Tuesday, May 02, 2006

Diversification vs. Specialization

Brief respite from stock picking for today, I promise we’ll jump on another stock soon.

Being a professional financial planner must be very tough. It’s not like they give you extra brains when you get the job, so how does one add value and show worth to the customers? The answer is that financial planners (if properly trained) get taught all sorts of tools and concepts such as how to divide assets between stocks and bonds based on the needs of the client – known as asset allocation. There are other tools in that toolbox as well but I’d like to talk today about a familiar one called diversification – the practice of making sure that a portfolio contains components of a wide variety of stock types. This is a good idea in principle but if applied poorly it can and does result in more harm than good.

I can hear the crowd sharpening pitchforks already, how dare I speak out against the sacred concept of diversification? Diversification is a principal tenet of modern investing, and basically just means owning a little bit of a lot of different industries. You wouldn’t want to be left out of the oil boom of the last 3 years, after all, but at the same time you wouldn’t want to lose your whole portfolio when oil stocks eventually come back down. People who owned only dot-coms in 2000 wish they had been more diversified, as do people who owned no dot-coms from 1990 to 1999.

So how can I speak out against diversification?

The answer is that I am not against diversification, I am against the way many people go about it. I have watched many people go through the thought process like this: “I need a stock from sector X. Well, stock Y has a nice low P/E ratio in sector X and some buy ratings from big banks, I’ll buy that,” followed a short time later by, “Hey, why is this stock dropping?”

Warren Buffett and Charlie Munger regularly get asked their thoughts on diversification and have come up with a reusable answer I will paraphrase: “we expect any collection of good stocks picked by one person to have some specialization.” Why? Because no one person can have in depth knowledge about all industries, or to break out my oldest quote,"only a fool speaks on every topic,” (Ptah-Hotep, prefect of ancient Egypt, 2200 BCE). If he were alive today Ptah-Hotep might say “only a fool or a financial anchor speaks on every topic” but that’s kind of a cheap shot.

I face this issue regularly. Just a few weeks ago I started analyzing Oxford Industries [OXM], maker of Oxford shirts. The price to cash flow ratio was 11, reasonable for a small to mid-cap stock, and the implied discount rate using analyst predicted growth was 20%. It sounds great by those numbers but when I started reading through the annual report I quickly realized a problem: I don’t know anything at all about the garment industry. Normally when I read an annual report I think of all sorts of clever questions as I read through the report and I get to dig up answers. I try to find the details the executives don’t want to talk about or the places they are using spin. But I don’t know the first thing about a shirt manufacturer. If I read an article in the paper about an increase in tariffs on Chinese fabrics is that good or bad for OXM? I just don’t know. If I had a few weeks presumably I could try to learn where the cost and profit centers are for a shirt maker, and what concerns keep them up at night, but when I listened to their prerecorded earnings call I found myself paying attention to their tones and hopes, which is always a bad sign. Executives are always optimistic, even when their company is firmly in a death-spiral. I realized I had no idea what kind of growth to expect or how skeptical to be of projections on OXM. I didn’t even really have a grasp on the impact of consumer spending or a recession on their business. Eventually I just threw in the towel (shirt?) and forced myself to write in the conclusion area of my spreadsheet,” I don’t know the first thing about textile markets.”

You probably won’t see me making calls about any clothing makers in this column. Maybe I'll get a guest columnist to do it one day.

I tend to focus my analysis on industrial concerns and companies focused on electronics: Lincoln Electric Welding [LECO], Dow Chemical [DOW], and probably next up Nokia [NOK] for example. In all these cases I have some related industry knowledge or understanding that at least leaves me with some idea what questions to ask. I know what chips and parts Nokia needs in a cell phone, where they are made, and which parts are changing in upcoming generations of phones. I have a feel for the logistics and supply chain issues of Dow Chemical and would feel comfortable walking around an ethylene plant. And I understand Lincoln Electric’s product strategy and how they intend to make money. Thus I can actually analyze these companies. Good analysis is hard enough when you understand companies that I wouldn’t want to complicate things by analyzing businesses I don’t understand.

So does this mean the Financial Wonk is purely exposed to companies in his narrow field of expertise? No, of course not. But those are the only fields where I engage in stock-picking. I use exchange traded funds (ETFs) and sometimes even good old fashion mutual funds to make sector and macro-economic bets outside my area of expertise. At this moment a good chunk of my money is in a broad index stock fund providing diversification while awaiting better ideas. I make options bets at times using those index ETFs when I feel I have a good handle on the immediate direction of the economy, and one of my current public ratings here is to buy RRPIX – an inverse-bond mutual fund I recommend because I expect interest rates to rise. In each case I have achieved exposure at the level of my understanding of the market. I have not even tried to predict which bonds will be most strongly impacted by economic forces, for example, instead I just put down an investment in the direction of Treasury bond rates.

So this is my philosophy: Get your diversification from cheap and broad indexes and then try to achieve your outperformance (your “alpha”) within your areas of understanding and expertise.

A close corollary to this philosophy is to try to constantly understand and expand the boundaries of your expertise. That is what this site hopes to help with. By digging aggressively into both economic data and the specific motivations of buying or selling a particular stock we try to learn a lot and expand the categories within which we can make a profit. The best way to get as much out of this as possible is to participate in the comment boards and challenge everything. Recently we’ve had very lively comments; I look forward to this trend continuing. Working through some of the analysis behind the stock calls is another good way to learn a lot. This is the only site I know of where each stock call stands before the audience completely revealed, every calculation and opinion ready for widespread consideration. Think of it as open-source investing, designed to maximize the learning of the participants as well as the quality of the results.

Finally I leave you with yet another pre-stock-market quote which seems to have been made for investors, consider it well and don’t wander too far from things you understand: “The only certainty is that nothing is certain,” Pliny the Elder – Roman senator.

Click back to the main page!

4 Comments:

Anonymous Michael Brothers said...

I first stumbled upon your website while looking at Yahoo's DOW Chemical message board. I'm really impressed with your analysis, and bookmarked your page. I'm fairly new to investing (2 years in stocks, and just beginning with options), but I'm only 20 years old, and still in college, so I guess I'm forgiven. Keep up the good analysis.

8:32 AM  
Blogger FinanceWonk said...

Starting early is great, it allows you to take risks while you have time for markets to correct themselves and of course saving money early is worth much more than money put away later.

Welcome!

8:56 AM  
Anonymous Anonymous said...

Well done and I generally agree with your strategy. It is very similar to mine, although I tend to use a broader array of stocks coupled with some ETF's. Following your portfolio design strategy ETF's represent sector concentration. But now for the key remaining question that I believe would make a good follow-up column - how do you choose the sectors / ETF's?

c6h6

3:17 AM  
Blogger FinanceWonk said...

As usual C6H6, an excellent point.

I don't have a magic recipe for that. Right now my ETF selection is mostly governed by a supplemental option strategy I use to squeeze more from the index. I have some old notes on the topic though... I'm not sure if any of it is really all that clever but I'll dig it up and review it.

Comments from your direction are, as usual, welcome.

- FW

9:36 AM  

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