The Diversification Myth (Part II)

A couple of weeks ago, I explained that academia typically views risk differently than do most value investors (post here). In short, many finance professors espouse the merits of holding a large portfolio of stocks…diversify. Financial planners and financial services commercials also blare the same message…“hold a diversified portfolio of stocks.”

 

But the problem is that diversification is often associated with reducing volatility. And I think that people often diversify simply to reduce volatility sacrificing performance as a result. But some of the most successful investors place more importance on clarity (really knowing a few good names) over diversification in the commonly understood sense.

 

Take the holdings of Joel Greenblatt (Per his latest 13-F filings)...

Wal-Mart (WMT)
Wal-Mart has a world-class franchise, a global footprint and the ability to expand its business for many, many years to come. While the business does not generate phenomenal returns on capital, Wal-Mart enjoys something that many other retailers do not – the company absolutely lords over suppliers unlike any other retailer. Wal-Mart demands price cuts and concessions, sometimes at pre-determined intervals, as a condition of doing business. They can do so because of sheer size – they are larger than Target, Sears, Safeway and J.C. Penny’s combined.

With so much control over the cost of goods, it’s easy to see why Joel Greenblatt likes the company. The current price combined with anticipated modest growth means that the is stock trading at less than 14X three years forward earnings which is simply too cheap for such an established and proven business.

American Express (AXP)
The case for AMEX is a little less obvious. With the recent judgment against Visa and Mastercard, American Express is now allowed to offer branded cards through banks like Citi and Bank of America. This should add a boost to both its foreign and domestic growth for a long time. 

After spinning off its Ameriprise (AMP) unit the company represents a high return on equity business that is growing at 20% per year. This pick is harder for me to swallow since it is trading at a multiple of 30X per year, but Greenblatt is almost always right so he must know something the market does not.

Despite betting heavily on these stocks, Greenblatt himself knows of the potential benefits to diversification in the academic sense.

In his book “You Can Be a Stock Market Genius”, he shares the following numbers about reducing non-market risk:

· Owning 2 stocks eliminates 46% of non-market risk of owning 1 stock

· 4 stocks eliminates 72% of the risk

· 8 stocks eliminates 81% of the risk

· 16 stocks eliminates 93% of the risk

· 32 stocks eliminates 96% of the risk

· 500 stocks eliminates 99% of the risk

 

OK. So what I learn from this is that nearly ¾ of the non-market risk that everyone seems to intent on making go away I can make disappear just by owning four stocks. News to me. If I double that, another 8% of that risk goes away. “Great” you might say. But why then doesn’t Greenblatt hold 500 stocks in his portfolio?

For one thing, he has clearly found a couple of names in American Express and Wal-Mart that have some clear and sustainable advantages like the ones I laid out above.

 

As well, it’s a lot harder to find eight stock ideas I think are great than four. And certainly a lot harder to find 16 great ideas that I really believe in than eight. Owning four additional stocks that I don’t believe are winners for the sake of diversification will hurt my returns if I am not as confident or right about them. I would rather hold the cash. Investing isn’t just a game of intelligence—it’s about patience.

 

There may be some assumptions that I am making here: that the people picking the assets are well-informed, proficient in evaluating a stock, and that their confidence about their first idea is greater than their last. And that may not always be true. But looking at Greenblatt’s performance, at the very least we should begin asking the question, “Just how much diversification in my stock portfolio is right for me?”

 

I am not sure that there’s one right answer to that but Whitney Tilson makes an interesting argument for what he called Focus Investing in an old article of the Motley Fool that may be a great place to start.

I currently own a position in WMT but do not own a position in AMEX or AMP of the date of this writing – this may or may not change in the future. Under no circumstances should any of the comments stated above be viewed as a recommendation to buy, sell or hold any security. A decision to invest or not invest in any particular security should be made in the context of the financial situation of the individual or entity involved and, as such, this communication should not be construed as a recommended action. Please see additional conditions of use for disclosures and relevant information.