This article on Value Investing Portfolio was written by Net Net Hunter member Bryan Shealy. Bryan worked in the inventory business for 5 years which gives him an edge in net net investing. Article image by avantrend, edited by Broken Leg Investing.
Establishing a value investing portfolio can be a difficult task. Fear sets in as you look at your first deep value companies. How can you manage the risk associated with deep value companies and offset the fear of permanent loss of capital? The author Charles H Brandes had this to say about risk in a value investing portfolio:
“MPT (modern portfolio theory) is based on the notion of redefining risk as share price fluctuation, or price volatility. But the value investor would find this definition unacceptable.”
What does MPT have to do with value investing? MPT assumes that different asset classes have little correlation with each other. By allocating your assets into different areas you can reduce the risk that one asset decreasing in value will affect your other assets. Seems simple enough. Why then, does Brandes find it unacceptable? One reason might be that it relies on revaluation of price volatility.
Volatility is of course a value investor’s friend, as without it, we could never take advantage of mispricings in the market. Volatility is quantifiable and by decreasing volatility you can smooth out your portfolio’s returns. Beta is one way to measure volatility and is used to measure volatility against the market. High beta stocks have been stigmatized as extremely volatile and a sure fire way to lose your principal. This however is a very shallow way to view beta.
Our most famous investor Warren Buffett actually used beta to his advantage. For example, if a stock that was worth $1 could be purchased for 75 cents but then dropped to 50 cents while the market stayed the same its beta would increase. Would it make it a worse investment? No, it would make it a much cheaper and more valuable investment! In a case like this, because the stock dropped but the market stayed the same, Buffet saw a large spike in beta, however it was a favorable increase. The increase in beta caused an increase in value. Since the actual value of the company did not change, the short term volatility increased the overall value of the investment.
High beta stocks should not be dismissed so easily. A value investor should be looking past beta and really dig into the fundamentals of a company in order to ascertain its value. In the example above, Warren Buffett was able to purchase a company for less than its worth. In order to do this, its current assets must exceed the total market capitalization of the stock.
High beta can be an excellent way to increase your returns over time. However, there is still risk involved in any investment. For example, if a company suddenly has a rapidly declining current asset value, the burn rate could be detrimental to your portfolio and could also destroy your principle. Brandes explains one way you can decrease the possibility of this happening to your portfolio:
“While diversification is important, some investors believe that diversification not only limits risk but also enhances returns over the long term. This may or may not be true.”
I’ve fallen into the blind diversification trap many times in my early investing career. While volatility and diversification aren't necessarily bad, they are not always good. It really depends on the situation. Brandes uses this quote to establish that not all diversification is bad - in fact it is incredibly important to diversify - however, different types of assets provide different returns. For example, if you were to invest in a bond vs a stock, you would achieve much lower returns and create less volatility.
There are a few types of diversification that make sense to a value investing portfolio. The old saying “don’t put all your eggs in one basket” rings true here. You would not put all of your money into one company, as it becomes a gamble. The more companies in unrelated industries you purchase, the lower your risk for one specific company. If you have 10 stocks in a portfolio, your risk is reduced by 90 percent!
Reducing risk is never free. Risk reduction and cost have an inverse relationship. The more stocks in different areas you purchase, the more transactions you need to make, and the purchase costs add up. There comes a point where the cost of diversifying outweighs the value. The most common value investing portfolio size to limit risk and decrease cost is generally around 20. This allows you to easily track your stocks and reduce risk appropriately.
It is important to view risk not just from a fundamental standpoint. Risk can also be psychological. Brandes acknowledges that diversification and decreasing volatility is beneficial to your financial health in the form of psychological piece of mind. While short term volatility can be a problem, it's also the key to long term success. Before you get too excited about the possibilities of volatility and long term success, remember that buying deep value companies carries with it another major risk: liquidity.
“Some may wonder, for example, if a problem develops in a certain company, is the door big enough for everyone to get out at the same time?”
Brandes explains the liquidity fear in the quote above. If there is nobody available to sell the stock to, you will end up with an exceptionally low price and take a large loss.This is a valid concern for many institutional investors, but not in the way you would think.
The difficulty is buying these stocks. If any large institutional investor tries to purchase an illiquid stock it would create a price surge. The lack of shares for sale pushes the current price higher in order to fill the order. These stocks also already have major issues and have already been depressed to extremely low valuations. While liquidity is not as much of a concern to small investors, it is important to find a basket of quality value stocks. Focus on purchasing companies with low levels of debt. This will lessen the impact of illiquid stocks since bankruptcy concerns will be minimal.
Illiquid stocks provide unprecedented opportunities for any value investing portfolio under a million dollars. We can buy in and out of these stocks with ease and many of the most undervalued stocks can be found where no institutional investor would dare go. Brandes believes worrying about illiquid stocks over the long term is largely a waste of time.
Many of the best opportunities available can be found in illiquid stocks. Not only that, but, these stocks also tend to be much more liquid when the time comes to sell, alleviating any future liquidity fears.
Brandes does a great job explaining how risk plays a role in a value investing portfolio. The concerns that many investors have when investing are alleviated through diversification, while many of the other concerns, such as liquidity and high beta, can uncover opportunities rather than cause concern for principal preservation.
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