Why You Should Never Buy A Single Share

7th Aug '15 by Edward Croft

28 comments 25532 reads

So there’s this stock. It lists on a £30m market cap, well under the radar of all those fund manager folk. It’s profitable, seriously profitable. Its profits are growing so fast that the valuation can’t possibly keep up. 40% profit growth over the next year will see the P/E ratio fall down to 5 or less within 12 months. It’s addressing a huge new market that literally everybody can see is an enormous opportunity for first movers. I start buying it right after the IPO. 12 months pass. The stock has doubled. The profits came in up 50%. The expectation is for the stock to do it again… the P/E is expected to keep falling. I buy more. 12 more months on. Profits up 60%. P/E is expanding… interest is heightening… market cap now £120m… I’ve four-bagged. Now the story is catching on… the bulletin boards are alive. I tell my wife it’s going to quintuple by Christmas. So why is it dropping? Must be a consolidation. Check the bulletin boards… everyone still thinks it’s going to quintuple by Christmas… course it is. Growth is accelerating. It’s too cheap. It’s a no brainer.

It halves.

This is a true story. I’ve played it out several times, and often several times at the same time. I’m sure this story is playing out right now in more people’s portfolios than they can admit. It’s just the story hasn’t finished yet…. we are caught up in the telling… in the tangle of the myth. Ah but I was so much older then, I’m younger than that now.

Mind worms

Whenever you buy a share, you also infect yourself with a whole host of dangerous entities known as “mind worm larvae”. These mind worms trigger parts of the brain’s reticular activating system that seek out confirmatory information. Any information that aligns strongly with the original idea feeds the mind worms and helps them grow, while information that doesn’t align strongly makes them really quite agitated.

The infection leads to all sorts of bizarre side effects. A growing sense of wild confidence that you are right and others are wrong. A burgeoning desire to seek out like minded individuals so powerful that it leads the infected into strange online forums no sane person would ever enter. A strong belief that the narrative must continue in the direction previously imagined. A refusal to sell if it doesn’t. An…

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John

8th Aug '15

On the subject of diversification I have been working on establishing a stock rank portfolio since last October.
Because of my eventually settled strict SR parameters (SR>90, QR>75, no debt) I have found diversification quite a challenge.
Currently I am invested in only 7 Sectors (with nothing in energy, telecoms and utilities) but have a much greater coverage of sub-sectors (spread over 23 out of 29 sub-sectors – with nothing in Oil & Gas, Auto, General Retailers, Insurance, Telecoms and Utilities). The result of all this is that I have ended up with quite heavy investment in two Sectors (Industrials 28% and Consumer Cyclicals 25%) of my portfolio, whilst in sub-sectors my largest investment is 8% (Homebuilding & Construction, Investment Banking, and Software and IT), with a maximum original investment of 3% in any one company.
I have come to the view that I shouldn’t diversify into a Sector or Sub-sector just for the sake of diversification.
Thus far this method has been quite successful – but of course the period chosen has been very favourable!
Any further views out there on the subject of diversification?

Rusty2

I think its important, so if one sector falls you are not badly affected. However some companies I feel are in wrong sectors with some housebuilders listed under Fincancial, so you need to watch that. I also have most in Industrial, I note Lord Lee also has. Industrial is very wide spread of businesses and is probably highest ranked on Stockopedia, with 4/10 highest ranked. I agree about not buying into a sector for the sake of diversification, I have the same problem with none or little in some sectors. I have cut my exposure to housebuilders this year.

9th Aug '15

Quite right, Herbie. I have BDEV and BKG in Real Estate which comes under Financials and EPWN, PSN, and SFE in Homebuilding and Construction Supplies which comes under Consumer Cyclicals. Don't really see any slowdown in housebuilding if we stay in the EU and migration continues unabated.

raggedtp

Very interesting thought, about cluster buying, Ed. About diversification in general, after some years of development, I believe there are two other important considerations beyond the reach of normal maths.
1. Most people do not want to sell their whole portfolio at once, ever. So the whole insidious internal question about how your portfolio's overall value is doing, is not relevant. I hope most of you would agree that some stocks in your portfolios are up, some are down, at any time. So with diversification you get cash-like optionality to cash in the stock most fully valued (to you at least) at the time. And it makes you then review the rest of your balanced portfolio to make adjustments or, you hope, deliver relative outperformance over the next year. Cash and hope, two fundamental needs of modern man met in one go.
2. If you have a dealing a/c and an ISA, with diversification you get a great chance, when your favourite shares are unloved but you don't want to sell, to Bed & ISA. I have established capital losses this way on shares that have subsequently floated back up to gains. CGT becomes largely optional to all but the super-rich.

Carcosa

I have to disagree somewhat. Lets take your first paragraph where, if I am allowed to paraphrase to get my point across, you say you discovered the ideal bet the farm share and buy into it. You double your money. Your analysis/viewpoint is proved correct and then "Now the story is catching on… the bulletin boards are alive". So you went from an independent thinker to a mob mentality, follow-the-herd investor. A completely different psyche.

To me, being an investor, whether successful or a complete failure, is more about a person's psychology than their ability to delve into the accounts (otherwise all accountants would be hugely successful investors!).

From my observations an investor that consistently makes above average profitable trades is arrogant. I don't mean the sort of arrogance that makes them obnoxious in a social setting - indeed the opposite may be true - but when it comes to investing there has to be an arrogance in their approach to investing. You wrote "A growing sense of wild confidence that you are right and others are wrong." Perhaps I would rephrase that as "A sense of confidence that you are right and others are wrong." That going against the crowd mentality is what makes a very successfulinvestor as opposed to a mediocre investor. Most investors seem to buy high and sell low because of a lack of self belief.

Buying a single share is perfectly okay (I have made a few bet the farm style investments over the years) but you need to have the right attitude/approach/confidence/arrogance for it to work out. Detractors may say I have been 'lucky' but Thomas Jefferson has something to say about that!

Diversification is ideal for things like a HYP or an investor with limited time or interest in the stockmarket. It hasits place but am not wedded to it and I don't think most 'active' investors should be.

Finally, in your example may I remind you that you still made a multibag return on that£30m market cap company, so if that is your measure of failure then I embrace it lol!

janebolacha

Carcosa, selamat malam,

Very sensible observations.

For me, it's to be your own analyst, to first do your work thoroughly in researching the company concerned, its management, business, markets and competitors, besides its track record and financial position. Do your own projections of what the company's future may be. Keep on top of the company and everything related to it, on a daily basis. Review and revise thoroughly all your work on a regular basis and make any further decisions accordingly.

Go for a small number of investments, as many as you feel you can properly handle. Diversification for the sake of it may seem a psychologically comfortingly easy way of reducing risk but is it really so if it leads you to invest in a larger number of companies that you have not had the time to research thoroughly and do not have the time to follow properly?

Above all, believe in yourself. Of course, it may not always work out but, should it not, at least you'll have got it wrong yourself and ought to be able to learn and improve from the experience, rather than starting instead to fish around for the next crowd to follow. Is the crowd more likely to get it right than the individual who is prepared to put the work and effort into it?

Re 2, that is all very well if you have losses on your shares outside your ISA and you have enough cash in your ISA in order to repurchase. Also note that holding in an ISA is more expensive due to fees than outside for some investors. Also I would watch out selling and buying back shares to use up your capital gains allowance.

tongosti

Thank you Ed.

Discipline is the key word here, I think.

I have also had my fair share of mistakes caused by blind overconfidence which has inevitably led me to review the whole process on how I go about the investment process.

I have now come to believe believe that once you have developed an end-to-end model which:

1. Tells you what to buy (Screening)
2. When to buy (Valuation)
3. How much of it - as a % of your portfolio - to buy. This implies that you already know what is the max number of stocks you desire to have in your portfolio (Diversification)
4. When to sell (Valuation)

then, you should not worry too much whether you act on stock at a time or on a group of stocks simultaneously.

Naturally, the key word here is discipline.

You need to to be able to stick to you stick to your own rules (as we all know, it is a very big if!). Without fail.

Cjenkins8

11th Aug '15

I agree
What's the point of holding the worst sectors - you can diversify by holding the top 50% sectors. The problem is sector rotation (ie getting the improving ones and avoiding the deteriorating ones) and working how to define which are the best sectors. Ed croft has outlined previously academic research that one month momentum a poor indicator - one could look at Performance over 3 months 6 months 9 months or a mixture? Melanie Faber has a downloadable PDF entitled "relative strength strategies for investing" 2010 which is quite helpful

CJo Russel
I agree
What's the point of holding the worst sectors - you can diversify by holding the top 50% sectors. The problem is sector rotation (ie getting the improving ones and avoiding the deteriorating ones) and working how to define which are the best sectors. Ed croft has outlined previously academic research that one month momentum a poor indicator - one could look at Performance over 3 months 6 months 9 months or a mixture? Melanie Faber has a downloadable PDF entitled "relative strength strategies for investing" 2010 which is quite helpful -

While I really liked the recent Nap idea ohttp://www.stockopedia.com/content/semi-year-snaps...f getting one or two high stockrank shares from each of 10 sectors - it would be interesting to compare the same approach with just the top 5 or 6 sectors - perhaps this could be done retrospectively - Ed

Mark Simpson

I think the key with diversification is to understand what is the right level for your personal strategy. If you are willing to do detailed and exhaustive research then it can be right to hold a smaller number of shares (although I doubt that holding a single share ever makes sense.) However if you are using something like a StockRanks strategy you need many more shares to protect from what you (intentionally) don't know about individual companies.

One of the keys though is to recognise that you will be overconfident in what you know about a company so you should always err on the side of greater diversification not less. I've written about these concepts in more detail on my blog:

http://www.dangercapital.co.uk/2015/07/Diversification-Diworsification.html

Over the years I've become more diversified. I've rarely found my exhaustive research has paid off in proportion to the effort required so prefer to be a bit more quantitive, hold 25-30 positions to manage the unkown risk, and spend a bit more time getting my investing strategy right and avoiding behavioral biases.

pka

Danger,

Thanks for the link to the articles on your blog. I found them very interesting and useful.

Cisk

Personally, the majority of my investments are in companies that operate in sectors that interest me and that I understand.

For me, it's aerospace, automotive, engineering in general, energy and medical diagnostics.

Over the years I've cut exposure to sectors that, with the odd exception, have always lost me money. So oil&gas & mining are no-nos for me, as is banking (only financial stock I own is Experian (LON:EXPN) because I think it's a useful business model).

And I might have 1 to 3 stocks in each sector. In terms of building a portfolio, I will start off small, in a trading account, perhaps buying small amounts of shares each month via a regular purchase scheme.

Once I've built up a large enough holding, am satisfied with the company and, by this time, have usually learned more about it (and hopefully had some share price appreciation), I will sell in the trading account and the stock gets 'promoted' to my ISA, where I will buy and hold.

I'm happy to take 1-2 years to do this, and aim to hold around 25-30 stocks, although not with equal amounts in each, as there may be 5-10 junior stocks with very small amounts in them.

Not advocating as a strategy for everyone, just what works for me.

Andrew L

25th Aug '15

Interesting and thought provoking article. In the book "how to be a stock market genius" the author has advises not buying a single share.

Taking the devil's advocate approach, though, and I think you can argue it the other way. Diversification means lower potential rewards and some of the best investors have concentrated portfolios. It also depends on the type of stock as if you buy Unilever it is already diversified by country and brands and so it could have a high portfolio percentage position.

I'd also turn the article around in that what appeared to have been done was to predict the future for the company you were analysing. You were also more confident when the prediction started to come true and the shares went up.

This is called adaptive rather than rational expectations (one of the single best concepts for an investor to understand in my view). Adaptive expectations means you change your views as a stock does well or badly and rational means you keep your views based on the underlying fundamentals.

I think an alternative way to combat this issue is to not try to predict the future but have a hypothesis and assess the risk/reward ratio. So company X looks like it could grow 10X but at the same time there is an outside risk competition could come in and eat its lunch. On that basis as the stock does well it would make sense to not add to the position but to cut back.

If you look at Mark Slater who invests in high growth but high risk stocks he typically has bullish perspective on a stock but also cuts back when a company is doing well. The irony is in the example you gave you could have done very well if you had positioned size by cutting back as the stock was doing well.

The key question to ask, in my view, is not whether the company is going to become X but: what is the risk/reward ratio now at this valuation?

Asking this question helps avoid the psychological biases of needing to be right and becoming overconfident. In the tech boom it should have led to investors selling down on the sector given the high valuations. This is because it must have made the risk/reward ratio less attractive.

A final thought is that we should probably treat companies in different ways. High quality stocks that are impervious to competition and see resilient demand don't need to have their positions cut back when they are doing well. However, stocks with a chance of a major setback should be cut back when they are doing well so as to preserve capital.

So on balance I think we can invest in individual stocks if we know what kind of stocks they are and are able to position size them correctly and alter that position over time. If we try to evaluate every position freshly after a major move and ask what is the risk/reward ratio now then that should stand the investor in good stead.

The danger is when we fail to ask this question and become overconfident on our ability to predict the future. To take the example of ASOS we can't really predict its future very well given the changing nature of fashion and competition. If I bought ASOS and it did well I would cut back on the position given the risks.

However, if we take the example property group Daejan Holdings that should be able to be bought as an individual share. This is due to its long track record, growing dividends over decades, low financial gearing and mature assets in major global cities - London and New York.

As a final thought (unless I come back to edit) I think it can be good to own a few shares when a sector is fairly homogenous..so in the homebuilders you could pick the whole lot or say the top three you like and do very well if the sector does well..probably would need to change strategy and opt for ones with strong balance sheets if you thought a downturn was ahead.

WarrantStar

1st Sep '15

Hi Ed
I have to say that I really don't agree with your article. Surely the whole idea of Stockopedia is to help investors to do thorough research to enable us to buy the shares with the best prospects. Are we to abandon that approach and just buy five, ten or however many different shares at the same time with very little research into each one? Your piece is quite clearly about BUYING a number of different shares at the same time, rather than OWNING a number of different shares at the same time. However, I believe that the best approach is to have good processes for decisions about buying and selling individual shares, and to have the discipline to follow them. Inevitably this requires time to do the research and would be impossible to do on a long list of companies at the same time.
Some people have taken your piece to be about diversification. But it is quite easy, and in my view preferable, to achieve diversification buy BUYING one company's shares at a time, and OWNING a suitable number of companies shares which have been bought at different times.
Another possible interpretation of your piece is that it would be more sensible for us to buy some sort of fund rather than individual shares. If that was to work well for a period of time, then what would there be to stop us from forming some sort of unfortunate emotional attachment to the fund, in the same way that some people form an unfortunate attachment to individual shares? However, it seems more likely to me that many of us would do better to only buy the best shares and avoid the inferior shares that we would end up owning if we were to buy some sort of fund.

Edward Croft

2nd Sep '15

Warranstar. The article was an light hearted interlude with a serious core. I think the biggest behavioural problem driving underperformance amongst private investors is the Disposition Effect - i.e. our tendency to cut winners and hang onto losers. One of the best ways to counter the disposition effect is to buy shares in sets rather than individually. As the research indicates, it leads to less emotional attachment and quite possibly more optimal decision making. It certainly works for me.

I've written before that there are two types of investors. Hunters and Farmers ... i.e. stock pickers versus systematic investors. I used to be a hunter myself, but I found the process left me over-exposed to my own self-defeating biases - which included over-optimism and over-confidence. To counter these biases I became a systematic investor.... buying sets of stocks rather than individual stocks. All a systematic investor does is try to replicate the process that good stock pickers take - i.e. hunt for high quality, reasonably valued shares to invest in - but do it in a more systematic way. The goal of Stockopedia should be to serve both these sets of investors - the Hunters are the majority, but the Farmers are a growing subset who are currently poorly served.

On diversification - I don't believe it can be achieved naively by buying shares one by one or in sets. An investor could buy/own a dozen shares which he believes are all individually fantastic. Sadly they may all end up in the same sector (e.g. oil) or in the same region or at the same point in their business lifecycle which effectively makes the whole portfolio a single correlated bet. Indeed the vast majority of private investors hold concentrated portfolios with most of their stocks in the same sector - another core reason for private investor underperformance. It needs a conscious effort to diversify each selection.

On ownership - I think the over-emphasis on ownership may unhelpful in the stock market. I know all of Warren Buffett's aphorisms and letters on the subject, though I'm more in the Gerald Loeb camp who once said "all stocks are speculative". As common stock holders, we're all outsiders and don't receive the insider information we'd need to become real owners. I see too many examples of investors who fall in love with their stocks, marry them psychologically and hold them to zero. I know this may be controversial, but I think it may be more appropriate to think of stock ownership as an affair rather than as a marriage.

10th Sep '15

Great debate and I like the metaphors..... stocks are for having affairs rather than having a marriage!!!! But being a devil's advocate kind of a person I would take an opposing view. I think the metaphor applies to low quality stocks and is the opposite of the buy and hold mentality that has served many value investors in quality stocks well. Or to use another metaphor... those investing like having affairs may get their comeuppance.

The presumption is that we can easily flit in and out of stocks to find the next big thing. Secondly, the assumptions is that investors can't find a few long-term stocks that will generate good returns and act as a store of value.

I think both assumptions are not necessarily true. The issue is whether investors can distinguish between high quality and medium to low quality stocks. This is quality not in terms of financial statistics but the underlying business franchise. I think high quality stocks can be identified.

Also the question is whether an individual stock is itself diversified by geography and product isn't asked. Some stocks are and so are fairly low risk and resilient.

In the long-term you would be likely to outperform just having a 50/50 split of Unilever and Reckitt Benckiser in a portfolio. This is deemed as risky but both are diversified by product and geographically. They also are in the relatively low risk area of consumer staples which tends to be defensive in a downturn and is the best long-term performing sector.

The key killer of long-term performance is selling out of long-term high quality positions as they have moved up a lot or seem expensive.

Saying all of that the approach outlined in the article does apply to cyclical stocks like the homebuilders or stocks with a chance of a significant loss.

I can't disagree much with your musings. Here's your 2 stock folio returns from our simulator (excluding Dividends):

55f1eb846a4b6Untitled_spreadsheet_-_Goog

That's a 10.1% annualised capital return, and you'd have pocketed a 3% yield to boot. The max drawdown in 2008 was only 27% too... which was basically half the market's fall at the zenith.

Of course - why not amp up the returns so that the volatility matches the overall market using leverage ? After all that's what Warren Buffett does - he just buys good, cheap, low volatility stocks like these then applies 60% leverage.

If you had leveraged this portfolio to 2x the position sizes then you'd have returned 20.2% annualised plus a 6% yield. Sure you'd have some financing costs, but that's not much these days. A 54% drawdown would have seriously hurt in 2008, but you'd never have been below your initial starting value.

Personally I wouldn't do the above (too much stock specific risk), but I'd be happy to do it on a more diversified low beta portfolio - maybe 20 low beta stocks like this with 60% leverage.

underscored

11th Sep '15

Hi Ed, it would be really great if you could put together that spreadbetting guide, as this seems to me to be the only realistic way a UK retail investor can lever up.

kjdean34

13th Sep '15

My opinion of diversification: I have two different companies where I invest stocks in my portfolio, and if one of the companies got a serious problem, my portfolio will decline. To help reduce this problem, I would include cash and bonds to reduce the risk in my portfolio that has multiple investments. I'm a type of investor with limited means or simply want to invest without complications so I would invest all of my assets in a balanced mutual fund.

Why you should never buy a single share

Mind worms

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Edward Croft

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