Concentrate or diversify?

Sharing an email exchange here:

Hi AK,

 

I am a retail investor who has been investing for some time, and I've also been a long time reader of your blog. Before I go on any further, I would like to thank you for your blog as it has provided many people with valuable insights on investing and personal finance. Your contribution to the investment community is immense, I sincerely hope that you continue blogging!
 

I have a question regarding diversification vs concentration. While I am aware of the benefits of both strategy, I'd like to hear your view on this topic. Very often, I find myself identifying several undervalued companies. However, instead of buying all of them, I try to narrow it down to 1 or 2 high conviction stocks. As such, my portfolio tends to be extremely concentrated. I take into account factors such as the potential upside, catalyst, expected holding period, circle of competence etc.

While my investment record is satisfactory, I have missed many opportunities (mainly because it is impossible to predict when prices will rise) when I did not buy the other undervalued stocks.

Diversification will solve that problem. However, I might risk missing out on huge gains from my high conviction ideas just because I don't want to lose out on the others when prices rise. I hope to find an investment philosophy that would help me reconcile these two strategies and would love to hear your views on this. Thank you.

Regards,

WJ

 

 

My reply:

Hi WJ,

From your email, I get the impression that you prefer a concentration strategy. You have, however, rightly pointed out one of the weaknesses of such a strategy, especially if our funds are limited.

There is a simple solution to the problem you have. Do a lesser form of concentration. What is this?

Let us say you had identified 10 stocks which met your criteria, instead of selecting 2 stocks to put all your money into, put 50% of your money into these 2 stocks. The other 8 stocks get the rest of your money.

You could argue that this is diversification but diversification to me is 10% of your money in each of the 10 stocks. OK, if you like, my suggestion is an adulterated form of diversification. A rose by any other name smells just as sweet. ;p

Best wishes,
AK

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Marco Polo Marine: Reason for price weakness.

Yesterday, a couple of readers asked me what could be wrong with Marco Polo Marine since the share price declined. A reader also asked me where the next support could be, using technical analysis. Last night, I checked if there were any announcements from the company and found a plausible reason for the recent weakness in share price.

We know that Marco Polo Marine has an Indonesian subsidiary, PT Pelayaran National Bina Buana Raya (BBR). Well, the subsidiary has released 1Q 2014 results and the numbers are very bad. Of course, BBR is not all of Marco Polo Marine's business but it is a significant part. So, I would expect Marco Polo Marine's own quarterly results to be affected. How badly affected would depend on how other business segments perform, of course.

Now, the BBR story:

Over at BBR, revenue reduced by 11% while direct expenses increased almost 20%.

The OSV segment of the business did well as revenue improved some 57.3%. However, Tug and Barge vessels segment of the business saw a reduction in revenue by some 47.5%. (The two segments put together, OSV segment now has a 61.5% share of total revenue.)

OSVs are clearly profitable while Tug and Barge vessels are not. Why? OSVs recorded $4.8 million in revenue and incurred expenses of $2.1 million. However, Tug and Barge vessels recorded $3.18 million in revenue but incurred expenses of $4.37 million! This segment bled massively!

In the same quarter in the preceding year, the Tug and Barge vessels segment of the business turned in a revenue of $5.84 million and incurred expenses of $3.95 million. This suggests to me that the expenses incurred by this segment has been quite consistent but the revenue drop, year on year, is astounding!

If this were to continue, BBR would be better off without the Tug and Barge vessels segment of the business. Gross profit declined a massive 62.5%. Operating income declined by 73.5%. After financial charges and income tax, total comprehensive income reduced by 92.1% for the quarter, year on year!

How does this affect my investment thesis?

With the decision to gear up significantly to purchase a jack up rig which could potentially double earnings in FY2016, I was prepared to accept lower earnings in the next two years because of the much higher finance costs resulting from the MTNs although I have to admit that the jack up rig was never a part of my initial investment thesis for Marco Polo Marine.

With the jack up rig and higher finance cost thrown in for the next couple of years, I rationalised that as long as operating income improves steadily over time with more OSVs being added in the same period of time, logically, any decline in earnings due to the higher finance costs could be cushioned. This was an important assumption.

I said that to stay invested in Marco Polo Marine is to believe that:

1. Earnings will improve as more OSVs join the fleet in the next 2 years.

2. The rig delivery by end of 2015 will improve earnings massively.

If well executed, the strategy will catapult earnings upwards, possibly doubling EPS by 2016.

Now, for earnings to improve gradually over time until the jack up rig is delivered by end of 2015, I had focused on the OSV segment of the business as the growth driver. I had simply assumed that the Tug and Barge vessels segment of the business would continue plodding on and that the segment's revenue and expenses would more or less stay constant.

So, for BBR's Tug and Barge vessels segment to turn in a massive loss is a shocker and this has thrown a spanner into my thesis for having a significant investment in Marco Polo Marine.

Does it mean I no longer believe that Marco Polo Marine is on the right track? No. In fact, if not for the decision to focus on growing its fleet of OSVs, BBR would have turned in a loss making quarter instead of one with much lower earnings.
 
Unfortunately, to be realistic, FY 2014's numbers could turn out to be disappointing, everything else remaining equal. This is even if the Tug and Barge vessels segment of BBR's business should see revenue improving and expenses reducing in the next two quarters to what should be the mean.

Lower utilisation of the Tug and Barge vessels in the preceding quarter was put down to seasonal factors (i.e. monsoon period). Expectations of a reversion to the mean did not happen. Is this weakness in the segment temporary or is it going to be more enduring? I am inclined to believe that it is temporary but if a reversion to the mean does not happen in the following quarter, then, the risk of being invested in Marco Polo Marine could be much higher than initially thought.

I am staying invested as I still believe in the growth story but I should move Marco Polo Marine higher up in the pyramid (see related post no. 1 below) from an investment that is for growth and some income to just being an investment for growth. Without the income component, my approach will demand that I trim the size of my investment in the business.

See BBR's 1Q 2014 results: here.

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2. Marco Polo Marine: Drilling for higher income.