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Value investors are generally split along a distinct dichotomy. One side focuses on the value of a companies future cash flows (earnings), while the other side focuses upon the value a company’s assets. In most cases, the side which focuses on assets is exposing themselves to considerably less risk; although the average investor would probably believe that exactly the opposite is true. The reason is simple; the value of a company’s future cash flow is much more difficult to predict that merely assessing the value of a company’s net assets.
In past articles, I have written extensively about Walter Schloss and Philip Fisher. The two investing legends represent polar opposites when it comes to investment philosophies: The creed of Schloss calls for heavy diversification in low price to book stocks, with the intent of selling the stocks when they become fairly-valued in terms of price to book. The creed of Fisher calls for low diversification in a few truly outstanding companies, with the intent of holding them for decades, without regard to price to book metrics.
The Schloss approach accords the average investor with a much greater margin of safety than the Fisher approach. However, it appears that the margin of safety is not so much a function of diversity; rather it is a function of a low price to book ratio.
Price to Book Value and Margin of Safety
Many readers are probably familiar with the theories Eugene Fama and Kenneth French. Their theories are still taught in post-graduate Finance classes. Farma is credited with developing and advancing the"Efficient Market Hypothesis" which is a major component of the Capital Asset Pricing Model (CAPM). Simply stated, the core belief imbedded in CAPM theory relies upon the assumption that the volatility of an equity (beta) is commensurate with its risk (risk=beta). Additionally, the market is assumed to be efficient since all investors have access to the same set of information. The theory advances the edict; the only way to outperform the general market is to take additional risk by investing in high beta (highly volatile) equities.
The notion that low price to book stock accord an investor a greater margin of safety as well a much better market returns is backed by statistical research. Ironically, one of the best studies which confirms that observation was conducted by Fama and French. http://www.investorhome.com/anomfun.htm
Fama and French back tested the performance of stocks based upon their price to book ratio from the period of 1963 to 1990. The study examined virtually all the stocks from the three major US indices and realigned them on an annual basis. They were classified in 10 separate groups ranging from the lowest price to book ratios to the highest.
Not surprisingly, the study confirmed that the group which contained the lowest price to book metric outperformed the group with the highest price to book metric by 21.4% to 8%. More significantly Fama and French also measured the groups of stocks for volatility using beta. The low price to book stocks not only outperformed the high price to book stock by performance, they also exhibited a significantly lower price volatility. That suggests that low price to book stocks are not only better performers but also much less risky in terms of beta. That translates into not only a higher return but also a greater margin of safety.
Diversification and Risk
Common sense would dictate that a greater diversity of holdings would result in a diminished risk to the volatility of one's portfolio; however the idea that a high degree of diversification provides a greater margin of safety is largely a fallacy.
James Montier addressed the subject of diversity in Chapter 4 of his investment classic: "Value Investing Tools and Techniques for Intelligent Investment". http://www.amazon.com/Value-Investing-Techniques-Intelligent-Investment/dp/0470683597/ref=ntt_at_ep_dpt_2
Montier cited a 2009 study by Society General Global Study titled "Total Portfolio Risk as a Function of Stocks Held". The study demonstrated that holding as few as eight stocks would eliminate 83% of the risk to one's portfolio, while holding 32 stocks would eliminate 96%.
Buffett has pointed out: "Wide diversification is only required when investors do not understand what they are doing". The question remains, why do so many investors and investment funds over diversify? Walter Schloss for example, routinely held over 100 stocks at any point in time and no one in their right mind would accuse him of "not understanding what he is doing".
I think that the main reason most investors over diversify is two fold: 1) psychologically, it provides them with a false sense of security and 2) investors do not like to sell their losers until they break even. Peter Lynch described the latter phenomena as "pulling the flowers and watering the weeds".
If an investor systematically refuses to sell a loser until they get their money back, then his/her portfolio tends to become cluttered with a large number of tiny positions. Warren Buffett described just such a situation in his biography, "The Snowball." The company was National American.
Decades before when National American sought out investors in Nebraska the company was a fraud. The company had used a prominent Omaha-based insurance agency to unwittingly sell worthless shares to out state Nebraska farmers at 100 dollars a share. The family of the agency gradually turned the company into a viable business and at the time Buffett discovered the company in a Moody's manual, it was selling for 30 dollars a share while its current earnings represented about 29 dollars per share.
The defrauded farmers who still owned a large percentage of the stock had no idea that the company was now legitimate and the Omaha family who resurrected the business was slowly accumulating the stock at $30 per share. The family had been successful in accumulating approximately 70% of the stock and their price was etched in stone for anyone who wished to sell.
Buffett was unable to accumulate any shares since the local stock agent who dealt in the shares would only purchase the stock for the controlling family. The broker also held the list of shareholders; therefore Buffett was unable to contract any of the shareholders directly in a attempt to purchase their stock. Buffett eventually outsmarted the family by identifying a small farm community which held a large amount of the remaining shares. He immediately started overbidding the family, offering 35 dollars per share. He was successful in accumulating a modest amount of shares before the farmers became wise.
The farmers rightfully sensed that a price war was ensuing and many refused to sell their shares. Buffett slowly upped his bid and was successful in buying about 10% of the company. He found it easy to accumulate shares when his price reached $100, which was the break even point for the farmers. At that point they easily rolled even though the company was still trading ay less than 3.5x its earnings.
The key element was the fact that the farmers had originally paid 100 dollars per share. They were finally willing to liquidate their positions decades later; they had finally recouped their paper losses when they accepted Buffett's bid of $100 a share.
Conclusion
1) The average investor is better served by modeling their investment philosophy after Walter Schloss rather than Philip Fisher. Both philosophies can be highly successful however the average investor does not conduct the necessary diligence or possess the intimate understanding of a business which is required to outperform the market under the Fisher model.
2) Low price to book stocks not only promise oversized long term returns, they also provide a greater margin of safety than stocks which have higher price to book ratios.
3) Research implies that investing in stocks which have the lowest price to book ratio is a winning strategy. When an average investor couples this strategy with a modicum of due diligence the results can be outstanding.
4) Most investors tend to over diversify and could enhance their returns by reducing their holdings to a manageable number.
5) Diversifying quickly reaches the law of diminishing returns; holding more than 32 difference positions does not result in significant reduction of risk.
6) Many investors are guilty "pulling the flowers and watering the weeds". One should never blindly hold a position merely because it is currently under water.
About the author:
I have been of student of value investing since the mid 1990s. I have continued to read and study value theory on an ongoing basis. My investment philosophy most closely resembles Walter Schloss although I employ considerably less diversification. I also pattern my style after Buffett's early investment career when he was able to purchase shares of tiny companies.
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I believe that Eugene Fama is the correct name rather than "Farma". Otherwise this is a helpful article. The idea that diversification beyond 32 names interests me.