“Ironically, then, diversification is not helpful when you most need it during systemic downturns, and it hinders performance when you least need it during systemic upturns.” -Anurag Sharma
For many contemporary investors, risk refers to volatility or standard deviation, and diversification becomes a function of mathematical calculations. In chapters 21 and 22 of “Book of Value: The Fine Art of Investing Wisely,” Anurag Sharma challenges both of those propositions.
Suppose you have two stocks and they react in very similar ways when responding to an internal or external stimulus. While they may not behave in exactly the same ways, the overall returns look much the same. Then we can say these two stocks are correlated and if one collapses, the other is likely to do the same. Obviously, there is no diversification.
This was known well before Harry Markowitz introduced his modern portfolio theory in 1952; for example, it was discussed by Edgar Lawrence Smith in his 1924 book, “Common Stocks as Long Term Investments.” Markowitz’s contribution was to see the correlations among stocks in a portfolio and then to build theoretical and mathematical foundations for assessing portfolio risk.
Sharma added, “Markowitz’s genius was in showing how to lower investment risk, mathematically and specifically, by grouping unrelated stocks into a portfolio.” Further, Markowitz claimed that the valuation of an individual stock had little meaning in a big and well-diversified portfolio.
In the Markowitz world, the risk of a single stock in that portfolio could be summed up with one statistical measure of risk: standard deviation. By extension, portfolio theory assumed that markets are efficient and that all stocks are perfectly priced because all available information about companies is known to everyone.
In contrast, value investing rejects the idea of efficient markets and perfect pricing by emphasizing the study of individual companies. Value investors need to know how companies create wealth, and the real and potential challenges to their wealth-creating models. Following Benjamin Graham and David Dodd, the authors of the 1934 book, “Security Analysis,” they want to understand each business in which they might invest.
For example, Warren Buffett (Trades, Portfolio) and those he called “The Superinvestors of Graham-and-Doddsville” have little interest in mathematical formulas. Rather, they study businesses individually and intensively, measuring risk not by volatility but by the possibility of losing invested capital.
They would no doubt agree with Sharma when he wrote, “I submit that the arms-length mathematical approach simply cannot adequately capture the complex of factors that comprise true risk. We need to understand the wealth-creating machinery by getting up close with the businesses in which we invest.”
While I have covered this chapter quite briefly, the original provided an excellent analysis of the differences between the two main schools of investing thought. Markowitz created a platform for academic finance, which has emphasized a mathematical approach to risk and diversification. Sharma makes clear that value investors reject much of this approach and insist instead on staying focused on individual companies.
In essence, Markowitz and academic finance have taken a top-down approach to investment, while value investing takes a bottom-up approach. Can Sharma justify this bottom-up approach? That’s what he took on in chapter 22.
He began the chapter by arguing investors must shed the idea of objectivity and reject the argument that risk can be measured with “a simple statistic” (standard deviation). Therefore, effective portfolio construction must acknowledge that it is a complex undertaking and that risk represents the probability of loss, not volatility in a stock price.
In addition, Sharma notes that there can be a cost to diversification, or as some have dubbed it, “diworsification.” That’s because it reduces upside potential as it reduces potential downside losses. What’s more, in times of severe crisis, such as during the dotcom bust or the financial meltdown of 2008, companies effectively become correlated. As the author put it, “Ironically, then, diversification is not helpful when you most need it during systemic downturns, and it hinders performance when you least need it during systemic upturns.”
What’s missing from conventional theory, he argued, was a place for valuation, the measuring of a stock’s intrinsic value. He also pointed out there is little guidance about the probabilities of future returns because the academic model relies entirely on past returns (that’s where the data are).
Without knowing those probabilities, it is hard to know whether a stock price will go up or down, let alone how large or small that change will be. That, Sharma argued, was why he had been discussing companies, not stocks. Assessing companies means determining how companies generate cash flow and earnings, and how well management is positioned to do that.
Therefore, each company should be evaluated on its own merits, not how it will affect the risk profile of a portfolio. Focusing on just price history and correlations results in meaningless conclusions.
Each company’s business should be vetted with the disconfirmation process, and its intrinsic value should be compared with market prices. When value exceeds the price by a sufficient amount, a margin of safety, then a stock might be added to a portfolio. In other words, a portfolio made up of multiple stocks that all have margins of safety is better than a portfolio based on theoretical correlations.
If you have a portfolio made up of stocks that all have margins of safety, you do not need a lot of diversification. It’s possible to create a robust portfolio with as a few as 10 stocks. For newcomers with little confidence in their analysis, a concentrated portfolio of just 10 stocks can be volatile and frightening. For veterans who are confident in their ability to analyze companies, volatility provides opportunities to accumulate a position. From another perspective, the more confidence you have in your abilities, the more concentrated you can make your portfolio.
Regarding portfolio size, there is a great deal of variation among the GuruFocus gurus:
- David Tepper (Trades, Portfolio) of Appaloosa Management, who has held the top 10-year and "since-inception" returns in recent years, had a portfolio of 22 stocks as of Feb. 14.
- Buffett (and Charlie Munger (Trades, Portfolio)) of Berkshire Hathaway (BRK.A)(BRK.B) had 52 stocks in their portfolio at the end of December 2019. Note that some gurus may have large portfolios, but perhaps 80% or more of their capital is in just a handful of stocks. That’s the case with Buffett and Munger; their top three stocks, Apple (AAPL, Financial), Bank of America (BOA, Financial) and Coca-Cola (KO, Financial), make up more than 50% of Berkshire Hathaway’s holdings.
- Seth Klarman (Trades, Portfolio) of The Baupost Group held 29 stocks at the end of calendar year 2019.
Conclusion
Sharma has explained a deep and meaningful distinction between value investors, the successors to Benjamin Graham and investors who follow Harry Markowitz and modern portfolio theory. The latter depend on mathematical formulas and standard deviation in putting together a diversified portfolio; the former, value investors, study individual companies and insist on margins of safety.
Valuation is a key point of departure and is essential for value investors because it determines whether a company's stock price has a margin of safety. Sharma has argued that a portfolio made up of stocks that all have margins of safety is superior to a portfolio made up of stocks that are chosen for their theoretical lack of correlation with each other. Diversification is much less an issue among value investors than among the followers of Markowitz.
For investors who wonder how many stocks they need in a portfolio, as few as 10 will be enough if all have sufficient margins of safety. For more ideas about portfolio size, review the holdings of the gurus.
Disclaimer: This review is based on "Book of Value: The Fine Art of Investing Wisely” by Anurag Sharma, which was published in 2016 by Columbia Business School Publishing. Unless otherwise noted, all ideas and opinions in this review are those of the author.
Read more here:
- Book of Value: Due Diligence on Management
- Book of Value: Assessing Business Models
- Book of Value: How Well Is Management Using its Equity, Debt and Assets
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