are high quality but theoretically not as mispriced, or have a portfolio of 8-12 good businesses that you feel are mispriced, in a material way. The cost of the latter may be sitting on your butt for a while and waiting, but are the potential outsized returns worth the time you spent waiting? If you’re wrong, certainly not.
To your point about the issue being that when these great businesses become very attractively priced, they are perceived to be experiencing moat eroding issues, that is ultimately our jobs to discern between perception and reality. Not saying it’s easy, quite the contrary. But you must make assumptions no matter how you slice it. Paying 35x FCF for something can be equally risky in that, assuming your hurdle rate is 12-15% or higher, you are assuming the market is under appreciating either the durability or magnitude of the business’ growth. You may be wrong there as well. Will you lose less money in the former, or latter? Not sure.
Last point, if you are a manager running a small pool of capital, I believe you have more opportunities available to you than just buying wonderful businesses at fair prices. You can be more nimble, fishing in less efficient pockets of the market. One could practice a mixed portfolio of “
1. core investments” that are high quality businesses which have perceived problems or are just overlooked, and therefore are mispriced
2. Special situations.
Now, to your point about this type of portfolio being more lumpy and harder to deal with, I certainly can understand that point. But, this would allow you to pick your spots of only the best (in your mind, not saying it will turn out to be the best) in each respective category and still have a 12 stock portfolio. In theory, if you are a good analyst, this approach may be a good alternative.
Sorry for the lengthy response. Great article overall and I appreciate the thought behind it.
Good arguements for diversification.
But what would the diversification number of stocks to be considered sufficient diversification?
The number of undervalued stocks that can be followed or?