Thursday, March 12, 1998
TOWACO, NJ (Mar. 12, 1998) -- At around 3 p.m. this afternoon, the Cash-King Portfolio purchased our RP4 stocks: General Motors, Exxon, Eastman Kodak, and Chevron. We tried to spend equally on the four, though the share prices obviously force a few dollars extra here, a couple fewer there. Click "Thursday's Numbers" to get a look at the final tallies. Now, on to today's report...
There has been some discussion on the Cash-King Web Board recently about the subject of diversification. Some Fools think our twelve stocks isn't defensive enough; others opined that diversification beyond a handful of stocks reduces your potential gains.
This is the sort of debate I love to see in Fooldom. The financial media sometimes bizarrely misrepresents this forum as being one driven by herd mentality, a cult of rookie investors all acting on online hype. (Zzzz.) A snoozer argument... but nice try.
What's really happening in Fooldom is that nearly a million people each month are choosing to discuss and debate (always politely, in C-Kdom) the merits of given investment approaches, the value of particular businesses, the best way to buy a new car, et cetera. It's a non-restricted, open forum for debate... a model that is radically changing how Wall Street and the money world works.
Just take our recent discussion on diversification, as an example. All of us end up in unique situations -- with different dollar amounts to invest, different time horizons, different investment holdings, and different goals. The public discussion of this in the Cash-King folder is a way for us all to hear what others are doing, to challenge assumptions, and to reconfigure our portfolio if we feel it necessary.
Today I'll consider this issue of diversification, and I'd actually like to focus on a response to those Fools who think that our twelve-stock portfolio is over-diversified. Some investors in our area are allocating seemingly large portfolios in 3-5 different stocks, and certainly many of them will do very well as investors. Let me explain, though, why we're holding more positions.
If we absolutely knew -- beyond a shadow of a doubt -- that we could pick 3 to 5 long-term market-beaters, we'd be more than happy to load all of our money into them. And wed use all of our future savings to purchase more shares of those companies. Then we'd never have to research another business. We'd be approaching the markets from the "Put all your golden eggs in one basket, and watch that basket" vantage point. And that would leave us with even more time than your average Cash-King investor to go rafting down the Yellowstone River, to read the collected works of Mark Twain, or to play whiffle ball with the kids.
What a great deal! We'd limit the number of decisions to make, we'd increase our returns, and we'd free up additional time to pursue numerous other interests. What a great deal.
The problem with that theory, though, is that when it comes to investing, theres no such thing as a sure thing. This mantra applies whether were talking about small-cap, mid-cap, or large cap stocks and even includes our beloved Cash-Kings. Check our buy reports for each of the stocks that weve purchased so far Microsoft, Pfizer, T. Rowe Price, Intel and Coca-Cola. You'll see that we recognize potential risks in owning each of these stocks.
Mind you, we love our general approach here. It's strict -- no matter how diligent we are in our research, virtually no stocks that we select will meet all of our expectations. Coca-Cola appears to be the one with the best shot at it. But that doesn't guarantee that Coca-Cola won't hit hard times. In the 1970s, Coke's CEO was afflicted with Alzheimer's, and the company's operations wobbled. We believe that, under horribly adverse circumstances, any one of our investments could topple.
I'll give you two examples. If you check the predecessors to the Cash-King Portfolio (see Step 1 of the 11 Steps to Cash-King Investing), youll see that both of these portfolios included a dog. The Simpleton Portfolio had its Silicon Graphics -- grrrr,grrrr. And the Money-Heavy Portfolio had its Oxford Health Plans -- see Spot chewing on a Booda-bone.Yet, despite their dogs, so far these portfolios have rather dramatically outperformed the market's return (no word from the financial media on that yet!).
The market-beating Fool Portfolio has had a dog or two (and more) as well. There was ATC Communications -- Lassie, don't come home -- which was sold at an 85% loss last year. And even The Foolish Four model, which has thrashed the market for three decades running, got a bunch of Fools into Woolworth five years back... howwwwww-oooo... !
Every dog has its day. And I think that even every market-beating portfolio has its dog(s).
You might insist that these dogs could have been avoided. But the principles of 20-20 hindsight do have a way of misleading our foresight. At the time that each of these stocks was included in the relevant portfolio, there were valid reasons for their inclusion. And, in many ways, it was because of the inclusion of these sorts of stocks that the portfolios also purchased some monster winners. The two can't cleanly be divorced in my mind. You have to err to succeed. You see, it may just be that even if you are Warren Buffett (or particularly if you are), you can't find American Express or Capital Cities/ABC without suffering through US Air or Berkshire's textile operations, first.
This doesn't mean that we can't learn from our mistakes. We must try to. It also doesnt mean that we shouldn't fight to avoid future mistakes. But I personally am uncomfortable with the idea that any of your Cash-King managers here are so expert that a 3-5 stock portfolio would suffice. If a dog shows up, investors with only a few holdings run the risk of substantially underperforming the market. Two blunders and the investor is doomed. Can't you imagine that happening? Think on these scenarios. One of your errors ends up coming from dishonest financial accounting by your company that no one foresaw. The second one came from a class-action liability suit that would've been nearly impossible to predict.
Two mistakes in a three-stock portfolio, and you're toast.
I think that oftentimes, more broadly-defined portfolios (10-20 stocks) end up being carried by one or two stocks that deliver such extraordinary returns. As they double, triple, quintuple, then gain ten-bagger status, they push the entire boat higher. If you're picking from great companies, I honestly believe that you reduce the risk of your overall portfolio with a dozen holdings, without diluting the force of two phenomenal performers.
The Fool Portfolio is a great example of this concept. They hold between 10-15 stocks, have had a healthy mix of great winners, market-performers and losers. But two of their stocks (Iomega and America Online) have led that portfolio to market-beating returns since its inception. No surprise that the harsh critics of The Fool Portfolio aren't money managers. They haven't been exposed to how portfolios beat the market by riding a few huge winners to monstrous long-term gains. For Buffett, Coca-Cola at times has represented 50% of his investments.
To my eye, though, securing those 2-3 monsters is very difficult to do, if you limit your total selection to 3-5 stocks. While it's certainly true that owning fewer stocks increases your chance of outperforming the market, I think that relative to that upside, it more substantially increases your risk of underperforming the market.
For us, the perfect number is between 10-20, more likely between 10-15 businesses. More than that, and you do risk diluting a few great performers. And more importantly, it's tough to follow that many businesses, and still live! My guess is that investing is not a profession for those of you that are reading this report. If youre like me, I suspect that you dont have the time to research and follow more than ten companies. Once you get beyond that, I think it likely that 1) there will be too much regression of your portfolios performance towards the level of the market, and 2) you'll ultimately think of investing as a burden that eats into your social life. (Ask Tom -- his social life is pathetic!)
I'll see you tomorrow in this column, if I still have a job after that parenthetical.
Phil Weiss (email@example.com)
Day Month Year History C-K -0.12% -1.16% 0.58% 0.58% S&P: +0.14% 1.96% 6.86% 6.86% NASDAQ: +0.41% -0.36% 6.73% 6.73% Rec'd # Security In At Now Change 2/3/98 22 Pfizer 82.30 86.13 4.65% 2/3/98 24 Microsoft 78.27 81.88 4.61% 2/27/98 27 Coca-Cola 69.11 71.63 3.64% 3/12/98 15 Chevron 83.34 82.94 -0.49% 3/12/98 20 Eastman Ko 63.15 62.81 -0.53% 3/12/98 17 General Mo 72.41 71.94 -0.65% 3/12/98 20 Exxon 64.34 63.88 -0.72% 2/13/98 22 Intel 84.67 76.38 -9.80% 2/6/98 28 T. Rowe Pr 67.35 69.88 3.75% Rec'd # Security In At Value Change 3/12/98 15 Chevron 1250.14 1244.06 -$6.08 2/3/98 24 Microsoft 1878.45 1965.00 $86.55 2/3/98 22 Pfizer 1810.58 1894.75 $84.17 2/6/98 28 T. Rowe Pr 1885.70 1956.50 $70.80 2/27/98 27 Coca-Cola 1865.89 1933.88 $67.98 3/12/98 20 Eastman Ko 1262.95 1256.25 -$6.70 3/12/98 17 General Mo 1230.89 1222.94 -$7.95 3/12/98 20 Exxon 1286.70 1277.50 -$9.20 2/13/98 22 Intel 1862.83 1680.25 -$182.58 CASH $5666.26 TOTAL $20116.27 *The year for the S&P and Nasdaq will be as of 02/03/98