Andrew Kuhn April 14, 2020

In a Market Like This – Is It Better to Buy 10 Stocks Instead of Just My 5 Favorite Stocks?

Someone sent Geoff this email:
Hi Geoff,
On regular days your focusing on overlooked stocks makes much sense to me and is the right place to look for good companies at a decent price.
But in this market selloff, wouldn’t it be better to buy blue chip stocks such as Nike, Disney, BrKb, etc.. if they fall to the right price (and I’m not sure they are there yet…).
Also, wouldn’t it be better to diversify? To own 10-12 stocks instead of 5-7.
Answer: It Depends On Which Stocks – Conglomerates like Berkshire and Disney Give You a Lot of Diversification, Some Other Stocks Don’t
(Note from Geoff: I’m going to split this email into two responses – this one will talk about diversification, tomorrow’s response will talk about overlooked versus big cap stocks)
I don’t know about whether it makes sense to own 10-12 stocks instead of 5-7. I’m not sure it does. It depends on which stocks you’d add to the portfolio. Remember, there is a lot of diversification in certain stocks already. So, you mentioned Disney (DIS) and Berkshire (BRK.B). Berkshire already gives you more diversification in terms of its underwriting than many insurers do. Plus, Berkshire has a big stock portfolio. Plus it owns a railroad. Plus it owns an electric utility. You could separately buy other insurers, stocks like Apple (AAPL) and Bank of America (BAC) and Wells Fargo (WFC) and Coke (KO). You could buy a publicly traded railroad. You could buy a regulated utility. If you add up what you’d put in all those stocks if they were in a 12 stock portfolio – maybe you’d put 33% of your portfolio or more into recreating what Berkshire already has. So, should you buy a bank, an insurer, a railroad, a utility, etc. – or just buy Berkshire? I don’t know the answer. If you pick the right bank, insurer, railroad, and utility – I’m sure you could beat just buying Berkshire. But, if you think you’re somehow safer putting 10% each into one bank, one insurer, one railroad, and one utility than 40% in Berkshire – I don’t think that’s true.
Disney is similar. The company is diversified across a couple big entertainment segments. It has a big allocation to parks and resorts. This includes things like cruise ships. But, it’s mainly theme parks. Disney has the most visited theme parks in several parts of several different continents . So, you could buy SeaWorld (SEAS), Six Flags (SIX), or Cedar Fair (FUN) – or you could get a similar allocation by owning 3-5 times more of Disney than you would of any one of those companies. If Disney is say 20-33% parks by value (you’d have to appraise the stock yourself to make this decision) then simply buying a 3-5 times bigger position in Disney and you’d get the same allocation to theme parks you would from buying one of those other stocks. Disney has a big movie business (it is now, by far, the leading studio in Hollywood). It also owns cable channels and other media properties through which it is more of a distributor. For example, it owns ESPN. In a case like Disney, you might end up with some allocation to assets you don’t want (the same is true at Berkshire). But, you’d probably have a more financially sound overall investment. Remember, the problem with Cedar Fair and Six Flags and SeaWorld is that they don’t have other businesses producing cash flows to cover their losses this year. Disney – like Berkshire – is more likely to stay solvent. So, the same exact theme park in Disney’s hands is probably worth more to an investor than if it was in a standalone business. A standalone theme park business is now at risk of insolvency. Disney is a source of support for all of its subsidiaries. This is probably a better form of diversification than you could practice by buying individual stocks in the entertainment industry.
So, if you were buying stocks like Disney and Berkshire – I don’t think you’d need much diversification. The idea that a portfolio that is 20-25% Disney and 20-25% Berkshire Hathaway is too concentrated seems strange to me. They are very diversified businesses. And they have better financial strength than a basket of non-diversified competitors in their industry could offer you. So, diversifying into specific stocks to replace Disney and Berkshire would simply lower the financial strength of your portfolio. That’s a bad idea.
The other reason why I’m not sure diversification is helpful in a situation like this is that you need to consider what risks you’re trying to diversify away. What risks do stocks today face? Well, their industries could be shut down by government order. Or, their industries could fail to attract business because people are afraid to frequent the sites the company operates. Or, the company could face solvency risks. Or, the company could be hurt in a recession/depression etc.
Okay. How does diversifying help you?
Should you buy one of the top 4 U.S. airlines or all 4?
It probably doesn’t matter. They all face the same risks. Would it really be safer to buy all 4 airlines instead of just the #1 safest airline in terms of balance sheet strength as of the moment.
Likewise, should you buy Boeing and Airbus instead of just Boeing?
Should you buy Chevron and Exxon instead of just Exxon?
Should you buy Amadeus and Sabre instead of just Amadeus?
Should you buy Uber and Lyft instead of just Uber?
None of these ways of diversifying make an ounce of sense to me. In fact, in some cases, one stock will have a stronger balance sheet than the other. You could easily be better off putting 100% of your allocation to that industry into the company with the strongest balance sheet instead of spreading it around.
Having said that, would it make sense to diversify by country?
It might. So, there’s a company called Straco that operates aquariums in China. There’s a company called Six Flags that operates theme parks in the U.S. It’s possible that there will be devastating problems with the virus causing shutdowns of attractions in one country but not the other. So, it might make sense to diversify between multiple countries.
But, does any of this reduce risk as much as avoiding industries that are likely to be harmed by shutdowns in response to the virus or by a recession/depression etc. that follows these shutdowns?
For example, is it safer to diversify across: 1) An ad agency 2) A theme park operator 3) A restaurant and 4) An airline – or just buy the best supermarket stock you can find. Supermarkets will continue to make pretty good money when people are in lockdown, when the economy is in a recession, when the economy is in a depression – etc. They aren’t very economically sensitive.
But, you surrender upside potential by doing that. Ad agencies, theme parks, restaurants, and airline stocks are all a lot cheaper than supermarket stocks. So, you could buy a basket of 4 riskier stocks instead of 1 safer stock.
The problem I see with diversification during dangerous times for the solvency of companies is just that you might know less about each of the stocks you end up buying. If you’ve studied one stock really well and then you choose to buy 3 stocks instead you know less well – I’m afraid many investors will underestimate the potential credit risk to that stock in severe circumstances.
I have written about bank stocks recently. But, I definitely would not just buy a basket of bank stocks. I’d only consider banks I’ve looked closely at and feel I have a good idea of their credit quality. Loan losses are going to rise at banks. Credit lines are going to get drawn. Banks will be stressed in a way they haven’t been in a while. So, I wouldn’t recommend learning about a new bank stock today for the first time and then buying it on Monday. If you’ve known and liked a particular bank for a few years now – that’s the bank to consider.
In general, I’d say a lot of today’s risks are “systemic” or industry or country risks. You can’t do anything about market risk. All stocks could plunge in price on some days even when some businesses are sound and others not. So, forget trying to eliminate market risk. Systemic risk is complicated. You can somewhat avoid it if you own companies with lots of cash, minimal borrowings, they don’t sell anything on credit, they don’t rent anything, and their product is a necessity. I can’t think of many stocks that fit all those requirements. But, some stocks fit a lot of them. The supermarket with the strongest balance sheet faces little systemic risk. Industry risk can easily be diversified. Just promise yourself you won’t put more than 5% of your portfolio in cruise lines total (no matter how many cruise lines you choose to buy), no more than 5% of your portfolio in airlines, etc. That kind of diversification is helpful. Although be careful to note that all “going out” industries face the same risk. So, putting 5% in a utility, 5% in an ad agency, 5% in a core processor, 5% in a bank, and 5% in a cement maker is very different from putting 5% in a restaurant, 5% in a hotel, 5% in a cruise line, 5% in an airline, and 5% in a theme park. Things like theme parks, movie theaters, restaurants, hotels, cruise lines, and airlines are all really just one form of bet – it’s a bet against a virus shutdown annihilating entire industries. If you bet wrong, then 25% of your portfolio will be on the line even though you think you only put 5% into any one industry. For now, all “going out” industries are really just one super-industry for the purposes of taking on risk. Country risk is tough. The virus has spread all over the world. I think it’s speculative to assume you know where the next outbreak will be, how bad it will get, and what the government response will be. I think there are slight benefits to diversification by country. However, they are much more slight than normal. The correlation between countries is going to be higher than normal in terms of risks. Like I said, maybe you want to buy an aquarium stock in China and a theme park stock in the U.S. I think that does diversify you ever so slightly. The Chinese and American responses to the virus may be different. But, they both face much the same risk of imposing shutdowns from time-to-time on attractions. So, I still think two stocks in the same industry but in different countries isn’t doing a lot to diversify you.
The better way to reduce risk in your portfolio is to buy the financially strongest company in the industry you want to invest in. I think Berkshire and Disney are good choices. I wouldn’t prefer owning 5 stocks instead of Berkshire or 5 stocks instead of Disney. If someone told me their portfolio was half in a combination of Berkshire and Disney – I’d say that’s probably a safer portfolio than what most people own.
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