One subject about which even professional investors hold widely divergent views is portfolio diversification. Most often, investors accumulate shares like postage stamps. While such diversity provides a feeling of safety and commemorates stock market history, portfolio performance is typically sub-par. Such investors are doomed to high commissions, endless paperwork and a truly hopeless task when it comes to diligently tracking what they own.
The cause of this dilemma—modern portfolio theory—used sophisticated mathematical principles to suggest that a portfolio’s volatility could be kept in check by carefully selecting stocks that moved counter to one another. The argument suggested that owning 20 stocks provided ‘practical’ diversification and crossing 30 led to negligible benefits in reducing volatility. The truth is that ‘market risk’ always lurks around the corner and all that owning 20 or more stocks does is lessen the probability of loss. In a sense, the crash of 2008 destroyed the wise men who invented modern finance.
Not only did nearly every stock round the globe drop in price at the same time, all major asset classes fell together in total defiance of conventional market wisdom. In reality, risk arises when you fail to understand the business that you buy and pay a price in excess of what the company is worth. To quote Warren Buffett: “I want to be able to explain my mistakes. This means I do only the things I completely understand.”
Put in a sensible perspective, the essence is to
- avoid viewing diversification as an exercise in higher mathematics;
- never get carried away to the extent that you lose sight of what you own;
- define risk based on what you know about how the business works rather than wild gyrations in stock price;
- keep a close watch on what you own so that there is a greater chance of anticipating change;
- focus on pulling out the weeds and watering the roses.
Another hotly debated topic is the merit of rupee cost averaging. This method encourages investors to spread out their purchases regularly over time, regardless of price. The mutual fund industry has led the charge with the intent of luring investors into the market. For the talking heads in media, it is an article of religion that puts paid to the sins of market timing and epitomises the most powerful tenets of buy-and-hold investing.
Stripped of its cosmic charm, the strategy is fundamentally a forced savings plan that seems too simple and too good to be true. The reason why rupee cost averaging is anathema to the value investor is that it stacks the odds against your doing better than the market. The method guarantees poor performance during extended bull markets since investors are forced to add (albeit lesser and lesser quantities) to their positions at steadily increasing price levels.
Since value investing gives primacy to purchasing stocks at prices that are as reasonable as possible, the prospect of diffusing such a strategy by remaining oblivious to price and spreading purchases over an extended period is utterly senseless. A thoughtful investor should never depend on trial and error in arriving at portfolio decisions, the true emblem of rupee cost averaging! In effect, price is paramount since no purchase should ever occur at a price that cannot be justified by underlying business fundamentals.
The difference in mindset between a value investor and proponents of rupee cost averaging can be summed up as follows: Rupee cost averaging allows the market to take control of your portfolio allocation, your profits and losses, and eliminates valuation and risk assessment from the purchase decision. In marked contrast, value investors are never passive with regard to market price; they are obsessed with minimising risk and creating a margin of safety via the purchase price. Their interests are far better served by patiently waiting for their preferred stocks to fall to a level where there is clear-cut undervaluation and then buying as many shares as they can afford—within a limited period of time.
Constructing a robust portfolio which preserves a balanced temperament during turbulent markets is not out of reach for the individual investor. Contrary to popular belief, portfolio construction is neither about grasping arcane statistical models nor spending lavishly on plug-and-play software.
Not long after a baptism by fire in learning portfolio construction techniques in the hallowed precincts of IIM-A, I abandoned these methods outright! What settled the debate was the constant quest for new information to fine-tune the model based on the notion that stock prices are ‘perfectly efficient’. This search was truly scary for a hapless novitiate since it suggested that you were at the mercy of the markets and the past was prologue to the future!
A few years later while reading about ‘owner earnings’ in the Berkshire Hathaway Annual Report, the blinkers came off. Since companies exist to return profits to shareholders, ownership of a diverse portfolio of businesses is tantamount to having operating subsidiaries within a holding company structure. Therefore, regardless of whether you own a dozen companies or a hundred, they are equivalent to subsidiaries in your equity portfolio with a primary responsibility of generating adequate cash flow for you, the investor—sufficient to cope with your needs at the worst of times.
This approach suggests the need to build upon the following principles in creating a customised portfolio:
- Aim to minimise risk in each individual stock.
- The sector composition is immaterial provided each stock carries reduced risk consistent with your personal understanding of the business.
- Always own companies with a lower cash-flow payback period.
- The financial position (balance sheet) of each company should be such that it has a capacity to survive high levels of financial and operating adversity caused by unanticipated changes.
- Future returns are irrelevant (the hunt for multi-baggers?) in buying a company.
- Disciplined and rational capital allocation by senior management is vital to long-term success.
In sum, the real challenge is to maximise the owner earnings you expect to receive from your initial investment over the holding period. Very few individuals have achieved either the clarity or brevity of the Sage of Omaha in putting it all together: “Your goal as an investor should simply be to purchase, at a rational price, a part interest in an easily understandable business whose earnings are virtually certain to be materially higher five, 10, and 20 years from now. Over time, you will find only a few companies that meet these standards—so when you see one that qualifies, you should buy a meaningful amount of stock. You must also resist the temptation to stray from your guidelines: If you aren’t willing to own a stock for 10 years, don’t even think about owning it for 10 minutes. Put together a portfolio of companies whose aggregate earnings march upward over the years, and so also will the portfolio’s market value.” Disclosure: This column is neither an offer to sell nor solicitation to buy any of the securities mentioned herein. The author frequently invests in the shares discussed by him.
(This story appears in the 19 April, 2013 issue of Forbes India. You can buy our tablet version from Magzter.com. To visit our Archives, click here.)