From Joel Greenblatt to Jim Rogers, Part II: The Downside of Excessive Diversification

The intent of this series of posts is to put my later posts about specific investment ideas in context, by describing the evolution of my thinking on investing over the last year and a half, as I've made mistakes and tried to learn from them. I'm going to break this up into a few posts, just to keep each post from being too long. This is Part II.

The Downside of Excessive Diversification

An observation I've made over the last year is that during a period when most stocks and most sectors are performing poorly, excessive diversification can be a liability. With his own money, Joel Greenblatt is a concentrated value investor: he has written that he feels comfortable keeping 80% of his assets in 5-8 well-researched, high-quality companies. For his Magic Formula methodology though, he recommended that non-expert investors diversify more broadly, buying a total of 20-30 stocks over a period of several months. A problem with this, from my experience, has been that there haven't always been 20-30 stocks worth buying on the Magic Formula list. Many of the "good" (high ROIC) stocks recently haven't been "cheap" (high earnings yield), as investors have flocked to the relative handful of winners, and many of the "cheap" (high earnings yield) have been cheap for a reason: in some cases they had no consistent earnings but ended up on the list because one windfall quarter (e.g., from a legal settlement) distorted their trailing twelve month EBIT numbers; in other cases companies were facing negative macro trends that would be reflected in their earnings over the coming year or more, etc.).

An example here is the retail sector. Last year around this time, a number of retailers appeared on the Magic Formula list. If you bought a large basket of them, you would have probably had poor performance since then. But if you had bought Wal-Mart (as Greenblatt himself did), you would have had a 20%+ return on it. I didn't think of this at the time last year, but in hindsight, Wal-Mart was well-positioned to benefit from the weakness of the American consumer over the next year. With economic headwinds* affecting consumers (I consider the resulting weakness of the U.S. consumer a macro trend), it makes sense that many of them would spend less, while spending a higher percentage of their budgets at a lowest-cost retailer such as Wal-Mart.

A few data points I've seen that support the advantage of running a more concentrated portfolio in this sort of market:

• One of the professional investors who bucked the trend and posted solid results last year was Bruce Berkowitz, who manages a concentrated portfolio in his Fairholme Fund. About 50% of the fund's assets were in cash and its two largest positions.
• Another professional investor, Ken Heebner, who manages the CGM Focus Fund, had spectacular returns last year running a relatively concentrated portfolio (although, in Heebner's case, his out-performance was due more to his astute attention to the relevant macro trends).
  
• One of the only individual investors on the Yahoo! Finance Message Board who claims to have had 70% cumulative returns over the last year. The difference in his application of the strategy? He confined his portfolio to 10 holdings that he chose from the Magic Formula list after doing his own homework.
  
• Two of the individual investors I have corresponded with on investing websites (one of whom I've mentioned previously here, Daniel Wahl) had good-to-excellent performance over the last year with portfolios of fewer than 10 stocks each.
  

As important as it is to avoid excessive diversification for diversification's sake, the example of Ken Heebner shows the greater importance of paying attention to the relevant macro trends. More on macro trends in the next post.

*These four economic headwinds, specifically: the negative wealth effects due to the real estate bust, high debt levels, lower access to credit, and rising energy prices.