Warren Buffett is quoted as saying "wide diversification is only required when investors do not understand what they are doing." Buffett's friend and partner Charlie Munger has even stronger words, saying diversification is for idiots. While I certainly would not call anyone who believes in diversification an idiot, I will say I do not understand the concept of owning a plethora of stocks. I have read articles on Seeking Alpha where individuals report to owning 20, 25, or more stocks in the hope of reducing their risk. I believe having a large number of stocks actually increases your risk.
Diversification can mean different things to different people, for some it may be having investments in various industry groups, like health care, consumer staples, energy, technology etc. For some it may mean owning a large number of stocks to reduce the damage if one blows up. For others it might mean having investments in different asset classes, bonds, hard assets, stocks, etc. For the sake of this article, I am considering diversification as holding a large number of stocks (greater than 12) to reduce risk.
Being an owner requires your time and attention. As I stated in a previous article, I believe when you buy a stock, you become an owner and should follow the company closely. I do not believe an individual can closely follow 15 to 25 companies as closely as a person needs to, to be as informed as you should be. Every day I search the news and several websites for stories on the various companies I own. I listen to all the webcasts the companies have on their websites. That is every quarterly conference call, every analyst meeting, and every industry conference presentation. It is a time consuming endeavor, but it allows me to know what is going on with the companies I own.
I feel that by following a company closely, I will know when their business climate changes. For instance, I owned Procter and Gamble (PG) for a period, but sold it in 2008. I sold because while listening to conference calls I heard the same thing over multiple calls, consumers were trading down and input costs were up. This was a recipe that I did not see changing and decided to put my capital to work somewhere else. I feel that by owning fewer stocks you can stay on top of the companies' affairs and reduce the risk of being broadsided by news you did not see coming.
You should only invest in your best ideas and you do not have 25 best ideas. I only want to invest in companies that I have the utmost confidence will reward me over time. I believe a person should only hold stocks that are their best ideas and I do not believe there are 20 to 25 best ideas. When I have money to invest, I always ask myself, is my money best invested in a new company, or should I buy more of what I already own. In most cases, I buy more of what I already own.
I spend a large amount of time researching stocks, following much of the same procedure I mentioned above, reading articles, listening to conference calls, etc. When researching a company I am looking for four things:
- Company must have a sustainable moat. Yes, I know you have heard it before, but do you really consider it before investing? A sustainable moat gives a company a competitive advantage over its current competitors and creates a barrier to entry to any future competition. A company that can limit current competition and prevent future competition should be able to grow their profits over time. I find very few companies that have a sustainable moat.
- Company must pay a rising dividend, with a minimum yield of 2%. I know that if I hold a stock for a long time, there will be periods of lackluster or even negative price performance. However, if the stock is paying a dividend, I will be able to collect that dividend and reinvest into that company to lower my cost basis or use the dividend to invest in another holding that might be a better investment at that time. In addition, the rising dividend will add to my growing income stream.
- Price must be reasonable at the time of purchase. If I find a company that I think may make a good long-term investment, but it is over-priced at that time, I will not buy it. The key to good long-term performance is buying the stock at an attractive entry point. All stocks go on sale periodically; when the one you want goes on sale, pile into it.
- Company must have a sustainable product. When I invest in a stock, I worry more about the downside then dream about the upside. One of the questions I always ask myself is will this company's product be around in 10 to 20 years. If I think they may have a product that will eventually end up like the buggy whip, I will not invest, no matter how popular the product is at that moment. This rule eliminates most technology companies. I know money is made in technology, but my investing process eliminates most, not all, technology companies. A company like Apple (AAPL) is a technology company I may eventually look at because to me, it also qualifies as a consumer product company.
As you can see, not too many companies are going to pass all those tests. After those tests other miscellaneous factors like profitability, management, union issues, etc. enter in to the equation. As a dividend growth investor, I intend to buy a stock and hold for an extended period, perhaps forever. I am not looking to grab a quick profit on a couple dollar pop. Therefore, when I invest in a company I want to make sure it has what is needed to be a lasting profitable business. I do not think you can find 25 of those.
You should only invest in industries you understand. In the 1973 movie, Magnum Force, Dirty Harry told his supervisor "A man's got to know his limitations", knowing your limitations applies to investing too. There are several industries; I freely admit I know very little about. Industries like biotechnology, computer chips, enterprise software, are outside my area of expertise; therefore, I do not invest in them. I prefer to stick to areas where I have some knowledge, such as consumer products, restaurants, energy, real estate, etc.
By sticking to sectors of the market where I have some personal knowledge, I am better equipped to analyze the companies within that sector. For example, I am required, as part of my job duties, to have knowledge of the energy business. To gain and maintain this knowledge, I attend energy conferences, interact with utilities and study the oil and gas business on my own. While attending college, I also spent three summers working for a natural gas pipeline company. Thus, when I study companies in the energy sector I understand what I am reading and understand the nuances of the business. This added knowledge, I believe makes me a better investor in that industry.
I do not understand the biotechnology business, I cannot pronounce most of the drugs, and do not understand the economics of the business, thus I do not invest in that sector. If I were to buy a biotechnology stock, it would be a shot in the dark and I will not take a shot in the dark. Rather than invest in a sector of the market I do not understand so that I am diversified into a different sector of the market, I prefer to invest in what I understand.
Having read numerous articles on Seeking Alpha I have noticed that dividend growth investors come in different flavors. Some have stated they do not care about the price of the stock or capital gains, just the dividend growth. Others look for stocks with higher yield and/or a high dividend growth rate, but also want capital gains. I would argue you can achieve your goals of greater income and/or capital gains better with 5 to 10 stocks than you can with 20. I believe you increase your risk when you add more and more stocks because your ability to monitor a large number of stocks decreases and your 15th stock is probably not as good a selection as your third, or you would have bought it sooner.
In my personal portfolio, I have four "pillar" stocks, companies that I will never sell unless the fundamental story changes. These four stocks are Coca-Cola (KO), McDonald's (MCD), Exxon Mobil (XOM) and Kinder Morgan (KMI). I believe all four of these stocks, have a sustainable moat, growing dividends, a sustainable product and were purchased at reasonable prices. In my next article, I will dissect all four stocks and state why a person can expect these four stocks to continue growing earnings and dividends for a very long time.
I should add, that I do, on occasion, buy a stock that I consider too cheap and hold it until it reaches fair value. These stocks would still have to pass all the tests I mentioned previously. In the last year I have bought and/or sold Enterprise Products Partners (EPD), Philip Morris International (PM), Canadian National Railway (CNI) and TransCanada Corporation (TRP) All of these stocks fell to prices I found compelling and I purchased them knowing, for various reasons, I would not hold them forever. However, I was willing to hold them for a long period if necessary. I have never held more than eight stocks in my portfolio at any given time.
I will close by saying I understand that everyone's personal situation and goals are different and that how I invest is not the only way to invest. I also admit that I am somewhat risk averse and some investors willing to make more riskier bets may on occasion end up with better returns. However, I do believe that over time my approach will beat the S&P 500 and reward a patient investor.