Background and Context
Diversification within equity
Don’t put all your eggs in one basket is a famous quote. For an investor, this phrase can be read replacing ‘eggs’ with ‘funds’ and ‘basket’ with company. So the revised quote goes like this don’t park all your funds in one company. The content in this white paper is an attempt to decode the idea of diversification but within equity. Investors need to understand how to construct their portfolio and with what logic should they add companies to mitigate risk. Remember, equity, over long time periods, is a tried and tested asset class that has delivered alpha over the last few decades in India.
Diversification is subjective
The concept of diversification has multiple dimensions and is not limited to merely increasing the number of companies in a portfolio. Also, the meaning of diversification can be subjective and may vary from individual-to-individual based on one’s (i) income; (ii) age and (iii) temperament. We, therefore, have compiled list of factors that need to be considered to decide the extent of diversification.
Investing style of two legends – Lynch versus Munger
We have preceded this list by giving examples of two legendary investors Peter Lynch and Charlie Munger who are successful investor-cum-fund managers while being at extremes in the context of diversification in their portfolio. They have fantastic track records of performance but have mutually exclusive theories for diversification. Lynch at some point had as many as 1000 companies in his portfolio while Munger only 3 companies – hyper concentrated – businesses that he understands and tracks.
There are no rules or defined strategies available as both risk and returns can be defined differently by different investors. However, we have evaluated investing style of these two legends to draw key learnings as takeaways.
Diversification ≠ solution to poor analysis of a company
We also want to highlight rather mention categorically that diversification is ‘Step 2’ in portfolio construction. ‘Step 1’ is selection of good companies with able management and is mutually exclusive. By no means can diversification mitigate the risk of having bad companies in a portfolio. Diversification ≠ solution to poor analysis of a company.
Business risk or Portfolio Standard Deviation
We believe it is important not to perceive portfolio sigma or standard deviation as risk if your time horizon is 3 years or more. Portfolio standard deviation (annualised) indicates by how much will the portfolio market value go up or down in a given year. Business risks are events that can change earnings expectation of a company. To re-iterate, volatility is not the same thing as risk for long-term investors. Therefore, when we add companies to a portfolio to mitigate risk the thought process should be to add different business and not to bring down portfolio sigma.
Who is Peter Lynch?
Peter Lynch (born January 19, 1944) is an American investor, mutual fund manager, and philanthropist. As the manager of the Magellan Fund at Fidelity Investments between 1977 and 1990,
What did he do?
Lynch averaged a 29.2% annual return, consistently more than doubling the S&P 500 market index and making it the best performing mutual fund in the world. During his tenure, assets under management increased from US$18 million to US$14 billion.
What is noteworthy about his investment style?
Peter Lynch ran a highly diversified stock portfolio. By the end of Lynch’s career, the Magellan fund was known to hold more than 1,000 individual stock positions at any given time.
What differentiates Lynch’s approach to diversification is that he does not buy stocks with less compelling investment prospects just to reduce the volatility of his portfolio.
Lynch diversified his portfolio based on the expected earnings growth of the underlying businesses.
Who is Charlie Munger?
Munger was born in Omaha, Neb., in 1924. As a teenager he worked at Buffett & Son, a grocery store owned by Warren Buffett’s grandfather. Currently, Charlie Munger is Warren Buffett’s business partner and vice-chairman of Berkshire Hathaway, one of the world’s most well-regarded corporations.
What did he do?
Charlie Munger heavily influenced Warren Buffett’s investment style. Munger’s philosophy of buying and holding high-quality businesses for the long-run clearly rubbed off on Buffett. Before Munger, Buffett was much more of a traditional value investor. After Munger, Buffett focused on high-quality businesses trading at fair or better prices.
What is noteworthy about his investment style?
Charlie Munger ignores diversification in the traditional sense. Munger believes in holding a hyper-concentrated portfolio of extremely high-quality businesses; he is comfortable holding as few as 3 securities at a time.
The point we are driving is while both the above legends are good at what they do, they are at extremes when it comes to ‘Diversification’. In the next section, we have highlighted thought process that will help decide extent of diversification in your equity portfolio.
Thought process that will help decide extent of diversification in your equity portfolio
Demography
Extent of diversification depends on the below factors:
Peter Lynch’s categorization of companies
Lynch diversified his portfolio based on the expected earnings growth of the underlying businesses. Lynch believed that stalwarts and slow growers provided stability in Magellan’s portfolio while fast growers were a source of alpha (outperformance over the benchmark).
What differentiates Lynch’s approach to diversification is that he does not buy stocks with less compelling investment prospects just to reduce the volatility of his portfolio.
Sector-wise diversification is a must
Sectoral diversification allows us to rationalize capital into investment hypothesis of unrelated sectors. Unrelated sectors are defined as ones have co-relation of less than 0.50 or in some cases even negative. Correlation is a statistical measure that indicates the extent to which two or more variables fluctuate together.
Optimizing Risk-Reward
The risk-return relationship. Generally, the higher the potential return of an investment, the higher the risk. There is no guarantee that you will actually get a higher return by accepting more risk. Diversification enables you to reduce the risk of your portfolio without sacrificing potential returns.
Care PMS strategy in diversifying individual equity portfolio
At Care PMS, we define risk is where we don’t know where we are investing, however though we do thorough studies in the company, there are no of risks which are inherited in any business, like government policies, sharp movement in commodity cost, technology advancement etc.
As a subject, diversification divides opinion. Modern portfolio theory (MPT) argues that portfolio risk can be adjusted by diversifying across a higher number of stocks. This may be agreed by majority of finance professionals in portfolio management.
However, the other school of thought suggests that smaller, high conviction portfolios are sometimes have delivered higher returns and are preferable. Warren Buffett, one of the most pragmatic investor, once remarked that: “Diversification is a hedge for ignorance. It makes little sense for those who know what they’re doing.”
So how do you strike middle ground? Whether to follow Munger or Lynch? The answer is that most investors should diversify more. However, a portfolio manager monitoring investments and tracking developments, on a fulltime basis, can get away with smaller numbers of holdings because he has an edge over a passive individual investor.
At Care PMS, we currently follow the below strategy:
Key Takeaway
Diversification is important but extent is dependent on various factors discussed above. Additionally, it will depend on size of the portfolio, competence to understand business, resources available for monitoring and the most important — expected returns. However, under no circumstances, diversification will serve as a solution to risk created by poor selection of companies.
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