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Christopher Pavese, CFA
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Mr. Pavese holds several positions within the Broyhill family offices, serving as Chief Investment Officer of Broyhill Asset Management and BMC Fund, Inc., an SEC registered investment company. His primary responsibilities include macroeconomic research, strategic asset allocation, portfolio... More
My company:
Broyhill Asset Management, LLC
My blog:
The View From the Blue Ridge
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  • Adequate Diversification

    A few words on “adequate diversification” from a legendary hedge fund manager.  Emphasis is our own . . .

    Last year in commenting on the inability of the overwhelming majority of investment managers to achieve performance superior to that of pure chance, I ascribed it primarily to the product of: “(1) group decisions – my perhaps jaundiced view is that it is close to impossible for outstanding investment management to come from a group of any size with all parties really participating in decisions; (2) a desire to conform to the policies and (to an extent) the portfolios of other large well-regarded organizations; (3) an institutional framework whereby average is “safe” and the personal rewards for independent action are in no way commensurate with the general risk attached to such action; (4) an adherence to certain diversification practices which are irrational; and finally and importantly, (5) inertia.”

    This year in the material which went out in November, I specifically called your attention to a new Ground Rule reading, “We diversify substantially less than most investment operations. We might invest up to 40% of our net worth in a single security under conditions coupling an extremely high probability that our facts and reasoning are correct with a very low probability that anything could drastically change the underlying value of the investment.”

    We are obviously following a policy regarding diversification which differs markedly from that of practically all public investment operations. Frankly, there is nothing I would like better than to have 50 different investment opportunities, all of which have a mathematical expectation (this term reflects the range of all possible relative performances, including negative ones, adjusted for the probability of each – no yawning, please) of achieving performance surpassing the Dow by, say, fifteen percentage points per annum. If the fifty individual expectations were not intercorelated (what happens to one is associated with what happens to the other) I could put 2% of our capital into each one and sit back with a very high degree of certainty that our overall results would be very close to such a fifteen percentage point advantage.

    It doesn’t work that way.

    We have to work extremely hard to find just a very few attractive investment situations. Such a situation by definition is one where my expectation (defined as above) of performance is at least ten percentage points per annum superior to the Dow. Among the few we do find, the expectations vary substantially. The question always is, “How much do I put in number one (ranked by expectation of relative performance) and how much do I put in number eight?” This depends to a great degree on the wideness of the spread between the mathematical expectation of number one versus number eight.” It also depends upon the probability that number one could turn in a really poor relative performance. Two securities could have equal mathematical expectations, but one might have .05 chance of performing fifteen percentage points or more worse than the Dow, and the second might have only .01 chance of such performance. The wider range of expectation in the first case reduces the desirability of heavy concentration in it.

    The above may make the whole operation sound very precise. It isn’t. Nevertheless, our business is that of ascertaining facts and then applying experience and reason to such facts to reach expectations. Imprecise and emotionally influenced as our attempts may be, that is what the business is all about. The results of many years of decision-making in securities will demonstrate how well you are doing on making such calculations – whether you consciously realize you are making the calculations or not. I believe the investor operates at a distinct advantage when he is aware of what path his thought process is following.

    There is one thing of which I can assure you. If good performance of the fund is even a minor objective, any portfolio encompassing one hundred stocks (whether the manager is handling one thousand dollars or one billion dollars) is not being operated logically. The addition of the one hundredth stock simply can’t reduce the potential variance in portfolio performance sufficiently to compensate for the negative effect its inclusion has on the overall portfolio expectation.

    Anyone owning such numbers of securities after presumably studying their investment merit (and I don’t care how prestigious their labels) is following what I call the Noah School of Investing – two of everything. Such investors should be piloting arks. While Noah may have been acting in accord with certain time-tested biological principles, the investors have left the track regarding mathematical principles. (I only made it through plane geometry, but with one exception, I have carefully screened out the mathematicians from our Partnership.) Of course, the fact that someone else is behaving illogically in owning one hundred securities doesn’t prove our case. While they may be wrong in overdiversifying, we have to affirmatively reason through a proper diversification policy in terms of our objectives.

    The optimum portfolio depends on the various expectations of choices available and the degree of variance in performance which is tolerable. The greater the number of selections, the less will be the average year-to-year variation in actual versus expected results. Also, the lower will be the expected results, assuming different choices have different expectations of performance.

    I am willing to give up quite a bit in terms of leveling of year-to-year results (remember when I talk of “results,” I am talking of performance relative to the Dow) in order to achieve better overall long-term performance. Simply stated, this means I am willing to concentrate quite heavily in what I believe to be the best investment opportunities recognizing very well that this may cause an occasional very sour year – one somewhat more sour, probably, than if I had diversified more. While this means our results will bounce around more, I think it also means that our long-term margin of superiority should be greater.

    You have already seen some examples of this. Our margin versus the Dow has ranged from 2.4 percentage points in 1958 to 33.0 points in 1965. If you check this against the deviations of the funds listed on page three, you will find our variations have a much wider amplitude. I could have operated in such a manner as to reduce our amplitude, but I would also have reduced our overall performance somewhat although it still would have substantially exceeded that of the investment companies. Looking back, and continuing to think this problem through, I feel that if anything, I should have concentrated slightly more than I have in the past. Hence, the new Ground Rule and this long-winded explanation.

    Again let me state that this is somewhat unconventional reasoning (this doesn’t make it right or wrong – it does mean you have to do your own thinking on it), and you may well have a different opinion – if you do, the Partnership is not the place for you. We are obviously only going to go to 40% in very rare situations – this rarity, of course, is what makes it necessary that we concentrate so heavily, when we see such an opportunity. We probably have had only five or six situations in the nine-year history of the Partnership where we have exceeded 25%. Any such situations are going to have to promise very significantly superior performance relative to the Dow compared to other opportunities available at the time. They are also going to have to possess such superior qualitative and/or quantitative factors that the chance of serious permanent loss is minimal (anything can happen on a short-term quotational basis which partially explains the greater risk of widened year-to-year variation in results). In selecting the limit to which I will go in anyone investment, I attempt to reduce to a tiny figure the probability that the single investment (or group, if there is intercorrelation) can produce a result for our total portfolio that would be more than ten percentage points poorer than the Dow.

    We presently have two situations in the over 25% category – one a controlled company, and the other a large company where we will never take an active part. It is worth pointing out that our performance in 1965 was overwhelmingly the product of five investment situations. The 1965 gains (in some cases there were also gains applicable to the same holding in prior years) from these situations ranged from about $800,000 to about $3 1/2 million. If you should take the overall performance of our five smallest general investments in 1965, the results are lackluster (I chose a very charitable adjective).

    Interestingly enough, the literature of investment management is virtually devoid of material relative to deductive calculation of optimal diversification. All texts counsel “adequate” diversification, but the ones who quantify “adequate” virtually never explain how they arrive at their conclusion. Hence, for our summation on overdiversification, we turn to that eminent academician Billy Rose, who says, “You’ve got a harem of seventy girls; you don’t get to know any of them very well.”

    Warren E. Buffett, 1966 Annual Letter to Limited Partners

    Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
    Jan 07 9:49 AM | Link | Comment!
  • Motivational Speakers - Belgium Style

    Six months after the general election, Belgium still has no new government. Flemish nationalist Bart De Wever, head of the country’s largest party, wants to split Belgium into two states. In an interview that has caused a scandal in his country, he told SPIEGEL why the nation has “no future.”  SPIEGEL explains:

    Belgium has sunk into political chaos. Following the parliamentary elections six months ago, all attempts to build a new government have failed. The country is divided into two camps that oppose each other, apparently irreconcilably: the socialists, who won the most votes in Wallonia, the French-speaking southern region of the country, and the nationalist conservatives in Flanders, the wealthier Dutch-speaking northern region.

    The New Flemish Alliance (N-VA) obtained the most parliamentary seats in June’s elections. Its leader Bart De Wever wants to split Belgium into two. In an interview with SPIEGEL that was published in German on Monday, De Wever described how Belgium is the “sick man” of Europe and has “no future in the long run.” The interview caused a massive outcry throughout Belgium. De Wever himself said he regretted it if anybody felt insulted but confirmed the message of the interview. “I have my opinion and my analysis is accurate,” he said. “There is nothing in the interview that is not true.”

    Thanks to our friend Cullen Thompson over at Bienville Capital Management for pointing out the underappreciated risks within the EU’s headquarters.  Since our initial conversation over dinner in New York earlier this year, credit spreads on Belgium sovereign debt have quietly doubled.  De Wever is certainly a unique Motivational Speaker.  Which poses an interesting question . . . Cullen, have you considered the similarities in the images below?

    Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
    Dec 16 4:45 PM | Link | Comment!
  • Chart of the Day

    Technically, the 10-year Treasury yield could back up further – even above 4 percent – and still be in line with the long-term downtrend in interest rates. The November rate backup was merely a correction in the accelerated decline in Treasuries that began in April. Notwithstanding, rates today remain approximately 120 basis points below where they were just seven months ago, and even prior to the European crisis this would signal that the downward trend remained definitively intact.

    Long term, I still believe that we will ultimately return to 2 percent on 10-year notes. But as any investor knows, markets don’t move in straight lines. In my opinion, a rise in rates to 3 percent or higher would be a buying opportunity because any backup in yields above this point would have a deleterious effect on the economic recovery, especially given the fact that the mess in housing is no better today than it was one month ago when rates were below 2.5 percent.

    -  Scott Minerd, Guggenheim Partners CIO

    Needless to say, with the long bond yielding north of four percent and core inflation on its way to zero or lower, we see good value in real yields today.  We expect rates to continue backing up through the first half of next year (beyond the imminent air pocket in risk assets directly ahead which should push yields lower) on a Washington inspired “recovery” before retesting (and probably breaking) prior “lows” later next year and into 2012.

    Disclosure: At the time of publication, the author was long US Government Bonds, although positions may change at any time.

    Disclosure: I am long IEF.
    Tags: IEF, Treasuries
    Dec 15 1:55 PM | Link | Comment!
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