Why you should diversify

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Charlie Munger and Warren Buffett are famous for advocating a concentrated portfolio of stocks. It seems common among many value investors to suggest that a portfolio of 3-5 quality stocks is enough diversification and also beneficial because you then will have the energy, time and concentration to really understand the companies you are buying.

The reasearch I have read says that any additional stocks above 15 has a very small effect on being more diversified and lessen your risk. I think I read that in The Magic Formula book of Joel Greenblatt.

Diversification

As you see from the graph the biggest effect of diversification happens up until 10 stocks or so. From there on the effect of adding more stocks to your portfolio has less effect.

The opposite of a concentrated portfolio is an index fund. With these you own several hundreds of stocks and your return will be close to the same as the markets return. With an index fund you are basically betting on a country’s long-term economic performance ( if you for example buy the SP 500 index fund). The downside of owning an index fund is that you both own the good stocks and also the crappy stocks in that index. In addition the index fund is usually market cap weighted, which means that more funds is going into stocks with the highest market caps and then probably also to the stocks that is overvalued. The benefit is that you don’t need to make many decisions and ongoing judgements so there is less chance that your irrational behavior is destroying the returns.

 

Here is what you seldom hear about diversification:

 

  • A concentrated portfolio can give you the best returns, but can also give you the worst returns. Investing is not about certainties. Nothing is 100% certain in investing. It’s about probabilities and being correct more than you are being wrong over a long time period. Holding only 3-5 stocks makes you very prone to business risk. Can you be really certain that the 3-5 picks that you have made will be performing as you expect? Choosing only 3-5 stocks can be considered overconfidence or it can be brilliance if you really know what you are doing. Investing is a marathon, not a sprint. So if you choose only 3 stocks and 2 of them suffers permanent capital loss, you can be almost wiped out at the beginning of the race. You want to have staying power and be in the game as long as possible and overall do more correct bets than wrong bets. To high concentration can make you prone to unexpected and uncontrollable events that you have little control over.

 

  • A concentrated portfolio can give you a much higher volatility than a more diversified. Are you emotionally able and willing to handle that volatility?

 

  • Even if you hold 10-20 stocks are you actually diversified enough? What about the correlation of the stocks in your portfolio. If you are holding 20 stocks and all of them are in the same industry, a downturn in that industry will drag down all of the stocks in your portfolio at the same time.

 

My advices for diversification:

  • The more experienced and skillful you are as an investor the more concentrated portfolio you can have, and visa versa.
  • For the typical value investor I would recommend 10-15 stocks in your portfolio
  • Diversify across industries and countries. Use the whole world as a hunting place for stocks.
  • Try to select stocks that are not correlated if a downturn happens.
  • If you have no experience with investing or are a beginner, consider buying some kind of value weighted index funds. If you want and if you gain more knowledge you can consider slowly adding more individual stocks in the mix.

 

 

The Acquirer’s Multiple: The numbers behind the strategy

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You have maybe heard about the Acquirer’s Multiple. It’s a quantitative value strategy based on the multiple EV/operating income. The man behind this strategy is Tobias Carlisle and he also wrote a great book called Deep Value. The strategy is very simple. It’s basically buy stocks with the lowest EV/operating income ratio and rebalance your portfolio once per year. According to his book when doing a backtest using this strategy, the returns have been very impressive. From memory I think it was around 18% annualized. This strategy has worked very well when backtested trough the past decades. EV/Operating income is also considered the cleanest valuation multiple as it include the debt of the company and also its difficult for the management to manipulate operating income.

But will it work in the future?

There is no guaranty of that, and with today screeners and computing power it’s easy to get a list of the lowest EV/Operating income stocks in the whole universe of stocks. That was probably not easy to do in the years up to the year 2k.

Why does the Acquirer’s Multiple work?

I think the reason is of psychology and human nature. The stocks that typically shows up on the screener is usually unpopular, hated and companies where the future is uncertain. This is the reason for the sell off by investors and the low price. And this create a higher chance of mispricing when the emotion regarding a stocks is more towards the extreme. So buying a diversified portfolio of low EV/Operating income stocks will make you be able to take advantage of this mispricing. The key is to be diversified because some of these stocks really deserve the low price. Typically 20-30 stocks is recommended. Another reason is reversion to the mean. Most things are cyclical companies that has financially underperformed for a period tend to have a period of better performance.

A deeper look at the numbers behind the Acquirer’s Multiple

I was curious what numbers characterize the stock except the low EV/Operating income ratio. In the Deep value book the author explained that adding quality components like a high ROE actually decrease the returns instead of adding to the return. So I took all the 30 or something stocks and put it in a stock screener that give me all of the most important fundamentals ratios. I used a free trial of Uncle stock stock screener.

Here is what I found:

Acquirers’s multiple- Excel Spreadsheet

Here are the median numbers for the 31 stocks:

P/E: 9.39
EV/Operating income: 7.3
Dividend Yield: 1.7%
F-Score: 6.38
Z-Score: 3.26
M-Score: -2.44
Current ratio: 1.40
CF Coverage ratio: 65.2%
LT/Debt to equity: 52.9%
FCF/LT-Debt: 21.7%
Quick ratio: 0.87
ROIC 5t avg: 15.5%
ROIC: 16.7%
FCF/Total assets: 5y avg: 4.9%
FCF/Total assets: 6%
CROIC 5y avg: 7.6%
CROIC: 8.0%
ROE 5y avg: 17.3%
ROE: 20.2%
ROA 5y avg: 6.4%
ROA: 8.2%
FCF/sales 5y avg: 3.1%
FCF/sales: 3.5%
Gross margin CAGR: 1.9 %
Held by insiders: 0.5%
Held by institutions: 87.3%
Outstanding share 1 year growth (share buyback): -4.6%
Outstanding shares CAGR: -2.4%
Price YTD change: -13%
Gross margin 5y avg: 22.7%
EBIT margin 5y avg: 7.5%
Net margin 5y avg: 4.8%
Shareholders yield: 7.1%
Damn what a long list.

 

This is my take on these some of these numbers:

  • Ev/operating income ratio is low but not extremely low.
  • The F, Z, and M-score is all within the limits of what can be considered acceptable. This is an indication for me that there is indeed some addition screening is being done than just spitting out a list of low EV/OI stocks.
  • Low D/E around 0.5 which indicate good financial strength
  • surprisingly high ROIC and ROE. Above 15%. So this shows that these companies have not been crappy companies in the past.
  • The Gross, EBIT, and net margin are quite low.
  • Shareholder Yield very high at 7.1%. This shows that the management are returning back money to the shareholders in form of dividends or share buyback. This also can indicate that the management themself think that their own stock are selling too cheap compared to their intrinsic value

 

Conclusion:

Looking deeper into the numbers we can see that the quality of the stocks that is selected is not as of bad quality as I first imagined. On average they also seem to pass the financial forensic screening of F,Z and M-score. Historically the ROIC and ROE has been quite good. Seems like there is more to it than just a low EV/OI ratio. Also in contrast to what I remember reading in the Deep value book these stocks the high ROIC would decrease the annual return, but still it seems like the stocks also have been screened for a high ROIC.

 

How to beat the market

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Beating the markets returns is difficult. Why? The reasons are many, but some of them are behavioral and others are trading costs.  Let’s start with the first one. To beat the market you need to have a portfolio of stocks that is different from the markets. That means that you can forget buying an index fund if your goal is to beat the market (As the index fund of course gives you the markets return)

So that means that you need a more concentrated portfolio of stocks. I don’t know any specific number but anywhere more than 50 stocks will probably give you a return that is closer to the markets return. So since you need a more consentrated portfolio (preferably 5-20 stocks) you will experience more volatility in the portefolio value. And that can hurt emotionally.

We know from research that the number one reason why the average investors underperform the market is that they buy on top and sell on the bottom. A higher volatility in your portfolio makes it easier to be affected to this behavioral error and do the exactly wrong thing at the wrong time. Apart from the need to handle higher volatility you also need to do a lot of more decisions about buying and selling stocks. This make you prone to get affected by the media, other investors, stocks tips etc.. that will increase the chances that some of the behavioral biases makes you make irrational choices that hurts your returns. One of these is frequent buying and selling stocks that will take away from your annual return in form of trading costs and taxes.

The next one I want to take about is that if you want to beat the market you need an opinion that is different from the market, and you need to be correct about it and the market need to be wrong. If the market is opinion is correct and yours is wrong you will lose money. If your opinion is the same as the markets opinion you will get the markets return. Just think about that for a second. You have to bet against what is the collective knowledge of maybe thousands of investors analysing a stocks future performance. You need have an opinion that is different from them, and you need to make a bet and you need to be right in you predictions. So whats the big deal about this?

Well, you need to be brave to be a contrarian and go against the common and popular opinion about a stock. We humans are social animals and its most comfortable to conform to the opinions of the masses. Also you need to be able to be comfortable looking like an idiot for a long time as the stock price can fall a lot after you buying it and you will still hold it until it reaches it’s intrinsic value. This can take up to many years, and in the meantime you will look stupidly wrong and the market will look correct and that you made a mistake. To handle all of this you need extreme patience, discipline, emotional intelligence, confidence, and at the same time humility.

Also when you know that for the most part the market is efficient (that means correct pricing of stocks) then you can say that you are bold when you bet against the market.

I am not saying that you should give up stock picking, and buy an index fund. Not at all, especially not in this current market conditions where US index funds are very highly priced. What I want is that you think about what it really requires and demand from you to beat the market over a long time period. Few investors manage to beat the market by a large margin over years and decades. Are you one of them?

  • Do you have more knowledge about analysing stocks than the average investors?
  • Are you willing and able to handle the increased volatility that can be experienced with a more concentrated portfolio?
  • Are you more knowledgeable than the seller of the stock that you are buying?
  • Are you able to handle to look wrong for and extended period of time, before you eventually are proven right (assuming you actually made a good bet)
  • Do you have more patience, discipline, emotional intelligence, confidence and humility than the average investor?

 

How often should you check your stock prices?

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Addicted to checking the price of your stocks every day? How often do you check your stock prices?

 

It’s very easy to fall into the trap of checking your stocks prices or portfolio value on a daily basis. It’s very tempting and we feel that we somewhat have more control of the outcome when we do this. With today’s technology is also very fast and easy to do this. However the research shows that people who check their stocks frequently on average gets a lower annual return on their investments than people who check less frequently. Actually the one who had the highest returns where the ones that had forgotten they had a stock portfolio and people who had deceased! The reason for this is that checking your stock prices often will lead to over-trading which then will lead to lower returns because of higher transaction costs. Remember in investing we usually are our own worst enemy and seeing you stock prices or portfolio value going up and down on a daily basis will trigger our non rational part of our brain to do stupid things.

One of the reasons is that we feel more than twice as much emotional pain when we see a loss in our stock account than with the equal amount of gain. So that means that a sure way to feel miserable is to check in on your stocks daily, because the fluctuation in stock prices in the short-term is random, close to 50/50. One of the keys to successful investing is to be able to control your emotions and be disciplined, and checking the stock prices daily is making it much harder for yourself. Setting up the environment around you so that you get less affected by the emotional brain and use more of your rational brain is very important.

Also for the long-term investor there is no need to check the stock prices frequently. First; the markets daily fluctuation in prices does not tell us anything if you have done a good investment or not. That is only after 1 year or longer that you can use the market price as an indicator of you did a good buy or made a mistake. Also the reason in the short-term for the fluctuation in stock price is because of market participants need for liquidity or just for reasons neither I or any other “experts” really know. Second; companies does not change that fast. The business of a company does not change more frequently than maybe every quarter or even on a annual basis. So to check your stock price on a daily basis to check how your company is performing just don’t make sense for the long term investor.

It’s also quite stressful to look at your stock prices daily and one of your goals with investing is to invest with the least amount of stress on a daily basis. The less stress you have the higher chance of better investment decisions. Our brains don’t operate well under stress, because under stress we rely more on our instincts and emotions rather than our rational decision system; a sure way to reduce your chances of high investment returns.

I can assure you that the best value investors are not concerned about their stock prices on a daily basis, but are more concerned about the stocks financial performance on a quarterly and on a annual basis.

 

Here is my advice for avoiding falling into this trap:

 

  • Nothing bad happens if you stop following your stocks on daily basis. Relax and do other more useful things like reading great investments books.
  • Remember that your long-term returns will likely suffer if you frequently check your stocks prices.
  • Remove stock price apps from your smart phone/computer!
  • Do not check your stock prices more than maximum once per month. Even less frequent is also OK. I suggest looking at your stocks on the 1’st in the month if your really feel the need.
  • When you check your portfolio, don’t get concerned about the decline of individual stocks, but instead you should track the total value of your portfolio over longer time periods. Check out the total portfolio value tracker at the free investor material page
  • Set up automatic price alarms that will alert you when your stock is reaching its intrinsic value or when it’s dropping to a price that you would be interested in averaging down. Gurufocus.com has a great price alarm tool for this.