Random Thoughts and Strategy
March 13, 2010
– Comments (17)
After my previous post detailing my general approach to investing, I found that I didn't really have much to say for a while. As a relatively inexperienced investor, I'm still learning quite a lot. I decided to highlight a couple decisions that come into play when putting together and maintaining a portfolio.
Concentration vs. Diversification
As with most things, there's really no catch-all statement or rule that works. Should you concentrate or diversify? It depends.
I generally believe it's best to concentrate. If you have 5-10 best ideas, you should put all of your money into your best ideas. This works quite well when you are invested in mid or large caps, companies with market caps of $2B or much more. Large caps are preferred, but I wouldn't mind putting my money into 5-10 high-quality mid caps that I've researched thoroughly.
However, I'm still most interested in micro caps. This presents a bit of a problem, because I think it'd be too risky to put all your money into just 5-10 micros. Instead, I'd put together 20+ companies if possible. The micro cap space has many more companies, so this shouldn't be too big a problem.
To summarize: concentrate with larger companies, but diversify with smaller ones.
Share Buybacks
This portion is inspired by this post by danielthebear.
In my opinion, the perfect company would obviously maintain a strong balance sheet in good times and in bad. Due to irrationality, every company's stock price is too low at times and too high at other times. If I owned a company, I would want that company to buy back shares at lows with that cash. At highs, I would want this company to issue shares if it could put it to use wisely. If not, I would not want any buybacks at all.
I've seen that buybacks are handled incorrectly by a whole lot of companies. Due to stock options associated with ridiculous executive pay packages, companies often buy back shares whether or not they're undervalued. This is obviously not good for shareholders.
I've also seen situations in which companies announce buybacks just to keep the stock price high. This is often done without regard for how undervalued a stock is. I've also seen that not all companies follow through with said buybacks. This can obviously be a red flag because it means management is dishonest.
In a nutshell, I put no stock in share buybacks. When doing research, I believe you can pretty much ignore buybacks. It's done incorrectly so often that you could ignore this aspect and still do extremely well in your valuations. I do, however, take notice when there is dilution. Watering down the stock is something I absolutely dislike.
Personal Finance
I'm 26. I still carry various debts, including student loans. I have just a small emergency fund and I work in the steel industry. Trust me, we're not doing so well in the steel industry. Anyway, before I became so interested in stocks, I was big on personal finance. I think it's more important to manage your debts and cash flow before attempting to compound your money through investments such as stocks and real estate.
Stocks were so cheap at times in 2009 that I couldn't resist putting whatever free cash I had into the market. In fact, I took out credit card balance transfers to get extra cash into the market. I did this in late Jan 2009, and have since paid the balances with profits from stocks. I know it was risky, but I would do it again given the stock prices from late February and early March, when I was buying with that cash.
While it worked out quite well for me, I've changed my stance in 2010. Now that the market has settled down and the irresistible bargains have just turned into decent ones, I'm being a lot more careful with my cash. I've decided one of the biggest priorities in the near future is to establish a larger emergency fund. I used to tell myself that I could pour all of my money into stocks and have that double as an emergency fund, provided the account balance was way higher than the size of emergency fund I'd like.
This didn't work so well, because having my "emergency fund" at risk didn't sit well with me, even if it could sustain a big loss and still have enough cash to cover many emergencies. I know you've all heard it over and over, but I must reiterate this: if you might need the cash in 3-5 years, it should not be at risk. Put it in high-yield savings, a CD, or some other riskless investment.
In short, get your own personal finances in order before putting money into the market. The crash of 2008/2009 will NOT be the only market crash. I expect to see many more in the future. I'd rather get my personal finances cleaned up completely so that next time, I will be putting money at risk that I could completely afford to lose.
Chinese Micro Caps
I've covered why I think you should diversify with micro caps. My various accounts hold mostly micros and cash. I do own quite a lot of Chinese micros, so I think a little discussion is warranted. There's been a lot of fuss about a possible bubble in China. All I have to say is this: Chinese micros often have trade at larger discounts, and I believe it's justified. When buying Chinese micros, I would demand better numbers than I would from a US company.
Government regulations and such play a large part in China. Some companies are privileged to be the only companies allowed to issue certain services or goods. At any point in time, the game can change drastically. It likely won't, but one should exercise caution.
With Chinese micros, basically:
1. Demand better numbers to justify purchases
2. Diversification is very important
Closing Thoughts
I look forward to comments and such. I've enjoyed the long discussions following my blogs, and I'd appreciate any discussion on the above points.
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