Mike Lipper’s Monday Morning Musings
Diversification
Editors: Frank Harrison 1997-2018, Hylton Phillips-Page 2018
Preface
On a recent trip to London, Ruth and I attended a private
fund and friend raising concert for the Academy of St. Martin’s in the Fields
(ASMF), where Ruth is the first American trustee. The wonderful music was performed
by Joshua Bell, the artistic director, and five other top-notch string
musicians from the ASMF. Between the six talented musicians they played three
different types of string instruments, alternating between lead and ensemble
roles. The result was a successful combination of each of their talents.
Even when listening to a magnificent concert performance, I
cannot forget my investment responsibilities. As individual musicians
alternated from leading to supporting roles, it reminded me of what individual
securities should do in a diversified long-term investment portfolio.
Application to Portfolio Management
In 1940 the SEC completed their depression-oriented reform
rules. Among the last of these was the Investment Company Act of 1940, which
unlike the other six regulations was not formed at their SEC headquarters. It
was produced at the Mayflower Hotel in Washington by lawyers for the fund
industry from Boston, New York (where the industry’s trade association was
headquartered), Philadelphia, and Washington. Considering their recent
experience of the market falling during the Depression, the mood of the meeting
was to try reduce the chance of big future declines. The best model for that were
state laws governing trust accounts, using generations of work by Boston and
Philadelphia lawyers. (Even as late as the early 1960s a few Boston law firms
had professional securities analysts on staff to assist in managing trust accounts.)
Note, the main concern of the creators of fund regulation was the avoidance of losses.
No word was spoken of making money on investments.
They thought the best way to reduce the chance of major
losses was to limit an account’s exposure to any single investment. This led to
limiting the percentage amount that funds could invest in any one stock, which
usually meant no more than 5% of the voting stock at cost (not market). To this
very day, most equity funds are labeled as diversified if they adhere to this
principal.
The Problem with Voting Stock Limits
The biggest penalty paid by investors is not losses, but the
absence of profits. Mutual Funds with long histories often make ten, twenty, or
even more times as much on some of their holdings, which more than covers a small
number of losses. Furthermore, great fortunes have been made, particularly over
successive generations, in single stock portfolios or portfolios having a small
number of investments.
For Professional Investors
The concept of risk management is critical but doing it by
name or percentage of voting shares does not reduce risk, it may increase if all
investments are exposed to a single concept. In the late nineteenth century professional
investors considered concentration to be the best and safest way to invest. My
college degree is from Columbia University, which had an endowment fully invested
in railroad bonds and stocks, every single one file for bankruptcy. Today there
is a risk that some participants in the “AI” surge could produce similar
results by investing in too much in a good thing.
For publicly traded securities I suggest the biggest risks is
with the stock owner and not the issuer, as they will be sellers of the stock
before you do. Other risks include countries, technology, politics, and
management. These can be identified as short-term and long-term factors. A possible
short-term indicator is slightly more participants being bearish than bullish in
the latest American Association of Individual Investors (AAII) survey of
expectations for the next six months. Interestingly, the long-term indicator
was Friday’s announcement by the Supreme Court, which ruled against the
President’s authority to set tariffs using the International Emergency Economic
Powers Act (IEEPA), which had very little to any impact on the market.
Bottom line, watch the musicians play and how well they work
together, both with other musicians and staff, but also watch the reaction of
the audience.
Understanding Going Global
In a recent conversation with a London-based fund manager,
who in the past was almost completely invested in the US but now has a growing
position in European stocks. While he has the biggest portion of his portfolio
in US securities, he is very risk aware and expresses this by augmenting his
portfolio with European stocks. Normally, he expects his US positions to
outperform his European positions, but not in a declining market. In terms of
P/E, Free Cash Flow, Dividend Yield, and other value measures, European stocks are
less risky than US holdings.
Another careful
investor was Charlie Munger, who listed six principles to be avoided: High
Financial Leverage, High Operating Leverage, Negative Cashflow, Poor
Governance, High Risk of Obsolescence, No Competitive Advantage vs. a Strong
Competitor.
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