How many stocks?

Should a share portfolio have one, five, 10 or 20 stocks? What is over-diversification, what is under-diversification? What is the appropriate number of stocks to own? Obviously there is no 'correct’ answer to this question. Anyone reading investment literature might get confused because some silly things are said about portfolio diversification. Here are a few observations that may help consideration of this important subject.

Benjamin Graham, the father of security analysis and the mentor of the world's best-known investor, Warren Buffett, advocated broad diversification. To him it was the second safety net protecting the investor against risk (the first safety net being margin of safety). Graham calculated intrinsic value for a stock and sought to buy at a significant discount (margin) to his assessed value.

Buffett is quite different. He is a focused investor and advocates a concentrated portfolio. “Diversification is a protection against ignorance,” he says. “It makes very little sense for those who know what they are doing.”

“Don’t put all your eggs in one basket” is an old proverb. The opposite point of view was advocated by steel baron Andrew Carnegie: “Concentrate; put all your eggs in one basket, and watch that basket”. The BRW rich list is, of course, full of (eggs in one basket) non-diversifiers.

To try and make sense of these conflicting views I think it is useful to consider a venture capital fund. Venture capital is essentially 'start up’ capital. I don’t invest in start-ups. I am more interested in 'development capital’ (as opposed to venture capital) – investing in companies that have survived the initial start-up phase and need funding for growth. But a description of a venture capital fund illustrates a point I want to make about diversification.

A venture capital fund might have a fixed 10-year life. You invest your money in 2007 and you get it out in 2017. The fund might invest in 10 stocks. Of them, two might go under for 100% loss, two or three might disappoint somewhat, two or three might do as expected, a couple better than expected and two might do spectacularly – blow the lights out. I once read a US venture capitalist comment: “We live off our home runs.” Such is the nature of venture capital investing: they live off their home runs. So it would be a misunderstanding of the nature of that type of investing (and indeed be churlish) to say: Gee, if you didn’t have stock X and stock Y (the home runs) your performance would have been very disappointing. Serious gains and serious losses are the nature of that type of risky investing.’

It should be clear that for a venture capital fund diversification makes sense. It also makes sense for my style of investing in micro and small-cap stocks. I try to find companies that are at their inflection point, at the beginning of a strong growth phase. Such companies often have not been public for very long, and they may have even floated recently. So they have limited track records. They are unseasoned. You don’t know whether the management can cope with growth. You try to form a judgment of course, but you don’t know because these are still the early days of business growth.

A small-cap investor can also live off home runs. You can only lose 100% but on a great stock you can make 1000% or more. ABC Learning Centres increased by 2200% between March 2001 and December 2006. A 'twenty-two bagger!’ So this type of investing can be relatively risky with big losses and big gains. The companies may not have long track records, their future is one of expected growth but it is often very difficult to forecast. Diversification makes sense for this type of investing.

Now back to Warren Buffett. He favours seasoned companies with predictable (forecastable) future cash flows. Portfolio concentration makes sense for that style of investing.

The concept is highlighted in a recent investment book Becoming Rich. The Wealth Building Secrets of the World’s Master Investors Buffett, Icahn, Soros by Mark Tier. In Chapter 2, 'The Seven Deadly Investment Sins’, Tier lists sin number four as Diversification. As one successful Sydney fund manager recently suggested: “Diversification works for the 'know nothing’ investor. If you don’t know what you are doing, broad diversification makes sense.”

But it is a mistake for Mark Tier and like-minded local fund managers to make this blanket claim. Diversification makes sense for some styles of investing. A highly concentrated non–diversified portfolio makes sense for different styles of investing.

How many stocks should there be in a portfolio? I once met a US fund manager who had a portfolio of four stocks. I’d say that was under-diversified. I’d be more inclined to say that if you invest in companies with well established track records and fairly predictable future cash flows then at least six stocks might be adequate diversification. But for the small-cap investor like me, owning four or even six stocks would be far too risky, in my judgement.

Three other comments on diversification

• All ideas are not equal. If you choose to have a portfolio of 10 stocks then equal weighting (10% in each) would be ridiculous because your best idea should have a lot more weight than your 10th best idea. Portfolios should be skewed in their weighting to your best ideas.

• If you owned the four major banks you should recognise that they should probably be looked at as a group in portfolio weighting. Similarly, if all your stocks were cyclicals (such as commodity price-dependent mining stocks) then you may not have appropriate diversification to protect against an economic downturn. So the concept of diversification is not just a function of the number of stocks in a portfolio.

• Relevant to the subject of diversification is the fairly common problem of stocks being in the portfolio that shouldn’t be there. There might be failed investments where the investor is reluctant to realise a loss and hangs on in grim hope that the original cost price will be attained again. This is an investment sin. A second type might be “stale” stocks. A stale stock is one that has failed to meet expectations and probably should be sold, but it is cheap and there is a reluctance to sell at an unsatisfactory price. You might have paid 60¢ thinking the shares were worth $1. Something goes very bad and the shares are worth say 40¢ but the shares are selling at 30¢. I tend to be guilty of having one or two of such investment failures linger in the portfolio. But money has a time value. A stock can be cheap (under priced) for years and keeping a disappointment there for year after year is a mistake.

There are many ways to skin the investment cat. On the subject of diversification, different degrees of diversification are appropriate for different styles of investing. It is common sense really, but as they say, common sense is not common.

Peter Guy is a Melbourne-based fund manager at Warakirri Asset Management.