How To Invest

How to construct a deep value stock portfolio

There are two approaches to portfolio construction. In one camp, you have investors who favor a concentrated approach of fewer than 10 stocks. In the other camp, you have investors who prefer a more diversified portfolio of 20-30 stocks.

The case for concentration

Buffett probably helped popularize this idea by focusing on his “twenty punch card rule”, citing that diversification is really a guard against ignorance. Charlie Munger is as much a proponent of concentration as Buffett and is famously known for saying that three stocks are enough.

However, the key difference between Buffett/Munger and the average investor is that the pair of them are probably some of the best investors that ever lived. They have had decades of experience and are simply so much better at stock picking than the average guy. It is important never to lose sight of this.

Most investors will not be full-time investors, nor have built up the sufficient experience to maintain conviction during times of market turmoil. One can only have conviction to hold on in persistent market declines by way of research that is both borne out of experience and hard work.

Malcolm Gladwell often takes about the 10,000-hour rule and the same applies to investing. The challenge is that one not only needs to understand a single business well but to be able to look at it in the context of the big picture.

Investors cannot simply focus on single trees and have to be weary of the going-on’s in the forest as well. This requires concentrated effort and time to pull off – along with a sound framework.

I’ve simply embraced that there are many things that we do not know anything about, much less control. Diversification is simply a way of me saying that there are plenty of unknown unknowns.

The case for diversification

Diversification allows investors to make mistakes, and still come out on the other end. The margin for error in concentration is much higher, and one mistake can blow a hole in your portfolio that is hard to recover from.

Investors often under appreciate how important the psychological element of investing is. It’s all fine and dandy when your portfolio is up double digits in a year, but what if the reverse happens?

What if a company that’s 10-20% of your portfolio in is under investigation for fraud? Would you still be able to maintain the same composure?

These questions aren’t theoretical, but real-life occurrences. They include the incredible blow-up of Valeant Pharmaceuticals (owned by Bill Ackman of Pershing Square and Sequoia Capital), and Zinc Horsehead, which declared bankruptcy (owned by Monish Pabrai and Guy Spier).

Hence my preference at this stage — and also for the framework of deep value — is to own 16-25 stocks. Put simply, it helps me sleep easily at night.

So, what stocks should you put in this diversified portfolio?

How to construct your portfolio

Emphasis should be first placed on securities to exclude — namely those of recognisably poor quality, and then securities which are of sound quality that are so richly valued that they involve considerable risk.

There are three types of operations that I focus on:

1. Net-nets trading below liquidation value

The idea is to acquire a diversified group of net-net stocks at a price less than their liquidation values. Now, many of the net-nets you invest in will be facing tough times – which is why stock prices are depressed in the first place.

Because of this, you don’t really want to put 10-20% of your entire portfolio into just one of these companies. These companies tend to be quite illiquid, they’re less correlated with the market than the large cap stocks. They’re very uncorrelated, simply because they’re very event driven.

Hence, this is really a group operation, so I might just buy — if there are five companies. I might just put 2% to each company, and for 10% in a basket of net-nets.

Caveat: Some undervalued companies may want to delist or sell at an undervalued price.

2. Blue-chips trading at discounts to historical book values

These are the largest companies in any particular exchange (let’s say the top 20% in market capitalization) and are often constituents on regional indexes.

Observing price fluctuations over periods of years, one can come to the conclusion that few companies have high rates of growth that continue forever, and fewer large companies suffer ultimate extinction.

Most of these blue-chip stocks move from rag to riches, and back again, on a fairly dependable cyclical basis. Assuming the fundamentals remain intact, It then makes sense to invest in these blue-chips when valuations are low and divest when they become overvalued.

3. Small to mid-cap companies

Many companies fall into this category and it provides fertile ground for enterprising investors. There is often little analyst coverage of these stocks and valuations are often less demanding. Informational edges can be easily obtained by a thorough reading of annual reports or by going to AGMs to source for information. Again because of their smaller size, I follow a group operation to provide for safety of capital.

One past example:


PEC is a specialist engineering group servicing the oil and gas, petrochemical, oil and chemical terminal, and pharmaceutical industries. They got caught up in the oil and gas slowdown and suffered a number of one-time write-offs and plenty of bad publicity as their clients faced difficulty.

However, a closer examination of their financials revealed a fortress-like balance sheet, the right incentive structure. The price eventually recovered significantly as their dividend was re-instated and business conditions improved.

Read more: Everything you need to know about deep value — including property conglomerates, Singapore banks and graham’s classic net-net stocks

Tay Jun Hao LLB

Tay Jun Hao is the fund manager of the Heritage Global Capital Fund at Swiss-Asia Financial Services Pte Ltd. Tay Jun Hao graduated with a Bachelor of Laws (Honours) degree from University College London.

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