Investing and concentration

BY BRUCE SHEPPARD

The antithesis of portfolio theory, (which is like opium - it allows you to drift off into a fog induced trace in an investment sense) is the concept of concentration.

In the words of Lord Maynard Keynes, "Concentrate your risk concentrate your mind".

Debt is the ultimate risk concentrator, thus when you are young the use of debt will ensure that you approach investing with considerable concentration. This means you are living your life awake and alert. This level of concentration will ensure your mistakes are more colourful and you will remember the lessons to be learned, and the rewards will also be more pronounced.

Debt - which is also pressure - will teach you to think. It will raise your adrenalin and its use early on will be like a grindstone to your knife-edge intelligence and intuition. Thus you should approach the use of debt with measured caution.

As you get older the adrenalin rushes are no longer necessary in an education sense, and in fact may be bad for your financial and physical health. However, debt is still useful as you get older to ensure effective scale of investing activity as well as ensuring liquidity.

All investing requires work, or cost - or both. With property, understanding the maintenance that has been deferred, council restrictions, title issues, perhaps also soil and land stability issues, should ensure you spend a lot of time on a property acquisition. Thus any investment has to have enough scale to justify the effort.

With property however sometimes you have to do all of that work on a number of properties. You then bid at the auction and lose out to someone else either on emotion, ie they just loved it, or because the saw something you didn't .The costs of acquiring one property are often the costs of thoroughly looking at 10.  If the property is only $100k then the cost is very high relative to the investment. Debt allows you to achieve economies on the cost of acquisition.

With equities you also have to do work, however if it is a listed equity all shares are the same and have the same risk, so you do not have to worry about missing out. This means the costs of investing in equity are your costs of researching the companies you buy as well as the cost of looking at the companies you don't want to buy.

To buy $5k of shares should require the same amount of work as buying $100k or $1m. When you buy a private company you will normally get an option and a detailed due diligence before you part with money, But the costs are also high.

With equities you have to understand the business, its resources and obligations, its market position, its competition, which the people are who are running it and who the owners are just to begin with. Of course if you are only investing $5k you might find that the time-related costs of doing this work are out of all proportion to your means.

But if you have done the work and found yourself a winner, access to debt allows you to achieve economies of cost.

With equities, unlike property, as result of doing comparative value work on say 10 reasonably good companies you might find three that you would be happy to buy. Then you can spread your investment across all of the top companies that you have found. The counter to this is Keynes. If you had to pick one and only one, you will really sweat which one it is to be when you have that choice. "Concentrate your mind."

Or in the words of Jim Slater from the Zulu Principle, If you have done the work and you are in a position to write yourself a list, of good companies, why would you take one dollar off the best one on the list an invest it in the worst one on the list?

There are a couple of presumptions behind his comment. The first is the presumption that you have done the work, and the second is that you have all the information. Now while the world is considerably better than it was when he wrote his book (we have continuous disclosure for example), YOU WILL NEVER KNOW EVERYTHING.

Debt-based investment strategies are a relatively safe one way street to riches in a bull market that is perpetually rising, eg housing, In a flat market debt is ok as well if it is an income trade-off - It will suddenly focus you on the investment's fundamentals. In a generally falling market debt is only ok if you considerably expand the amount of work that you do around the income of the investment. If you fail to grasp this, your knife will be consumed by the grindstone.

Here's one example of the use of debt. A friend was thinking of using his entire $1m credit line. He was proposing to fully borrow it, and lock it in for  five years at say 6 percent. He lent the lot to Fonterra at 8 percent pocketing $20,000 pa for in his words, "free". At the end of five years he hopefully gets repaid, and it will work out fine. In the meantime he is out of the market, and he has forgotten the reason he had the credit line in the first place, to be able to respond to superior opportunity.

Using debt for property is fairly well understood. However, low yields means other income is required to support such a strategy. That's only rational in a perpetually rising property market. We all have our views on that.

With property, and negative gearing the ability to survive is predicated on separate independent income. In a recession unemployment rises, bonuses and pay increases evaporate, and sometimes that independent income to pay for your negative gearing route to property wealth disappears. Remember to harvest a capital gain you have to be in the market over time. Too much debt and you will lose control of how long you are allowed to be in the market.

Virtually no one thinks abut using debt to buy equities, and they should.

The plus of equities is immediate liquidity if you need to or want to close out, this is much harder with property. Last month only 15 dairy farms settled in all of NZ. The lowest since records began. It is a bit telling on the state of the economy that our banking system can even deal with financing our main export earner.

Valuing equities is an art not a science but some simple things can work well if discipline is applied to sort out the crap.

If you could (and you can) buy a share for $2.40 with earnings of 20c per share after tax in the last full year, and if it also paid out 15c gross in dividends, preferably fully imputed,  and the EPS had been growing on average over the last five years at 10 percent pa, and the dividend payout at 15 percent pa over that period , you would have an ok investment.

If it could replicate that performance over the next five years, your ungeared returns would be 19 percent pa tax paid, assuming the share was saleable at the same PE ratio at the end of the fifth year as you  bought it at on day one. If you borrowed all the money at 7.75 percent you would be investing the difference between dividends and interest in the first year and you would have to wait a year for your tax refund. (Thus you are still making an investment in a traditional sense, as you are parting with some hard money up front.) With 100 percent gearing on purchase price you move your tax paid IRR to 81 percent.

Equities can be volatile. It's useful to look at the level of EPS volatility on the downside over the last five years. If say, this company had had an adverse movement of 25 percent at some time in the last five years and you have adjusted your forecasts to assume that immediately after you bought it this would occur again and that then it would revert to the historical growth pattern, without gearing your return over five years would still be nine percent. With gearing it drops to four percent. But if the adverse event is 30 percent you still make seven percent without gearing - with gearing you go into loss. An adverse event of 50 percent loss of income and dividends would have to occur before you would lose money over five years without debt.

This underlines the increasing sensitivities that debt has on return and risk, and it is this exceptional brilliance that will focus you  when considering investing in equities.

The next and last but one blog, will be about sifting the investments worth considering from those that are not.

Read Bruce's disclosure here.