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Should Value Investors Diversify or Concentrate Their Portfolios?

How many is too Many?

How many stocks do you have in your portfolio? Should your portfolio hold a large or small number of holdings? It doesn’t help that there are studies showing that famous value investors have had success with both methods.

 

With the rise in popularity of index tracking funds and ETFs, investors don’t have to think about this as these funds buy across the entire index. On one hand, index funds and ETFs result in maximal diversification, but on the other hand, some of the greatest investors value investors of all time held very concentrated portfolios. This can be especially confusing for those who want to get into the stock market.

 

So, which is it? Let’s compare the difference between concentrated and diversified portfolios and see if we can find a modern solution.

 

Concentrated

 

Munger and Buffett

 

This camp can best be described as the Buffett and Munger view of portfolio construction. As Buffett once famously quipped “Diversification is an insurance against ignorance”. What he meant by this is serious investors should diligently research the companies that they plan to invest in, and generally only invest in things that they understand well.

 

Ignorance

What Buffett’s “ignorance” isn’t an insult; in fact, the definition of ignorance is “the lack of knowledge”. Since you can’t be an expert on every topic out there, it is foolish to think that you are not ignorant in certain areas. Being ignorant is ok in this instance, as long as you are aware of your own ignorance.

 

To clarify for Buffett, here is what he really means when he talks about ignorance and investing:

 

Warren Buffett thinks it is better for investors to have more diversification if they do not have the time or effort to put into researching businesses.

 

Quality Investing

Over the course of their respective careers, Warren was known to hold between 6-8 major positions, with Munger taking it to the extreme and holding 3-4 holdings in his portfolio! What they had in common was that these positions were held for the long term and built around confidence and conviction.

 

In fact, they believed the only reason they were able to hold these stocks over the long-term, through volatile markets and steep declines, was due to the conviction they had built through thorough research. Only allowing yourself to hold a few companies, you allow yourself more time to research those companies in depth. They both know the businesses inside and out.

 

They perfectly represent the investors that look at qualitative factors when investing. They ask questions such as:

 

  • How strong/trustworthy is the management?
  • What is the long-term outlook on the business’s industry?
  • How strong is the business’s economic moat?

 

Diversified

 

Ben Graham

 

While Warren Buffett and Charlie Munger may be the most famous names in investing, other successful value investors have managed returns that match theirs with a much higher number of holdings. These are best represented by Benjamin Graham and Walter Schloss.

 

Traditional Value Investing

Both Graham and Schloss fully understood the concept of buying stocks at a discount to their intrinsic value (Benjamin Graham coined the idea after all!), yet both held more than dozens of companies. Benjamin Graham’s fund averaged 20% per year returns while Walter Schloss averaged 21% over 28 years, while holding in the region of 100 stocks in his portfolio.

 

These legendary investors were traditional deep value investors. They bought the statistically cheap stocks and bought baskets of them in order to smooth out the volatility that often came with these undervalued businesses. This is in contrast to the Buffett or Munger strategy who preferred to simply stomach the wild swings since they know the business.

 

Walter Schloss

 

Graham and Schloss encapsulate the mechanical investor, those who have a set of quantitative criteria and buy any stock that meets it. They rarely look into the ‘story’ of a business and invest on the basis of the numbers.

 

The driving principle for these value investors was that if you take care of your downside through diversification, then the upside would take care of itself. Additionally, to paraphrase legendary investor Peter Lynch, who while not a traditional value investor also held hundreds of stocks, “You have to turn over a lot of stones to find a winner.”

 

Middle Ground

 

Joel Greenblatt

 

Some investors have come up with a middle ground approach. Joel Greenblatt, another legendary value investor, did his own research and found that 8-12 positions is the optimal amount for portfolio diversification without the law of diminishing returns taking effect.

 

This means that investors gain a significant benefit for every additional stock they add to their portfolio, up to 12 stocks—from there, the benefit quickly diminishes.

 

But Joel Greenblatt’s strategy also implies that investors should blindly choose stocks based on multiples, which can lead you into trouble.

 

Investing Environments

Back in Graham and Schloss’s day, there were a lot more companies trading at ridiculously low valuations compared to today. Graham and Schloss recognized these companies and simply had to wait for the market to realize the error. They did not need to know the story; they just knew it was cheap.

 

Nowadays, companies very rarely trade at those low valuations. If you could formulate Graham and Schloss’s investing environment into an equation it would look like this:

 

High interest rates + slow flow of information = low stock valuations.

 

Fast forward to today, and we have the opposite environment equation.

 

High information flow + low interest rates = high stock valuations.

 

So, what does this mean for traditional value investing?

 

The traditional value method now requires a basic knowledge and understanding of why the company is trading at a discount.

 

If you lazily buy a company because it is trading at a P/E of 5 simply because it is a low multiple, that company may be trading at a cheap valuation for a reason. It could be losing market share or destroying shareholder value.

 

In my opinion, you should be immediately able to explain to anyone at any time why you hold a certain stock. The strategy can differ, but at a bare minimum an investor should be able to know these things about their holdings:

 

  • Intrinsic value
  • Holding period
  • Economic moats and tailwinds (if any)
  • Expected return

 

This can be really hard to do if you hold more than 15 stocks. The more you have, the harder it is to track. So, how many holdings are optimal?

 

The Modern Value Investing Portfolio

Here is my strategy for traditional value investors in today’s markets: combine them all.

 

By taking the quality investment method of Buffett and Munger, the traditional value tactic from Graham and Schloss, and Greenblatt’s 8-12 positions, we can develop our own modern approach.

 

Here is my model value investing portfolio:

 

The Modern Value Investing Portfolio

6 – 7 long term quality stocks (Buffett and Munger style)

4 – 5 short to midterm value stocks (Graham and Schloss method)

 

This take the successful methods of different strategies and combines them into one (hopefully) balanced portfolio. The quality stock are focused and still concentrated for long term compounding, while a few traditional cheap value stocks can still provide the portfolio with short to midterm big gains.

 

Of course, the number of stocks can fluctuate based on your personal needs and market situations. I believe this modern blend of quality, value, concentration, and diversification (and research!) can provide all investors the benefits of each strategy, with limited risk.