Making the Bet Part 2:The Hand
In our blog, “Making the Bet - Part 1: The Game”, we made the point that concentration is often viewed in a vacuum and instead needs to be viewed holistically. Doing so can uncover concentration and previously unknown risks. However, concentration from a finite level – such as a portfolio level – is just as concerning. If possible, one must be aware of their concentration on a macro level (“The Game”) and a micro level (“The Hand”).
The Hand and its concentration is often the one people think of most. Advisors typically discuss diversification inside their clients’ portfolio(s) and that spreading your eggs amongst baskets reduces portfolio risk. Furthermore, it is easy for an investor to see. The information is typically gathered in one place, and analytical software can produce beautiful graphics flawlessly showing the concentration behind The Hand. At LBW, we don’t disagree with diversification and recognize its risk-reducing nature. However, we feel there is a misconception behind how concentrated The Hand should be and why concentration could reduce risk and increase returns.
Risk – let’s start there. Risk can be defined as “the chance that an investment (such as a stock or commodity) will lose value”. This definition is cut and dry – create a portfolio that won’t lose money – if it was that easy we wouldn’t be writing this blog. The problem is, investors sometimes don’t agree on how to measurer risk. One widely-used metric is called beta; below is a brief description:
“Beta measures the responsiveness of a stock's price to changes in the overall stock market. On comparison of the benchmark index for e.g. NSE Nifty to a particular stock [sic] returns, a pattern develops that shows the stock's openness to the market risk. This helps the investor to decide whether he wants to go for the riskier stock that is highly correlated with the market (beta above 1), or with a less volatile one (beta below 1).
For example, if a stock's beta value is 1.3, it means, theoretically this stock is 30% more volatile than the market. Beta calculation is done by regression analysis which shows [a] security's response with that of the market.
By multiplying the beta value of a stock with the expected movement of an index, the expected change in the value of the stock can be determined. For example, if beta is 1.3 and the market is expected to move up by 10%, then the stock should move up by 13% (1.3 x 10).
Beta is the key factor used in the Capital Asset Price Model (CAPM) which is a model that measures the return of a stock. The volatility of the stock and systematic risk can be judged by calculating beta. A positive beta value indicates that stocks generally move in the same direction with that of the market and the vice versa.”
Beta is based on the price volatility of said stock and the benchmark it is compared to. Said differently, if the stock price moves more than the benchmark it would be deemed riskier. And if its price were to move less, it’s less risky. If this were to be true, then one would need to assume the stock’s price is equal to its intrinsic value (what that company is worth). Furthermore, sometimes the mechanics of the market is misunderstood. Take for example, the New York Stock Exchange (“NYSE”). It is a place to buy and sell shares of companies and is considered a secondary market. Meaning, that individuals buy and sell to each other at prices they feel each company is worth. It is up to the individual to assess the value of the company. Meaning, beta assumes the public is valuing each security at its appropriate price. Herein lies the issue, people aren’t always right, and sometimes they will sell shares at values that are too high, low, or exactly right. If you are in LBW’s camp and don’t feel people adequately value companies all the time or have a long-term investing horizon, then price movements don’t equate to risk, and companies’ actual health (i.e. their debt loads, brands, competitive advantages, etc.) do.
Risk is only one part to the investment equation; the other is return potential. Just because we may understand the risk to an investment doesn’t always mean the return on the investment will be great. To understand the return potential, homework must be done on the investment’s prospects. Combine the risk and return, and now The Hand can begin to be played. For example, let’s say Linda is playing poker and her Hand is a Full House. Should she bet big, fold, or check (let’s not assume she is trying to play games with the pot, which is very real in the game of poker)? The probability of Linda even getting this type of Hand is 0.1441%, meaning the likeliness of her winning is extremely high since there are only three hands that could beat her. So, if Linda is an experienced player, she should bet BIG! Understanding your investment is obviously a large part to reducing your risks and increasing your returns. Therefore, we tell many of our clients with closely-held businesses that reinvesting in their companies instead of the public markets could potentially derive higher returns, and one main reason is they understand the mechanics behind their respective money-generating machines.
Now we can begin to see why there is a misconception behind diversification. If one can truly understand their investment, they can begin to concentrate on their best ideas. For example, telling Bill Gates to diversify away from Microsoft in the beginning years, seems like a laughable joke – he’s made billions being highly concentrated in one company. However, Mr. Gates knew what he was tying his horse to, because he built the carriage. The point is, the level of concentration on one asset shouldn’t be determined by a random percentage, but by its risk/return profile based on the fundamental knowledge you have about said asset. And if you don’t understand the investment, placing large bets isn’t prudent. For example, cryptocurrency, such as Bitcoin, was the rage of 2017. For the public, investing a large amount of assets in Bitcoin probably wasn’t prudent. However, investing 0.25% of their portfolio would have been a prudent move – it would have limited the risk with the potential for exponential upside. In addition, the majority of your assets shouldn’t be invested in a business because your best friend from kindergarten told you it was going to be the next best thing; maybe 1% of your investable assets would do just fine.
We are not advocating that concentration is the way to go; we are asking people to rethink how they should approach diversification. Diversification has its place as it does reduce risk to a point, especially if you are unable to put in the time to properly research potential investments, but if you understand your investments’ risk/return profile and have a long-term investment horizon, concentrating on the best ideas can be fruitful.
 In fact, we would argue you shouldn’t invest in anything you don’t understand.