SmartInvesting.ca

List of Articles

Too much diversification can hurt investment returns, says portfolio manager

by Wayne Cheveldayoff, 2006-09-14

Too much diversification in your portfolio can hurt investment returns.

It is advisable to diversify to some degree -- splitting your portfolio into several asset classes such as equities, bonds, income trusts and other categories such as real estate to spread risk and reduce volatility.

But the practice of diversification within an asset class, particularly equities, can be taken too far, in the opinion of Larry Sarbit, a successful portfolio manager based in Winnipeg.

Most equity mutual funds invest in a large number of stocks, with many holding in excess of 100, and this leads to returns that are not much different than the general market, he says.

“It’s not surprising that so few mutual funds can beat the market,” says Sarbit. “No fund manager can follow over 100 companies well.

“Owning hundreds of companies, the proponents of diversification will tell you, offers protection if some companies’ stock prices collapse. After all, a loss of around 1 per cent or less of the portfolio can’t really hurt you.

“The flip side of this argument is that a great performance from any one of these investments will be so diluted that its outperformance is irrelevant.”

Most investors pay to have their assets managed. In the case of mutual funds, the typical annual management fee is in the order of 2.5 per cent.

“Underperformance is almost guaranteed if you deduct fees from an over-diversified portfolio that generates market-like returns,” he says.

“How can great results emerge from such circumstances?”

Sarbit’s answer is to imitate the successful businesspeople “who have achieved wealth by concentration in a few, terrific, well-understood, bargain-priced businesses.”

Sarbit showed his approach produces good returns when he managed the Investor’s Group U.S. Growth Fund, identified by the Globe and Mail Report on Mutual Funds in April, 1998 as among the top seven high-performing funds in Canada over a 10-year period. The Fund had achieved an average annual return of 18.6 per cent from 1988 to 1998.

Soon after, Sarbit moved to AIC Funds, where he managed the American Focused Fund, achieving positive single-digit average annual returns from 1999 to 2005 when U.S. stock indices actually declined.

He now runs Sarbit Asset Management (www.sarbit.com) and manages its U.S. Equity Trust, which was created in September 2005 and has produced a 9.3-per-cent return since inception, according to GlobeFund. The portfolio as of June 30, 2006 had only a dozen stocks.

“Our philosophy is to buy terrific companies at cheap prices. We’re buying businesses, not flipping stocks, and we don’t focus on short-term returns. We believe that longer-term results of three to five years are a better measure of what a portfolio manager is really accomplishing.”

The portfolio was invested at the end of June in companies such as Foot Locker, International Speedway, Clear Channel, SM&A, Regis, Home Depot, Dover Motorsports, Diamondex Resources, DTS, Collectors Universe and School Specialty.

The approach Sarbit uses often involves buying out-of-favour stocks that have been hit with bad news. If the bad news is analyzed to be short term, there is a good buying opportunity.

However, “when buying something out of favour, you don’t know how long it will take investors to come back into the stock. It could remain unrecognized for a long time but that doesn’t mean it’s a bad investment.”

An example in the portfolio is radio broadcaster Clear Channel Communications, which Sarbit believes will eventually be recognized by the market for the great company that it is.

“The stock has been bumping along at the bottom for two years but we’re very happy to own it. We believe it is a temporary problem that will fix itself. Part of it relates to the industry going through a rough time. But the company has a huge competitive advantage and lots of cash flow and it is run by terrific people. The value of this business goes up every day.”

Sarbit says his main concern in managing people’s money is to avoid losing money. “If you buy cheap companies that have good potential, you’re unlikely to suffer permanent loss of capital, which is hard to recover from.”

To do this, he says he just thinks and acts the same way a successful business owner does. His longer-run track record shows that it works.

Wayne Cheveldayoff is a former investment advisor and professional financial planner. He is currently specializing in financial communications and investor relations at Wertheim + Co. in Toronto. His columns are archived at www.smartinvesting.ca and he can be contacted at wcheveldayoff@yahoo.ca.



The URL for this page is http://www.smartinvesting.ca/articles/20060914010100.html .


©2006 Wayne Cheveldayoff