7 Investment Concepts Fundamental to Value Portfolio Management

by KenFaulkenberry

in Portfolio Management

Investment Concepts

Investment Concepts Fundamental to Portfolio Management

We are going to examine 7 investment concepts that are fundamental to successful value portfolio management. Notice none of these concepts require us to be a genius or have some special skill. However, it does involve putting a little effort and time into changing the way we think and approach investing.

1. The Importance of Time

The question of when to start investing for retirement seems easy, but few people understand the importance of the answer. Exponential growth is the powerful investment concept that makes time the most important factor in determining the value of your portfolio.

The earlier you begin to invest, the greater the probability of having choices and a quality retirement. Because of the power of compounding, the investments made in your early years should be worth many times over the value of your investments made closer to retirement.

If you need $40,000 per year in retirement income at age 65 (in addition to Social Security benefits) you will need to save approximately 1 million for retirement. Here is the amount you will need to invest each month to save 1 million, assuming you earn an 8% return on your investments:

Age 25:  $285/ month

Age 35:  $667/ month

Age 45:   $1687/month

This illustrates the importance of time. You need to let the “magic” of compounding work over time. By living a little more frugally in your early years you can save enough money to have a comfortable retirement. By waiting until middle age the task becomes much harder.

2. Keeping Expenses Low

High expenses do tremendous damage to portfolio values. Choosing the best investment vehicles is the first step in keeping expenses low. The mutual fund expense ratio is notorious for sapping an investor’s returns.

One percent can make an unbelievable difference. A $100,000 investment for 30 years earning 6.5% grows to $699,179. A $100,000 investment for 30 years earning 5.5% grows to $518,738. In other words, if your expenses lower your return by just 1% annually, you make $180,000 less over 30 years on a $100,000 investment.

3. Asset Allocation

Asset Allocation is what will determine the vast majority of your returns. It is the most important decision you can make in investing. Studies have shown that the average investor’s actual investment returns are considerably lower than market averages. This is because people tend to buy when prices are high and tend to sell when prices are low.

Historical analysis has proven that the valuation of investments when they are purchased will determine long term returns (time periods of 10 years or more). Buying at high valuations produces low returns. Buying at low valuations produces better than average returns.

When you buy is something you can control. Be conservative when valuations are high. Hold cash and be mentally prepared to buy more stocks when prices are bargains.

Ignore market comparisons in the short run. Most investors are too short sighted and impatient, looking for instant gratification. You can beat the market over long term cycles with valuation based asset allocation; it is the long run that matters.

4. Proper Diversification

There are large benefits to diversification in small numbers. In other words, three stocks is much better than two, and six stocks is much better than three. But with each additional investment added the marginal benefits decrease.

For instance, adding an 11th stock to a 10 stock portfolio would provide a significant benefit. But adding 1 stock, or even 10 stocks, to a 100 stock portfolio would not give you the same benefit. The benefits would be small but the costs might be great.

There are disadvantages of diversification in investing. The costs incurred by too much investment diversification are transaction fees and over diversification. Over diversification reduces quality, leads to average performance, and increases your costs. So while under diversification can be devastating; over diversification should be avoided too.

Most studies show that diversification is optimized at between 15 and 30 individual investments. Further diversification yields a smaller and smaller benefit. At some point the costs become greater than the marginal benefits of further diversification.

The goal is to combine assets that have a low asset correlation. You want to own many assets (i.e. 15 – 30) that will act differently and provide the benefits of diversification. For example, let’s say you owned 15 airline stocks in your portfolio. you would have diversification within the airline industry, but would incur a large risk to your portfolio. Those 15 airline stocks would have a high correlation.

In order to get the maximum benefit of diversification you might want to own the best 1 or 2 stocks in several different industries. Stocks in different industries will most likely have a lower correlation than stocks in similar industries.

For example, if consumer discretionary stocks were being hurt by a slowing economy, consumer staples might fare much better. If industrials were being hurt by inflation, gold stocks might be offsetting the decline in the industrial stocks. If airline stocks are suffering from rising fuel costs, oil stocks might be rising.

5. Don’t Follow the Crowd

In portfolio management, following the crowd can lead to poor investment returns. John Templeton said “If you want to have better performance than the crowd, you must do things differently from the crowd”.

I remember when I was a kid, my grandfather worked at a slaughter house. he would take us there and show us that if you got a some of the cattle to run towards the slaughter house, with the exception of a few, all would happily follow the crowd to their demise.

Following the crowd is “group thinking”. There is an emotional comfort in doing what everyone else is doing. We feel good when others agree with us. We are comfortable when we follow the majority.

The value investor must learn to be comfortable as an individual, an individual who thinks differently than the majority. If everyone is bullish on a stock, industry, or the market, beware; that means there are few investors left to buy but instead many are invested with the ability to sell. If everyone is bearish, look for opportunity; there are few investors left to sell and the price may be a bargain.

6. Buy Businesses – Not Stocks

When you buy a stock you are purchasing a business. Just because it is a fractional share doesn’t mean you shouldn’t treat it the same as if you were buying the entire business. Your perspective matters because it determines how you think and make decisions about your investment.

Buying businesses, not stocks, is one of Warren Buffett’s more important investment concepts. Your investment is not a piece of paper that you worry about the price every hour, day, or week. Think and behave like a business owner. Analyze the company like you are buying the entire company.

Personally, I de-emphasize the price of the stock and concentrate on enterprise value and enterprise value ratios. Enterprise value is the total value of a company. It takes into account cash and debt just as if you were purchasing the entire company instead of the fraction you’re purchasing with a share of stock.

7. Margin of Safety

In my book review of The Intelligent Investor, Revised Edition, Updated with New Commentary by Jason Zweig (affiliate link) I noted that Benjamin Graham made the investment concept of margin of safety the last chapter of the book because I believe he thought it to be the most important for investment analysis.

The margin of safety in investing is the difference between the market price and the fundamental or intrinsic value of the investment. The core financial concept of margin of safety is: price matters.

A value investor will estimate the intrinsic value of an asset and determine how much of a margin of safety they require before purchasing the asset. The difference between the intrinsic value and the price the investor is willing to pay is the margin of safety required.

Having a margin of safety doesn’t guarantee a profitable investment, but it does leave room for mistakes, unforeseen events, bad luck, or errors in judgement.

Investment risk and the probability of a large loss are reduced by purchasing an asset for less than its true value. A value investor will require a margin of safety to decrease risk and raise the odds of a profitable investment. The larger the margin of safety the higher the odds that investment returns will compensate you for the risk taken.

An investor can buy a great company with growing earnings but lose money because the price paid was too high. The goal is to buy companies at substantial discounts to real value and patiently wait for the mispriced security to gravitate towards its real worth.

Warren Buffett describes it this way, “Price is what you pay. Value is what you get”. The two, price and value, may be significantly different. Graham wrote “The margin of safety is always dependent on the price paid. It will be large at one price, small at some higher price, nonexistent at some still higher price”.

Sometimes the price is much greater than the value, in which case you should avoid or sell the security. Other times the price is significantly below the real value, in which case the value investor would determine whether it is enough to meet their margin of safety.

Two investors can buy the exact same stock and have two very different outcomes. For example, lets assume two investors have the same conviction: XYZ stock has an intrinsic value of $50. Investor A accepts a 10% margin of safety and buys the stock on a dip at $45.  Investor B is more conservative and requires a 40% margin of safety and waits until the price falls to $30. Later the stock rebounds to fair value ($50). Investor A has an 11% profit ($50 / $45), but Investor B has 67% profit ($50 / $30)! The only difference is the price paid.

Conclusion

I hope our discussion of these 7 investment concepts has provided you with a different thought process or approach to investing. Successful value portfolio management requires a different way of thinking. Make the effort to be above average. If there is anyway I can help you, please feel free to contact me.


Written by KenFaulkenberry

KenFaulkenberry

AAAMP Blog by Ken Faulkenberry
Ken Faulkenberry earned an MBA from the University of Southern California (USC) Marshall School of Business with an emphasis in investments. Ken has 25 years of investment experience and is dedicated to helping people with self-directed investment management through the Arbor Investment Planner. His asset allocation strategies have an outstanding performance record.
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{ 2 comments… read them below or add one }

Tangent Style

How do you reconcile the price conscious ideas in concepts 3 and 7 with the idea of buying businesses, not stocks in concept 6?

Thanks,
TS

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KenFaulkenberry

It all revolves around paying a price that offers a margin of safety. If you buy a business you would want to buy it at the right price (other wise you would pass). So #6 and #7 are totally linked. As for asset allocation, that is a little a harder. The best way I can explain is that the number of opportunities available that meet your margin of safety would have a lot to do with your asset allocation. For instance, today I am having a hard time finding opportunities that meet my standards, therefore I am holding more cash than I normally would.

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