Core Competence : The Case Against Diversification



What is the first piece of ‘investment wisdom’ that the self-appointed experts teach you? Hold many eggs in many baskets, because you don’t know which egg (or which basket) is bad. The argument for making a portfolio out of everything is repeated so often that its echo is often confused as the prevailing wisdom. Yet, when we talk about real businesses, we now make the exact opposite argument, i.e. focus on your Core Competence. The underlying assumption is that for a business to be competitive, it must have scale, intelligence/ knowledge/ data (about costs and revenues), and enough perspective/ wisdom/ philosophy/ know-why in all its business processes, to ensure that it outperforms the competition.

Declaimer: This article written was originally in April 2011, and some of the data points may be outdated.

There are few activities that require perspective, as much as Investing

There are few activities that require perspective, as much as Investing. If markets are a mechanism for the “transfer of wealth from the foolish (many) to the intelligent (few)”, then the meaning of these words has to be carefully spelled out. Investing, then, is at least as much about having intelligence, as it is about having any money (to invest) in the first place. Thereafter, the principle of compounding tells us that Intelligence/ perspective plays a disproportionate role in deciding who wins the investment sweepstakes.

Warren Buffet tells you to “buy a part of the business, and thereafter, to own your shares like you own a business”. He dwells on these aspects at length, and then goes on to tell you that “the best time to sell a good investment is never”. Indirectly, he is also bringing out the principles of Core Competence. For example, blind diversification for its own sake, is just that….blind!!! If you don’t know what you are doing, you are more likely to step into a puddle if you walk on many roads. As any blind person will tell you, the best way to ‘see’ where you are going, is to get a sense of a place by doing repeated passes down the same road. Jobbers often look like day traders and have unfairly been given a bad name, all of them being painted with the same tarred brush. Some of the best jobbers will stick to the same stock for a lifetime, actually adhering to Warren Buffet’s advice of never actually leaving a stock, even as they buy and sell stock many times during a day. Not only do they add liquidity to the stock, but they also have local insights about the price discovery prevailing in stock, its different ‘moods’, and its penchant for surprise, which outsiders will never have. This is perspective, something the stereotypical day trader does not have.

Investors get paid to identify trends; they make money when they (correctly) anticipate a trend. Markets are a discounting mechanism, and the winners are those who forecast accurately, and then put their money behind a hypothesis. If any of these 3 are missing (i.e. the forecast, the money, or the hypothesis), you don’t make money. The hangers-on, i.e. the pundits, sit on the sidelines and pass comments on the players. They are about as right as any cricket fan, about whether Sachin will carry India to victory or not. And their winning odds are similar.

So ‘diversify’; they say, but against what? If you don’t articulate the risks you are facing, what are you diversifying against? The gullible investor is actually buying ‘Hope’ and as we all know, “Hope is not a strategy”. The cost of buying Hope is actually the cost of buying randomness, variability, and unpredictability in investment returns. And most importantly, if you don’t know what you did right, then you have no hope of ever being able to repeat it.

The purpose of diversification

The pundits will tell you that your winners will make up for your losers, and that is the purpose of diversification. But if you don’t know (and don’t learn) how to tell one from the other, you have to live with the general belief that most stocks go up in the long run, often articulated as “market returns”. This, as we know, from recent experience, is not true over long stretches of time, and (you know from personal experience) is not the experience of most retail investors. However, this opinion (that markets go up in the long run) is prone to take widespread root in a late bull market, and shortly thereafter, is seen to be in the breach. Ironically, poor timing kills the people who claim to ignore market timing.

Over the last 5 months, you could have bought low Beta stocks (like Bharti, Power Grid Corpn), sold high Beta stocks (like Real Estate, Banks), bought the Dollar (against the Rupee), and sold the Euro (against the Rupee), bought Silver and sold Gold. Most of the positions would have worked out; to the uninitiated, this would look like diversification, but it is actually the same Investment Hypothesis and the same forecast. It may have been articulated over different instruments, but the underlying economic logic is unified. In the same way, in 2007-08, you could have bought a low Beta stock like Hero Honda, sold a high Beta stock like DLF, bought the Dollar (against the Rupee), sold the Dollar (against JPY), bought Gold and sold the broad market. If you diversify blindly, you might get some legs right by accident, but you would be most likely to get enough legs wrong, to ensure that you destroy value.

With the right economic arguments, you may choose to articulate it with one instrument or 10, that in itself is irrelevant. If your method of building your Investment Hypothesis is flawed, you have no hope….rather like the novice skydiver who took along 3 parachutes instead of one but forgot to learn how to open them. Without the underlying knowledge, the ‘diversification’ is bound to lead to disaster. How about telling the novice to eschew skydiving till he learns enough about it? Novices should not be investing, they should be saving, and generating capital, and if they MUST diversify, they can always buy 2-year Bank Fixed Deposits along with a 1-year Bank Fixed Deposit.  If you know how to articulate an Investment Hypothesis, diversification is actually “di-worse-edification”, i.e. it means that you are investing in the probability that you are wrong. The way to manage that is through hard work and better diligence, not through diversification.

If it turns out that you did a good job, you will actually reduce your Investment Returns, not your Risk.

It is when you don’t know which way the trend is going (i.e. you don’t know Investing), that you say it through ‘diversification’…….I don’t know, and I am just hoping!!!

Another canard floating around the Investment markets

This brings me to the idea of ‘buy and hold’, another canard floating around the Investment markets. When we buy a stock, we are actually buying a business, whose returns over the long term are linked to the fortunes of the business. Now, Business Risk is complex, has many aspects and there are many of them. Even the people running the business don’t have a full grip on all the risks in that business, and cannot tell you, for example, how much they will make (and why) in, say, 5 years. Why then, would ‘buy and hold’ be such a good idea? Just because you don’t know any better, and the pundits you trust don’t know either?

How about trying to figure out the volatility (of price discovery) in a stock? It is difficult and complex, perhaps, but it saves you the effort of trying to understand the long-term prospects of the sector, for example. It is much easier to buy a telecom stock when everybody is decided that “Telecom is an underperformer”, and then try to figure out the patterns in the stock, i.e. buy the stock when the rollover cost is negative and sell it when the rollover cost crosses 1% per month. Try figuring out the rest of the business….which way will 3G go, what effect will Cloud Computing have on Telecom, which African country is going up in flames, who is the new Minister in Telecom, what new social network is emerging among kids (and is it a threat to, or opportunity for, Telecom), and which new industry is going to come out of nowhere to suddenly replace existing technologies in Telecom?

To those who say, ‘Just buy mediocre management in a great business, rather than good management in bad business’, make sure that you define ‘good business’ well. Is soft drinks a great business, and is Coke a great co? And if it is (a great company), is it also a great stock? Depends on when you catch it. Market timers might choose to look for an irrational seller, who gives away great value because of a weaker moment. Those who choose to ignore timing, are saying that the company’s business performance will be adequate to create value, i.e. the greatness of the business is a replacement for the lack of skill on the part of the investor. Because the company works hard, you (the investor) don’t have to…!!!



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