Diversification..again..

I often get asked the question "what are your thoughts on diversification?"  Someone asked me recently and I thought that newer readers might appreciate my thoughts on it as well.  I wrote about this a year and a half ago, the post generated some lively comments, and I expect this one will as well.

Before I begin in I want to set out a few points accommodate those who are too lazy to read the post, but will post comments anyways.  I have heard that Warren Buffett says that only the ignorant diversify.  I have heard that I'm diluting my returns by investing in anything beyond my ten best ideas.  I've heard that what I do is just mechanically investing based on math, or formulas.  I'm already well aware of all these things, no need to refresh me.

It's surprising but I actually believe in concentrating one's resources into a single investment if the circumstances are appropriate.  If an investor has control over the investment, and can make decisions about the company's strategy, future direction, and capital allocation I think it makes sense to concentrate resources on that investment.  I think it makes so much sense that if you're in this position it might make sense to focus all of your money, time and effort on the particular investment.  I think concentrating in a position also makes sense for hedge funds and mutual funds in similar positions.  If they have the ability to control or influence the outcome of an investment it makes sense to concentrate their capital where they are spending a lot of time and energy.

There's a story floating out there where Charlie Munger talks about owning a small town restaurant, hardware store, gas station, and hotel.  He says he'd feel adequately diversified with that portfolio.  I would as well, the reason being that in the analogy I would own and control those properties.  How would the story change if I owned a tiny little sliver of each and a faceless manager 800 miles away who I couldn't get on the phone was making the decisions?  Would I still feel diversified?

There's a famous Buffett quote that's often used to bludgeon investors who concentrate their portfolios: "Diversification is nothing more than protection against ignorance."  This quote describes me and my investing perfectly.  When I look deep inside, no matter how much research I do I am still ignorant of the companies I'm investing in as an outsider.  I laid out my thoughts for that in this post, one that many of you skipped.

As outside investors we can't know everything about what's happening at a company.  If we think we do we're deluding ourselves.  I worked at a startup out of college that was in many ways run on a shoestring and a lot of hope.  We had outside investors who were blissfully unaware of what was actually taking place day to day.  At one point we had a massive system crash that destroyed all of the company's data, intellectual property and software.  Our core system had died suddenly without a backup.  Thankfully a coworker was able to engineer a solution and numerous hours later business continued as usual.  Customers knew there was a massive disruption, and employees knew without our co-worker's creativity unemployment would have been our future, but investors receiving quarterly statements they never knew they were hours away from losing everything.  Unfortunately many companies are run in the same haphazard way, and we as investors never have any idea.

I diversify my portfolio to avoid disaster, but that isn't the only reason, or the main reason.  The theory for concentrating is that no one is bothering with investments that will only return 50%, rather many only invest in companies that double, triple or quadruple in two or three years.  Why settle for a measly 50% return when you can search harder and find the 400% return?

If I could find five stocks that I knew would all quadruple in three years I'd bet the farm on them as well.  The concept sounds great.  The question I have is where are all the funds and investors doing 100% compounded?  Compound capital at 20% for a decade or more and suddenly you will be a 'guru'.  Why is there such a gap between what investors are looking for and what happens?  Many shoot for the stars investments fall flat.  A few do make it to space, but their gains needs to be spectacular to negate the losses for the rest of the investments that blew up.

The problem is consistency.  It's hard to consistently invest in companies that return 200%+.  To understand why think of baseball.  It's easier to consistently hit singles verses consistently hitting home runs or grand slams.  A grand slam is possible under the correct circumstances, but a single is possible every time the batter steps to the plate.  In theory a hit is a hit, but that's not true.  A pitch needs to be thrown just right, and the bat needs to hit the ball with enough power at the right place for a home run to occur.  Players who can consistently get on base are more valuable than the power hitter who makes a great highlight on ESPN, but mostly strikes out.  I think of Walter Schloss, an investor enthroned in value investor lore who consistently hit investing singles.

If a company meets my minimum criteria for an investment I'm likely to take a position.  It might be a small position, but it will be added to the portfolio.  It's important to note that not every position gets some pre-set mechanical sizing.  If a company is unusually cheap, or there's some other special characteristic I will size the holding larger.  Sometimes I'll increase a position if the company becomes cheaper, or if I become more convinced about their potential.  I have averaged down on holdings, but I've also averaged up.

Whereas sometimes I'll take a larger positions, I've also taken many small positions.  My holdings in community banks are a great example of this.  I have a general profile for a cheap bank that I look for.  If a bank meets my criteria I will take a small position.  There have been a few of these banks that after researching I end up liking and take a larger position.  In general most are tiny positions.  In the aggregate my exposure to small community banks is greater than 10% of my portfolio.

A great criticism might be to ask why I don't just invest in an index of banks.  The problem is there is no index that does what I want.  There are no indexes that invest in banks with $9m market caps, or $150m in assets.  I don't know of an index that has criteria that says if a Chairman and CEO are in their 70s it will buy more.  If there were an index that did some of these things I'd probably consider purchasing it.  I enjoy investing, but it isn't like I couldn't find something else to do with my time either.

I know my approach isn't for everyone.  It's probably not for anyone.  It works for me though, it's something I'm comfortable with and lets me sleep well at night.  I'm going to continue to hit singles and doubles and let the rest of you hit the home runs.