The late Charlie Munger was Warren Buffett’s sidekick and business partner at Berkshire Hathaway where he doled out investment wisdom at the company’s annual meetings.
He argued that intelligent investors should concentrate their holdings rather than diversify them. It’s hard to gainsay his claim because he took his own advice and did very well indeed.
The problem is, very few investors hold a candle to the investing-acumen of Mr. Munger or Mr. Buffett. Instead, nearly everyone else should diversify because they’ll likely do better over the long term.
Today concentration is put to the test using the Canadian value, dividend, and low-volatility portfolios that are followed regularly at The Globe and Mail. The portfolios handily beat the market index over the past 26 years and did so by picking 10 or 20 stocks.
All of the portfolios start with the largest 300 stocks on the Toronto Stock Exchange and then pick those with the desired characteristics.
The first pair of portfolios seek deep value stocks of the sort that Benjamin Graham (Warren Buffett’s mentor) might have liked. The Screaming Value portfolio buys the 10 stocks with the lowest EV/EBIT ratios (from the largest 300) while the Free Cash portfolio picks the 10 with the lowest EV/FCF ratios. (Enterprise value, or EV, is equal to a company’s market capitalization plus its net debt. EBIT is an abbreviation for a company’s earnings before interest and taxes. Free cash flow, or FCF, is approximated by subtracting capital expenditures from operating cash flow.)
The next pair of portfolios use different measures of value before applying a momentum filter to find bargain stocks on the upswing. The Dividend Monster portfolio picks stocks with above-median yields (half are higher and half lower) and then picks the 10 with the highest returns over the prior year. The Pink Lemonade portfolio starts with 20 stocks with lowest price-to-earnings ratios (P/E) and then selects the 10 top performers over the prior six months.
The last three portfolios focus on dividend stocks with low-prior volatilities with the expectation that they’ll continue to be relatively stable in the future. The Stable Dividend portfolio looks for the 20 dividend payers with the lowest volatilities over the prior 260 days. The Frugal Dividend portfolio starts with the 50 dividend payers with the lowest volatilities over the prior 260 days and then buys the 10 with the lowest P/Es. The Stable High-Yield portfolio is similar to the Frugal Dividend portfolio but it picks the 10 stocks with the highest yields rather than the 10 with the lowest P/Es.
Further details on how the portfolios operate, and the stocks they hold, can be found via this link.
Each of the original portfolios is tested against a one-stock version of itself that uses the same method with the exception of the last step where a single stock is selected instead of the usual 10 or 20 stocks.
For instance, the one-stock Screaming Value portfolio selects the stock with the lowest EV/EBIT from the largest 300 on the TSX. In a slightly more complicated example, the one-stock Dividend Monster portfolio starts with dividend stocks with above median yields from the largest 300 on the TSX and then it picks the single stock with the best return over the prior year.
Before getting to the results, it is important to point out that one-stock portfolios tend to be stupidly risky. Even the likes of Mr. Buffett and Mr. Munger have made disastrous individual stock purchases from time to time.
I have to confess that the results confounded my expectations owing to the lack of total disasters. While five of the seven one-stock portfolios trailed the returns of the portfolios they’re based on, they all beat the market index.
Mind you, the one-stock portfolios were a wild bunch because they were between 82 and 140 per cent more volatile than the original portfolios – apart from the utility-heavy one-stock Stable Dividend portfolio, which was merely 64 per cent more volatile. Yikes!
I’ve high hopes that the seven regular portfolios will continue to do well over the long term, but I expect some (or all) of the one-stock portfolios to eventually run into serious trouble.
Norman Rothery, PhD, CFA, is the founder of StingyInvestor.com.
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