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How Concentrated (or Divisified) Should You Be with Your Portfolio?
Posted by: whopper investments (IP Logged)
Date: March 29, 2012 10:55AM

In the past few weeks, GTSI has enjoyed quite a run, moving from the low $4s to the low $5s. Given it was already a major holding for me, the run up resulted it becoming a bigger holding than I was comfortable with, so I’ve been slowly selling the stock into the run up to keep it at ~10% of my portfolio (please note I’ve begun writing this on March 28. The stock is reporting earnings tomorrow morning, so it could end up much higher or much lower than the current price I’m looking at ($5.24)).

Now, given one thing I mentioned in my new year’s resolutions to becoming a better investor was my desire to concentrate more, and GTSI still sells for 0.5x book and about net cash value, it’s probably strange to hear me selling a piece of my position.

But I think it makes sense.

I was reading this article on why one of my favorite bloggers doesn’t diversify and instead focuses on his best ideas (~20-25% of his portfolio in his stocks, with only 4-5 stock in his portfolio). And it got me thinking of what it takes to invest with that much focus.

The answer- you need to be investing in great businesses. You can’t just be investing in things trading at a huge discount to assets. The business has to be one you’re confident will grow and compound wealth over time.

Let’s start with something that should be obvious, but I think goes a bit neglected.

The purpose of investing on your own is, over the long run, to realize positive relative and absolute returns.

To do that, you have to either buy businesses at a discount to their asset value, or buy businesses that can compound money faster than the market as a whole at a price that implies they’ll compound money at the market rate (this is what I mean when I talk about determining if you are an asset based or franchise investor).

If you’re investing in net-nets, you’re doing the first. And you’re simply betting on them returning to a normalized valuation level. This happens two ways- either the underlying business returns to earning a normalized return on assets (and thus deserves to sell for a somewhat average market multiple), or someone will eventually come in and liquidate the business until the remains can earn a normalized return. As long as you’re investing in safer net-nets (with low leverage and without a history of big losses), you’re probably going to end up with generally positive absolute results because they trade at such an extreme discount to asset value. But your annualized results in any one stock will depend heavily on how quickly the turnaround / catalyst takes place.

Let’s take GTSI as an example. Short of complete management incompetence actually destroying asset value, it’s a near certainty that an investment in GTSI will eventually result in a profit, probably at least of 50% (that level would still have them trading below their NCAV). The question is when the value will be realized- if management does something to realize value in the next twelve months (like a dividend of excess cash or buying back shares), you’d have more than a 50% annual return.

Outstanding.

But if it takes an activist getting involved to liquidate the business until it can invest at a decent ROIC and ten years for that to happen, you’d likely end up with a bit bigger absolute gains on GTSI, but a horrendous annualized return. Why? Because GTSI’s core business at its present size has shown an inability to invest capital at rates above 5%, so after factoring in a cost of capital, any investment in the core business in its current form is actually destroying value.

That’s why I think a basket approach to net net and asset based investing makes the most sense- spread your bets along ten or fifteen of them, and then you spread out the risk of one stock sitting dormant for years. Remember, the BEST you can hope for long term is these businesses compounding money at a market average rate, and thus if you’re in the stock for an extremely long time (ten-fifteen years), you’d likely earn about the market average. You invest in these knowing that these stocks are so cheap many of them will experience some form of catalyst or turn around, as there’s huge profit available for whoever performs that catalyst/turnaround.

This is also why I think that in general net net investing, you don’t really need to pay that much attention to business prospects. All net-nets are going to have some hair on them or they wouldn’t trade at such a huge discount to tangible assets. As long as you can determine that the business isn’t tragically flawed, doomed to constant cash consumption, or completely over-levered (the last is a rarity in net-net land, but it does happen), buying a basket of them should work out well.

So the net-net, asset based would argue for a somewhat diversified, spread out approach.

Let’s think about what you need to practice focus investing.

You need to either know that the business is about to return money to you, or you need to be investing in a business that can compound money faster than the market.

The first strategy is basically investing with a hard catalyst. It’s what you see the majority of activist investors do- concentrate in five or so stocks, buy a big portion of them, and then force the board to pay out a special dividend or sell themselves. In other words, they buy a crappy business at a huge discount and force a liquidation or a turn around. They can focus because they know they can force the catalyst and won’t need to wait ten years to realize value.

The second strategy is buying great businesses. When you do that, you don’t need hard catalysts. You can be content to sit back and wait, because as long as you bought at a reasonable price, the business will prove to be a compounding machine that will create value over the long term. Even if the market doesn’t immediately recognize the value, you’ll still make a very solid annualized return over the long run because of the underlying business fundamentals.

I think the best example of this is to look at Warren Buffet’s past. As far as I know, the biggest investments he ever made (on a percentage of his portfolio total) were Sanborn Maps, Berkshire Hathaway, American Express, Washington Post, and Geico.

Sanborn Maps was a declining business. But it was worth something, and it was trading for below cash value. Buffett could concentrate in it because he knew he could take control and force the catalyst of the business paying out its excess capital. If he hadn’t been able to force the catalyst, no way he makes it such a big position- if it had taken ten years for the big payout to come, Buffett would have made a larger absolute gain but a much, much lower annualized return.

Same thing with Berkshire Hathway (which, btw, he has admitted was a mistake). The textile business was a huge negative, but Buffett knew he could take control and liquidate the textile business, slowly allocating capital elsewhere. If he couldn’t take control, he wouldn’t have concentrated in Berkshire.

American Express, Geico, and Washington Post were all wonderful businesses. Buffett didn’t need to worry about catalysts- he could be content to just sit back and let the business compound. When the market came to its senses, he knew he’d make a great annualized return. It didn’t matter whether the market came to its senses the next day or fifteen years from then.

So, going back to the problem of portfolio allocation, I wouldn’t mind putting 25-50% of my portfolio into an idea if the right one came along.

Actually, I’d like to.

But it’d have to be a stock that was both incredibly cheap and with a business that I thought could compound at attractive rates for a long time. I don’t have any of those wonderful businesses at a huge discount on my radar currently, so my portfolio is geared more towards 5-10% positions trading at an extreme discount to assets like GTSI (and thus, the selling as it became a big piece of my portfolio).

Disclosure- long GTSI



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Re How Concentrated or Divisified Should You Be with Your Portfolio
Posted by: batbeer2 (IP Logged)
Date: March 29, 2012 12:16PM

Thanks for the article.

>> Sanborn Maps was a declining business.

The fact that it was trading at a discount to its portfolio of investments doesn't mean it was in decline. The company now has revenue of $ 75m per annum and dominates its niche.

Sanborn.com



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Re How Concentrated or Divisified Should You Be with Your Portfolio
Posted by: ramands123 (IP Logged)
Date: March 30, 2012 10:47AM


Good one. I will agree with most of the artical.

On concentration aspect Lucedia Ian Cumming invested 90 % of thier portoflio in one stock last year ..Jefferies.

I guess both approaches work very good. What ever makes you sleep comfortable in night when market drops 30 -40 % is the best one.


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Re How Concentrated or Divisified Should You Be with Your Portfolio
Posted by: Adib Motiwala (IP Logged)
Date: March 30, 2012 01:18PM

Hi,

You covered the net-nets as a basket and the focus/extreme concentrated approach via activism / great businesses.

How about a slightly lesser concentration just in cheap and good businesses....not necessarily the higher quality businesses like say MasterCard. Where do you see that fitting in the scheme of things.


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