Diversified versus focused approach to investing

04 Feb 2013 09:45
TEH HOOI LING

In one, you spread out your bets, in the other, you go with what you know well.

In the last few weeks, I talked about finding value in the market and ways to identify market under- and over-valuation.

Finding discrepancy between the value of a company and the price that its stock is trading at in the market is only part of the analysis. You have to build a portfolio that takes advantage of the opportunities.

If you find value in a basket of stocks, but they all happen to be, say, in the real estate business, do you put all your money in stocks from just that one sector? Or, in another extreme scenario, do you put all your money into just one stock?

There are two schools of thoughts. One is the diversified approach, and the other, advocated by legendary investor Warren Buffett, is focus investing.

Theories in finance say that diversification allows the investor to eliminate indiosyncratic risks – or risks that are peculiar to a specific company. Say, Company A’s big customer suddenly declared bankruptcy. And Company A was owed a big chunk of money by that customer. Once the news broke, Company A’s stock price tanked. That’s an idiosyncratic risk.

The theory says that this risk can be minimised by having at least 30 stocks in the portfolio.

Besides risks that are specific to the individual company, there is also the sectoral risk. For example, if you had all your money in real estate stocks a few weeks ago when the Government announced the surprise cooling measures, your portfolio would have taken a big hit the following Monday.

On a broader level, there are country risk and currency risk. There is even an asset class risk.

Say you had all your money in stocks when the global financial crisis hit. No matter which market you were invested in, your portfolio would have suffered as stocks plummeted globally.

So the idea of diversification is to allow an investor to spread out one’s bets.

The hope is that not all asset classes, not all stocks, will move in tandem. In some periods, you may have SingTel outperforming; other times Fraser & Neave might surge ahead. Or you may have China racing ahead in the last few years while Japan may power ahead in a different period.

In contrast, the other school of thought is that you should bet big on high probability events.

How does one know if an event has a high probability of occurring? Well, by studying and understanding an investable situation inside out.

If, after the in-depth analysis, you are 100 per cent convinced that the market has absolutely mispriced that asset, then you should have the conviction to allocate a big portion of your portfolio to that asset, says Mr Buffett.

There is little risk if you know the industry, the business thoroughly, the argument goes. Of course, work in a big margin of safety as well – pay a significantly cheaper price than the fair value of the company.

According to Mr Buffett, buying a whole long list of stocks increases the chances that you will buy something that you don’t know enough about.

One local fund manager, Mr Teng Ngiek Lian, of Target Asset adopts the concentrated approach in building his portfolio.

His fund invests in only 35 stocks. Here’s what he told me back in 2008.

“By having a concentrated portfolio, you stay focused. It makes you very honest with yourself. If you make a mistake, it’s going to be very painful.

“You can’t be casual. If you want to put in one stock, you have to take one out. So you have to decide why you want the new one and give up the old one. We find this a very effective strategy.

“Normal investors just buy and buy. Like African tribal chiefs, they don’t know how many children they have. They don’t have to bring them up, so they don’t worry.”

To narrow the list to just 35 stocks, Target actively monitors about 150 to 200 stocks.

This is for comparison purpose.

How do you know a stock is good unless you’ve compared it with others, he said.

Mr Teng’s strategy seems to work well. Target Asset Management returned 17.6 per cent a year between 1996 and November 2010, net of fees.

Another fund manager, Mr Eric Kong of Aggregate Asset Management, however, holds a different view.

“Warren Buffett advocates the focus approach,” he said.

“But we find that when you bring your holding up to 5, 10, 20 per cent of your portfolio, you’ll make more behavioural mistakes. You start to get emotionally attached to the stock, you fall in love with the stock. That is dangerous because it can really affect your judgment.”

Also, Mr Buffett has a gift. He is able to read business very accurately. Not everyone has that kind of gift, Mr Kong noted.

Aggregate prefers a more conservative and boring approach.

“We concentrate on what’s currently on hand.”

Its strategy is to buy a big basket of stocks with low multiples of earnings and cash flows, low price-to-net tangible assets, and high dividend yields.

I explored this strategy a few weeks ago and the results have proved quite effective.

Personally, I’m more inclined towards the big basket of cheap stocks approach.

I wrote about randomness in my first few articles. I wouldn’t want any random event to wipe out, say, 10 or 15 per cent of my portfolio.