Learnings from the Giants

Position Sizing

As an investor, amongst some of the advantages we enjoy is that of ‘diversification’. Unlike a businessman whose entire fortune is tied to one particular field of operation, we can spread it across multiple such businesses. Though that doesn’t mean our financial result from owning that particular business will turn out to be different from that of the business owner but we are better able to manage risks associated with any particular set of variables at the portfolio level.

But just like many other simple ideas whenever we take something to the extremes, we end up turning a boon into a bane. While taking away risks associated with owning a single business, the proponents of (excessive) diversification end up taking (ignorantly) the risk associated with too much diversification.

Speaking with excessive diversification, Phil Fisher said –

Too few people, however, give sufficient thought to the evils of other extreme. This is the disadvantage of having eggs in so many baskets that a lot of the eggs do not end up in really attractive baskets, and it is impossible to keep watching all the baskets after the eggs get put into them.

So, in otherwords to do away with the horrors of ‘putting all eggs in one basket’ we have ignorantly created entirely new set of complexities. It is not unheard of and in fact some of the top funds in the country hold as much as 40-80 stocks in their portfolio. They seem to be inspired by Noah’s rule – two of each and end up with a zoo 🙂 But to be fair some of these funds do suffer from something like ‘diseconomies of scale’ – they are too big a fish for the pond they are in. But it is not unheard of people – without having any size constraints – end up owning more than 25-30 stocks.

Which is the right number?

This is not the right question to ask in my view -partly because there are no precise answer for this. As investors we are trying to do away with risks while maximising our returns like improving upon our returns per unit of risk.

As Buffett said, in investing risk lies not knowing what you are doing. So for a professional investor if there is a particular industry or business which he cannot make out head or tail of it, his ideal weight there should be not more than zero. Again, it is not necessary to understand all the intricate details of a potential investment but certainly he should be able to understand it to the extent of action he is taking.

So, you certainly do not need to know what all goes into making ready to cook noodles but what you should know is factors which could influence its demand, the probability of adversities hitting the business from time to time, competition and how do they stack up against the company so on and so forth.

So if we cannot understand all the adversities which business in question generally faces or arrive at a reasonable range of probabilities of those adversities affecting the company then probably we may not be competent enough to own it. Which is fine. There are thousands of companies listed in India and we just need to move on to the one next in queue 🙂

So coming back to the question, if there is no specific number to hook ourselves too, then what is it which should guide us in our portfolio construction?

Fisher has answered this question beautifully with an analogy of his –

How much diversification is really necessary and how much is dangerous? It is somewhat like infantrymen stacking rifles.

A rifleman cannot get as firm a stack by balancing two rifles as he can by using five or six properly placed. However, he can get just as secure a stack with five as he could with fifty.

In this matter of diversification, however, there is one big difference between stacking rifles and common stocks.

With rifles, the number needed for a firm stack does not usually depend on the kind of rifle used. With stocks, the nature of the stock itself has a tremendous amount to do with the amount of diversification actually needed.

So adequate diversification depends up nature of the business in question. Given that expected returns are otherwise equal, a company which has its business spread across three different segments such that none of the segment contributes significantly versus the other, the amount of weight one can have in his portfolio for such business would be higher than the one which derives returns from just one segment assuming both of these businesses are otherwise equally strong.

For example, if otherwise expected returns are more or less the same, one can have more weight in HUL which has its business spread across multiple SKUs versus Bajaj Corp which is sort of a one product company earning all of his revenues from sales of light hair oil brand ‘Almond drops’.

So ‘strategic business unit’ (SBU) is what one should look at. While owning businesses we are indirectly owning their earning machines i.e. the SBU. If an investor assigns equal weight to Bajaj Corp and HUL, we should be aware that his exposure of a particular SBU is higher in case of former than the latter company. There is nothing wrong in his if one is compensated well enough to do so. But why take additional risk for free?

Second thing which Fisher says is management bandwidth. Generally, we see that in small companies, decision making is centered around one particular individual. Though nothing wrong in this since sometimes it is due to visionaries like these that the company has attained a particular level in the business but if the shoes are too big to fit and if there is no one else standing in the queue to take realms of the company then there is some additional risk here. Though it would be wrong of think of it as fatal. Replacement only takes time and patience from us as owners.

Also, family managed businesses may sometimes end up having lower bandwidth from a non-family driven or a professionally managed business. But again sometimes the commitment level of the management which some of these family owned businesses is difficult to match by someone who draws monthly salary. And there is also lesser chance of CEO leaving the company and joining a competitor 🙂 . But then these companies are good till the time family members stick together. Many of the synergies across products which they today enjoy would disappear tomorrow if the family were to split.

One last thing which one should look at is the exposure to the portfolio from owning businesses operating in similar SBUs. So if out of the love for recently announced ‘demonetisation’, if one ends up owning 20 stocks – 15 of which are banks, needless to say he is taking excessive risk and his portfolio is as good as undiversified. Hope he is also accompanying his investee companies in the evening calls which RBI has with banks these days!

One of the investor I follow and respect had 40% of his portfolio parked in Berkshire Hathaway stock (a company owned and managed by Buffett and his partner Charlie Munger) few years back. Given that Berkshire owns hundreds of SBUs – most of which are franchise in itself – and the depth of the management along with succession planning which they had been worked upon for more than a decade now, it does not seem so surprising to me now. Though I think this guy does have guts made up of steel – and hopefully so that of his clients 🙂

Thanks for reading. Hope you enjoyed as much as I did while writing it. If you have some additional points / insights, do write in the section below. It would be interesting to expand upon this concept further.


Niraj Bardia

Disclaimer: Stocks discussed in this post are for educational purpose only and not recommendations to buy or sell. Please contact a certified investment adviser for your investment decisions.

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