Bet on your confidence


Director, Banyan Tree Advisors

December 20, 2011

How many stocks, and how much of each, should you have in your portfolio? Well, that’s a function of the level of confidence you have in a company.

YOU’VE FOUND a really good stock to invest in: it could be Infosys or it could be that small software company your friend joined recently. Yes, there is promise of phenomenal returns, but how much should you invest?

Portfolio allocation is an investor’s nightmare; in fact, many experts believe this decision is more crucial to the performance of your portfolio than even your brilliance as a stock picker. Should you put all your eggs in one well-chosen
basket? Or should you look for a diversified portfolio? How much should you put in each basket? In the stock market, as in life, there are no pat answers.

To my mind, there are two major factors that determine the extent of diversification in your portfolio. The first is your style of investing — value or growth. The other is your own personality. Value investors are those who try to buy stocks at prices below what they consider the intrinsic value of the stock. Without getting into the intricacies of the term, it is the worth of a company that an unbiased, rational investor would be willing to pay if the company were not listed on the stock exchange.

Going for value. Value investors typically prefer to buy companies when they are trading at bargain basement prices (either on a price-to-earnings, price-to-book-value or market cap-to-current assets basis).

Growth investors, on the other hand, look for the best-managed companies in the ‘fertile fields of growth’. While value investors typically invest in a diversified portfolio, many growth investors prefer to concentrate their holdings in a few

Why do value investors need so many baskets to keep their eggs in? Simply because they know that some of these baskets have gaping holes in them. They depend on historical data to estimate future prospects, and since they are well aware of the dangers of trying to drive using only a rear-view mirror, they prefer to drive down roads they are familiar with and those that have fewer sharp curves.

But even this does not always prevent a mishap. The only security, then, is in diversification.

Too many stocks… But how much diversification does a portfolio need? I have seen a number of portfolios that comprise 100-200 stocks, most of them bought in a public issue (IPO). A large number of investors believe an IPO is the best
time to buy because they believe a promoter is offering the shares cheap to get a listing. This is a hangover from the days when IPO pricing was regulated by the CCI (Controller of Capital Issues) and companies were forced to issue shares at
large discounts to current market prices.

The truth is that most IPOs are launched when the market is strong. (Remember the slew of IT IPOs last year?) And since the seller decides the timing of the IPO, the odds are that he will issue shares when the time is right for him to sell rather
than when it is right for you to buy. Since few of us admit readily to mistakes and book losses, these shares gather dust. What this results in is a diversified portfolio of our mistakes, which we continue to hold, merely in hope.

Growth investors prefer concentration. Growth investing is another ball game altogether. Here, investors try to find certain industries or niche segments where a very large opportunity presents itself. They then invest in the best-managed
companies within this field or niche area. Growth investors usually prefer to have concentrated portfolios. Warren Buffett changed his approach from the cigar butt, value type to ‘growth at a reasonable price’ in the early 1980s. He moved from a portfolio of 50 stocks or more to one in which seven stocks constitute almost 90 per cent of his equity portfolio.

No room for mistakes. But, remember, a concentrated portfolio leaves little room for mistakes. Even the best investors don’t always make perfect bets. Warren Buffett, George Soros, Peter Lynch — almost all the investment greats have been
known to make mistakes. Just bear in mind that a wrong choice in a concentrated portfolio could leave you with plenty of regrets and little else.

The trick is to make sure you have analysed the company from every possible angle. Ideally, you should understand the core business as well as the CEO of the company does. This does not mean that you need all the information available to
him, but you should at least have spoken to customers, employees, suppliers and competitors (Phil Fischer calls this scuttlebutt). This will give you an accurate picture of the company’s operations, its key competitive advantage and the
prospects for the business over a five- to 10-year period.

Disciplined investing. One of the approaches to building a concentrated portfolio involves comparing each new investment opportunity to the existing basket of stocks in your portfolio. Assume that your portfolio consists of 10 stocks. Before you add the next stock, ask yourself whether you are better off adding to one of your existing positions instead. Buffett always found himself comparing any new investment to Coca Cola, Gillette and Disney, and since he could not find any company in his universe with comparable long-term sustainable growth prospects and solidity of franchise, he refused to add to his portfolio. Sure, he dabbled in smaller stocks to keep himself busy, but they never formed a large percentage of his holdings.

Another way of doing the same thing is to tell yourself that your portfolio cannot cross a certain number of stocks. So if you’ve decided on a portfolio of 10 stocks, one of these 10 must go if you want to buy a different stock. What both these
methods do is give your decision-making some discipline.

Your investment style. Ultimately, whether you are a growth or a value investor depends on your own personality. Actually, a lot of stock investing is about matching your investing style with your personality. If you’re the kind of person who is high on self-confidence with a certain amount of risk-taking ability, a concentrated portfolio will suit you. As we said earlier, you’d need to have time (or tremendous faith in somebody else’s judgement) to do the groundwork necessary to put all your money in a few stocks. On the other hand, if you are a risk-averse investor with an aptitude for numbers and the patience to hold on to your stocks even in the face of momentary bad news, value investing would be your preferred style, with a fair amount of diversification. (For more on that, read You are what your investment style is.)

Many investors believe that the proof of whether they have made a right purchase is how the stock does in the week or month after they have made the purchase. A lot of investors tend to use the market (which, as we’ve said elswhere, is just a voting machine) as a validating machine for their decisions. This is foolhardy and, in fact, very dangerous to your decision-making process. After you’ve analysed a company, I suggest you sleep on it — let the facts run through the back of your mind. If you’re still not sure, try to put your finger on what is causing the uncertainty, and root around some more. Every time I’ve made a great purchase (of course, the proof of that is available only much later), I’ve experienced a great sense of peace immediately after taking the decision. That may just be the surest way of figuring out whether you’re doing the right thing.