Ben Graham suggested that investors should be prepared for adverse movement in their holdings, and that a -30% move in any one (or a combination) of an investors holdings is not within the realm of the unexpected.
One method of coping with/synthesizing the risk of adverse movement in any one (or a combination) of holdings is to diversify. If an investor is sufficiently diversified, he/she may be more likely to cope with adverse movement in any one particular stock in the context of the overall portfolio. But diversification, in my opinion, is a misnomer and is misunderstood.
An investor who has structured a portfolio predicated on thirst for dividend yield first and foremost may actually end up being un-diversified. Case in point, the Canadian equity space is concentrated in resource/commodity focused stocks, but this exposure may stem beyond the direct culprits in the resource/commodity space in the event of an exogenous event impacting the underlying commodity. Anything in energy services, junior energy exploration, drilling, and production, midstream pipelines, oil sands, and even integrated oils, is now offering dividend yields which are substantially higher than they were before September 2014.
An investor who's primary criteria is a dividend yield in excess of say, 4%, may go about purchasing two energy services companies servicing different sectors of the energy space, one midstream pipeline company, and one integrated oil company or one oil sands company, all offering attractive yields in excess of 4%, and by doing so, may have inadvertently quadrupled his/her concentration of risk. At first glance, although each of the companies offers a distinct product or service, their bread and butter all comes from the same place.
The same investor may then go about purchasing two commercial REITs, one of which has greater than 40% of its property leased to a combination of junior energy producers, energy service companies, and oil sands companies. Each REIT offered yields in excess of 5.5%. Easy money right?
The same investor may then go about purchasing a railroad yielding 3%. Railroads are stalwart, long-standing, oligopolies. They own millions of kilometres of railyway tracks nationwide and there are huge barriers to entry. And yet, railroads are dependent on the energy space for a significant portion of their revenues.
The same investor may then go about purchasing a bank stock with significant loans to junior energy producers, energy service companies, and oil sands companies. The bank stock carries a yield of 4% and has paid uninterrupted dividends for the last 25 years.
If this investor constructed this portfolio well before September 2014, the portfolio may have apeared reasonably diversified. The portfolio would have included:
- Two energy service companies servicing different sectors of the energy space. Perhaps one company operates trucking and logistic services in Western Canada, and the other provides a suite of drilling diagnostic data products. Each company yields 3.5% and has grown both earnings and dividends combined at 10% over the last 10 years.
- One midstream pipeline company which has a substantial backlog of pipeline projects expected to add new capacity over the next 5 years, and which as a result of this supplemental capacity, expects to substantially inrease free cash flow sufficient to repay the cost of funding the new capacity and increase the dividend. The pipeline yields 4.5%
- One integrated oil company which has been operating for the last 50 years, and which has weathered previous cycles in the past. This company yields 3%.
- Two REITs, one of which has greater than 40% of its property leased to a combination of junior energy producers, energy service companies, and oil sands companies, and the other of which runs self storage facilities in Western Canada. Both REITs yield 5.5% and have conservative mortgage to property ratios.
- One national railroad which has been operating for 100 years, and which yields 3%.
- One bank with significant loans to junior energy producers, energy service companies, and oil sands companies. The stock carries a yield of 4% and has paid uninterrupted dividends for the last 25 years.
So what could this hypothetical investor have changed in terms of approach?
I believe that the answer comes back to understanding franchise/moat in the context of correct diversification.
Borrowing from Base Hit Investing, here's an interesting anectdotal clip demonstrating the difficulty inherent in understanding franchise/moat:
"Munger talked about moats a couple times during the meeting. The first time he recited a few examples of formerly great companies that had significant competitive advantages, but due to the nature of capitalism, eventually wound up bankrupt:
“The perfect example of Darwinism is what technology has done to businesses. When someone takes their existing business and tries to transform it into something else—they fail. In technology that is often the case. Look at Kodak: it was the dominant imaging company in the world. They did fabulously during the great depression, but then wiped out the shareholders because of technological change. Look at General Motors, which was the most important company in the world when I was young. It wiped out its shareholders. How do you start as a dominant auto company in the world with the other two competitors not even close, and end up wiping out your shareholders? It’s very
Darwinian—it’s tough out there. Technological change is one of the toughest things.”