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Robert Abbott
Robert Abbott
Articles (778)  | Author's Website |

Book of Value: Valuation and Creating a Core Portfolio

A concentrated group of well-chosen stocks can offer more protection than broad diversification

April 07, 2020 | About:

In chapters 21 and 22 of “Book of Value: The Fine Art of Investing Wisely,” Anurag Sharma showed why diversification was a poor basis for putting together a portfolio. Instead, he recommended creating portfolios based on valuations. Valuations in the sense that companies in the portfolio are purchased when the market price is less than intrinsic value. This would provide a margin of safety for each stock.

Given that each stock has a margin of safety, then the emphasis can be shifted from a broadly-based portfolio to a core portfolio. In exploring core holdings in chapter 23, he explained how an investor might put together a core portfolio that would have a limited downside while still providing an adequate amount of upside potential.

Sharma looked at a core portfolio having five to 10 unrelated companies. An investor might have more than 10 stocks, but those five to 10 would represent most of the portfolio’s capitalization. For example, in chapter 22 I referenced Warren Buffett (Trades, Portfolio) and Charlie Munger (Trades, Portfolio); they held a total of 52 stocks at the end of fourth-quarter 2019, but their top three holdings represented more than half of the Berkshire Hathaway’s (NYSE:BRK.A)(NYSE:BRK.B) total value.

Potential core holdings should be screened using a disconfirmation approach and defensive valuations. They must have strength in their fundamentals so they can deliver strong cash flows over time. Of course, they must come from different sectors, so they are at least somewhat unrelated. Sharma called this “limiting yet spreading the bets.”

With a limited number of companies, an investor can do intensive research, resulting in a deeper understanding and closer monitoring. In turn, that leads to a lower probability of losses. That’s unlike the situation with modern portfolio theory, which generally ignores the individual companies in favor of their collective but unspecified risks.

Continuing in that theme, Sharma added, “Once we define investing as solving the problem of making valuation-driven core portfolios, we must align our behavior to this way of thinking. No longer do we need to search for variances and covariances across the entire spectrum of companies listed on the various company exchanges.”

Following up on this statement, I’d like to elaborate on what I believe the author is saying. He sees the value investing approach as concrete and fathomable, while the modern portfolio theory approach is abstract and essentially unknowable. Variances and covariances are mathematical concepts and, as such, have to be derivatives of real elements.

In the abstract world, analysis involves the manipulation of data and symbols. That’s far removed from analysis based on real and fundamental data used by value investors. Real data can be used to reach valuations that can then be compared with market prices.

While the author has mentioned monitoring, it is less demanding after a core portfolio is in place. He added that core portfolios allow investors to economize on their most important resources: attention and time. It becomes as simple as reading the company filings for each quarter and each year, for fewer than a dozen companies. We can ignore all the noise that fills the market, the online and traditional media and more.

To create a portfolio, it is only necessary to find a handful of excellent stocks. I would add that a shortlist can be processed quickly using an online stock screener such as the All-in-One screener at GuruFocus.

A conscientious investor will continue to watch for bargains, looking for stocks with greater potential returns than those currently in the portfolio--while maintaining a margin of safety. Similarly, if investors have additional capital to put to work, they can add to existing holdings or search out new companies. In both situations, though, they should remember the basics of diversification and select stocks from different sectors or industries.

Sharma suggested that if you have confidence in your analysis, you could allocate up to 80% of your capital into the core portfolio. If you have less confidence, then you would allocate a smaller percentage to the core.

If you have a reasonable amount of confidence in your core portfolio, you will be less likely to speculate and chase returns. That will save money, not only by avoiding bad investments but also by keeping transaction costs down. Because of compounding, a penny saved can be many pennies earned.

What if one of the companies in your core portfolio begins to deteriorate? First, you will likely notice it sooner if you only need to monitor a relatively small number of stocks. Second, finding a problem sooner often means having more time to analyze it, perhaps using disconfirmation analysis as Sharma would.

Wrapping up, the author wrote, “In essence, carefully constructing a core portfolio is the common- sense answer to the obfuscating math of modern portfolio theory. It brings investing back to business analysis and valuation of individual companies.”

Still, he was not writing off Harry Markowitz, saying that the father of modern portfolio theory recognized the benefits of grouping and that core portfolios allow us to integrate business analysis with the idea of spreading our bets.

Conclusion

Having rejected the idea of diversification based on mathematical concepts, Sharma explained that a core portfolio of perhaps five to 10 stocks would be a better strategy.

Focusing on a core portfolio rather than a big, mathematically diverse portfolio means investors can focus on important activities like doing deep financial analyses of potential portfolio holdings. In addition, it means having fewer companies to monitor and more time to take corrective action if something goes wrong.

And, to get back to Sharma’s key idea in this section of “Book of Value: The Fine Art of Investing Wisely,” good valuations provide more protection than mathematical diversification.

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.

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About the author:

Robert Abbott
Robert F. Abbott has been investing his family’s accounts since 1995 and in 2010 added options -- mainly covered calls and collars with long stocks.

He is a freelance writer, and his projects include a website that provides information for new and intermediate-level mutual fund investors (whatisamutualfund.com).

As a writer and publisher, Abbott also explores how the middle class has come to own big business through pension funds and mutual funds, what management guru Peter Drucker called the "unseen revolution."

Visit Robert Abbott's Website


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