Building a Portfolio around Value

Street SignValue investing provides advantages that can be compounded in a portfolio. Keep in mind though; there is really no one answer for everyone. Circumstances, situation in life, available resources, time available and opportunities in the market place, to name a few will influence holdings in your portfolio.  That’s why in our Value by George portfolio all holdings are initially purchased in equal dollar amounts, no weighting is implied.

Portfolio Allocation is Important

Value investing is about finding those rare high return investment opportunities with an acceptable margin of safety.  After finding the opportunity, analyzing it, quantifying intrinsic value and margin of safety it is then equally important to determine how much money to allocate to each opportunity found. If we invest too little, perhaps due to fear, we miss out on some of the potential outsized return available from this rare opportunity. If we invest too much, perhaps due to greed, we risk losing too much of our hard earned money. The size of the position we take on any investment idea is very important in determining the size of the returns over time.

Diversification vs. Dilution

Since analysis takes a lot of work and good investment opportunities are rare doesn’t it follow that we should concentrate our money in those time consuming rare finds? That seems to make intuitive sense unless you have unlimited time and resources. But do we want risk all our eggs in one, or just a few, baskets? That too makes intuitive sense.

Do we choose a concentrated portfolio for higher returns or follow conventional wisdom of a diversified portfolio for lower risk? Fortunately, that’s really not a choice we have to make, let me explain. First, diversification is investing in different asset classes like stocks, bonds, real estate, currency, etc. It can be a valid investment strategy to reduce volatility but not risk. Increasing equities from 10 holdings to 30 holdings for example is not diversification it is dilution and doesn’t do much to reduce volatility either. Second, risk is not volatility; it is the possibility of loss or injury, often from not knowing what we are doing. We have a better choice in my view; it is higher returns and reduced risk although perhaps more volatility.

Let’s turn for the help of some good investors and scientific research, then with a different perspective and one important caveat we can gain insight on how to construct an equity portfolio for value investing.

From Successful Investors:

Two great investor known for their success and concentrated holdings, Warren Buffett and his partner Charlie Munger explain their view in Berkshire-Hathaway’s 1993 Shareholder Letter [Source]: The strategy we’ve adopted precludes our following standard diversification dogma. Many pundits would therefore say the strategy must be riskier than that employed by more conventional investors. We disagree. We believe that a policy of portfolio concentration may well decrease risk if it raises, as it should, both the intensity with which an investor thinks about a business and the comfort-level he must feel with its economic characteristics before buying into it.  In stating this opinion, we define risk, using dictionary terms, as “the possibility of loss or injury.”

Fifty years prior the influential economist and successful investor, John Maynard Keynes, wrote in 1942: To suppose that safety-first consists in having a small gamble in a large number of different [companies] where I have no information to reach a good judgment, as compared with a substantial stake in a company where one’s information is adequate, strikes me as a travesty of investment policy.

A Scientific Basis:

In the excellent book Fortune’s Formula: The Untold Story of the Scientific Betting System That Beat the Casinos and Wall Street author William Poundstone lays out the history, discovery and advantage of the Kelly formula. The book focuses on the work of scientists working at Bell Labs: Claude Shannon, who developed information theory; and John Kelly, who developed the Kelly’s formula and the third, a MIT mathematician, Ed Thorp.

The Kelly strategy does better than any essentially different strategy in the long run and where you have an advantage. It defines the amount of your money you should invest to maximize capital over the long term. It points to a level of concentration. The key is 1) you know something the market doesn’t and 2) you apply it over the long term.  It points to consistently concentrating those “bets” when you have an advantage, the approach used by many successful investors.

Explanation of the Kelly formula is beyond the scope of this post. If you are interested in an excellent introduction to it; Legg-Mason’s former investment strategist, author and Columbia University Professor, Michael J. Mauboussin explains concentration and the Kelly formula in an excellent article “Size Matters” [Source] for those who want a great primer on the topic.

Efficient Market Theory:

Those who argue against concentration in equities and for diversification (perhaps up to hundreds of stocks) tend to follow the Efficient Market Theory (EMT). Adherents to the theory have a probabilistic view of the nature of investing. This is the natural outcome of the theory’s underlying premise that all information is readily available to everyone. So, investors can’t really have an advantage.  Share prices immediately adjust to the new information. If this were the case I too would argue against concentration and for (dilution) diversification.

The EMT has just enough truth to gain some credibility but not enough to be useful.  The problem is the theory discounts human nature; emotions, fear and greed. People have different perspectives, perceptions of the future and different abilities to analyze impacts that ultimately drive investments and the markets.  Even if it were true; it assumes everyone knows exactly what to do with the information and are capable of acting on it immediately in a totally rationale manner.  Does that sound like the real world to you?

The Caveat:

A widely held assumption is that taking more risk increases the probability of both very good and very bad outcomes. That may be true but only if you don’t know what you are doing. We define risk as the possibility of loss or injury (not volatility) so in our view taking more risk does increase the probability of loss or injury but not good outcomes. EMT assumes you have no advantage; in effect you don’t know what you are doing, so you might get good or bad results. But if we know what we are doing, we have an advantage and good investors, common sense and science tell us something altogether different.

The Kelly formula requires an advantage for it to work. Our good investors above argue for: intensity…an investor thinks about a business…comfort-level…with its economic characteristics before buying and where one’s information is adequate. They too are referring to an advantage of knowledge and information.

The caveat is to sort out the difference between skill (advantage) and luck (probability). Investors who lack advantage and build a concentrated portfolio will probably underperform the market dramatically. These investors can maximize their long term return by adopting a policy of no selection such as index funds, mutual funds, etc. Investors with an advantage can maximize their long term return through deliberate selection of stocks and portfolio concentration.

Two Sources of Advantage:

Value investing provides an advantage because it requires a determination of intrinsic value and margin of safety. This information is derived from data processed through analysis. It requires the work that gives you an advantage. Not that we will always be right, but it sure beats a hot tip from a neighbor, stock broker or targeting for average.

Another source of advantage is to follow the advice of proven and successful investors like our above examples Warren Buffett, Charlie Munger and others. Investors capable of outperforming the market dramatically over the long term, and willing to share why they are doing what they do. This insight is critical to our own skill development.

A potential third advantage is good value oriented money managers. They do have an advantage and if good they will be willing to share with you why they are doing what they do. But they too are rare.

If you are willing to do the work, or closely follow those that do the work, you have a source of advantage. And if you do why not invest in the best 5-10 ideas instead of averaging down to your 20th or 30th idea?

My Portfolio Guidelines:

Thought I’d closed with the guidelines I’ve adopted overtime and find suited to my personal circumstances and limitations. I don’t use the Kelly formula to calculate a precise individual holding level but it influences the upper limit placed on single holdings. Also, my concentration limit is set lower than the Kelly formula would permit because I never know to what degree my advantage is valid.

My equity portfolio consists of two broad categories; core holding companies and special situation companies.

Core holdings are solid companies with the potential to be held forever and are likely to grow to be 10% or greater holdings (examples in the Value by George portfolio include BAM, BIP) They are viewed as compounding machines where I patiently wait to accumulate more when they go on sale.

Special situation companies are more opportunistic value investments, often out of favor companies, selling at a huge discount when purchased. They may never be a core holding (examples include AIG, GNW, ACAS). They start as relatively small positions (2-3%) and are increased or decreased as the investment thesis plays out. If the investment thesis plays out well, or the margin of safety improves, they too can become concentrated over time. They are sold as they approach intrinsic value, better opportunities are found or the investment thesis goes awry.

As Warren Buffett says; “Diversification is a protection against ignorance. It makes very little sense to those who know what they are doing.” But do we always know what we are doing? I know I’ll be wrong at times and must limit concentration or potentially lose all. So, I choose to concentrate capital into the best ideas within these limitations:

  • Focus on 15 or less holdings.
  • Consider each purchase as a potential 10% position eventually.
  • Positions of up to 20 percent are permitted.

Cash is treated as a byproduct of investing opportunities, not an objective.  A minimum of 5% is desirable to take advantage of opportunities that may occur at any time.

Speak Your Mind