Marty Whitman: Great Stock Picker, Wrong on Diversification

by: Roger Nusbaum

The Barron's interview this week was with Marty Whitman who is probably most known as the manager of the Third Avenue Value Fund (TAVFX). The fund is 20 years old and since inception it has absolutely clocked the broad market. According to Morningstar, $10,000 at inception would have grown to $112,949 versus $43,800 for "World Stock" and $30,772 for "MSCI EAFE NR USD." When the market dropped 44% ten years ago TAVFX only went down 17% (per Google - may not include dividends). However at the March 2009 low, when SPX was down 55%, TAVFX was down 62% as Whitman got caught in a lot of the "wrong" stocks during the meltdown.

There are several quotes from the interview that I think are very instructive. As I cast a critical eye here I would note that no single method of portfolio construction and cycle navigation can be the best for all times. Whitman is a hardcore value investor. In the interview he says that things like MPT and diversification are "absolute garbage." Diversification to protect against the downside is "worse than useless."

When asked how he protects against risk (the better word would have been volatility) with a concentrated portfolio, he said that "we get protection by being price-conscious and by being extremely knowledgeable about our holdings. And diversification is a surrogate—and a damn poor surrogate—for knowledge, elements of control [of a company] and price-consciousness. If you are really a value investor and do deep research, how many investments can you be involved in at the same time?"

Given the financials he held onto and how the fund performed in the last three years, the comments about being price conscious and knowledgeable don't really ring true. Not implying he is lying of course but from the standpoint of seeing who is naked when the tide goes out, it would be reasonable to wonder whether TAVFX got caught with its pants down. Was he overconfident in his price consciousness, knowledge and ability to understand what was happening?

In looking at the since inception chart on Morningstar, the fund had a really big pop when it first debuted. Taking that out, unscientifically, the outperformance is still huge but much less. Another huge boost in performance came during the tech wreck as it is unlikely that a deep value fund owned internet stocks with no earnings and little to no revenues. Sectors where you might find value stocks did not do anywhere near as badly as tech and telecom back then.

Clearly a large portion of the long term result is attributable to stock picking skill, but some measure of the result is also attributable to being in the right place at the right time. I am not critical of right place, right time as I'll take any good luck on the way that I can but the totality of this does take credibility out of his "extremely knowledgeable" comment.

I come at this sort of thing completely differently. However knowledgeable one can be about one of their holdings, they can always be wrong. However much you know about a stock you hold, I guarantee you there are other holders who know more than you and other holders who know less than you, and chances are some portion of the other holders who know less than you think of themselves as extremely knowledgeable. Whitman asks how many stocks can you be extremely knowledgeable about? I would ask how many stocks can you be right about?

In a portfolio of 35-40 holdings, I know that not every stock or ETF will work out as I expect. I also know that a holding that doesn't do much this year might be the best performer next year and vice versa. The idea of assuming every holding will work out exactly as hoped for seems crazy to me and this is exactly what someone is doing when they believe that their knowledge can supplant the need for diversification.

The next time the market has a ten year run like during the 1990s, most of your stocks are going to go up a lot and the next time we have a ten year run like the oughts, most of your stocks will not. I doubt you are the stock picker that Whitman is (I certainly am not) and even he was blindsided by the financial crisis. Just because he is a great stock picker does not mean he is immune to the various biases and fallacies that affect most investors.

You can sort this out for yourself and draw your own conclusions, but I think it is more conservative to realize you will be wrong at least part of the time and diversification mitigates a portion of the consequence of being wrong.