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Why we don't like pie

December 12, 2016

Diversification has become industry convention for reducing risk largely due to uncertainty in this business. Let’s face it, if you had 100% certainty in an investment, you’d make that one investment and rest easy. The more uncertain you are, the more you feel the need to diversify your investments because if a couple of the businesses in your portfolio do poorly, the performance of the others will hopefully offset it. This is where mutual funds come in. They allow investors to buy a stake in a collection of businesses.

Investments are like a box of crayons?

Industry regulators recommend that a fund company’s holdings should be “clearly organized” and “presented in a way that’s both meaningful and understandable to readers.” We completely agree. Providing information to investors that’s easy to understand is important – better informed investors typically make better investment decisions. Trouble is, it’s commonplace to organize holdings by geography and/or sector. We’ve always felt that classifying portfolio holdings in either of these ways is misleading to you and here’s why.

This information is supposed to show how well-diversified a portfolio is. More slices of pie means the investment isn’t too exposed to any one sector or region. We can see how this makes sense to some investors. After all, we know we’re not supposed to put all our filling into one pie shell (that’s a saying, right?)

Below are conventional pie charts that show EdgePoint Global’s holdings segmented first by sector and then by geography. Sure, all those colours make them visually pleasing but how does this information help investors make informed decisions about their investments? We’d suggest it doesn’t help them much at all.

EPGP Sector Distribution

As at November 30, 2016.

According to the chart, the biggest slice of pie is the Industrials sector. Are we under-diversified because we have too much exposure to industrials? Some might say so. Dig deeper and you’ll see EdgePoint Global’s holdings are actually very diverse despite being in the same category.

WESCO International Inc.: distributes electrical products
WABCO Holdings Inc.: global supplier for commercial vehicles
Union Pacific Corp: operates railroads in the United States
Generac Holdings Inc.: manufactures backup power generation equipment
Flowserve Corp.: a supplier of industrial flow management equipment
Rexnord Corp.: a supplier of power transmission components and water management & control systems 
AENA, S.A.: owns and operates airports in Spain
Wabtec Corp.: a provider of equipment and services for the global rail industry
Kubota Corp.: agriculture and farm machinery
Team Inc.: provides specialized maintenance services for piping systems
Grafton Group plc: operates building and plumbing supply outlets in the U.K. and Ireland

Think about it, what does the owner/operator of airports in Spain have in common with a plumbing supply company in Ireland other than they both have to deal with a lot of…well you know. How about a manufacturer of farm machinery and a railroad operator? The only similarity we see here is they’re both things the average three-year old is obsessed with. In case you don’t get the picture yet, here’s one more: an electrical product distributor and a global supplier of commercial vehicles. Both company names start with w? That’s where the similarities end as far as we can tell.

We think it’s silly to classify all these diverse businesses together in one sector because each represents a unique idea or proprietary insight. We don’t have some grand idea of why we think industrials are the place to invest; rather our Investment team has a distinct idea on how each of these businesses can grow over the long term. The same can be said for the other businesses in the portfolio. We like these 11 businesses for a variety of reasons, none of which are they’re all classified as industrials.

Location, location

On to another arbitrary classification – geography. For arguments sake, let’s review EdgePoint Global’s breakdown. Notice that almost three quarters of the pie is allocated to the United States. Seems crazy, right? Obviously we’re over-exposed to the United States which means our Global Portfolio isn’t well-protected against the potential risks that would come with a downturn in the U.S. economy. We really hate the geographic approach though because we’ve yet to figure out how a company’s head-office location has anything to do with its revenue sources

EPGP Country Distribution

As at November 30, 2016.

This is a list of the companies in our Global Portfolio that happen to have head offices in the United States and the percentage of their revenue that come from outside of it.

Holding% of revenue from outside the U.S.As at date
Source: FactSet, Research Systems Inc.

Not only do many of the companies above have significant revenue coming from outside the U.S. rendering the geographic categorization meaningless, risk is minimized by the simple fact that none of these companies are in our Portfolio for the same reasons. Like sector allocations, geographic ones don’t really inform investors on their risk exposure. Head office location means little more than what country the CEO buys his/her morning coffee in before heading to the office each day.

Save your fork

If we had to use a chart to illustrate how diversified our Global portfolio is, we’d highlight the unique ideas we have about each business, not what sector it falls in or where its head office is. It would look something like this:

HoldingBusinessOur idea
*Randolph B. Cohen, Christopher Polk and Bernhard Silli, Best Ideas, MIT, London School of Economics, Goldman Sachs, May 1, 2010.

We certainly don't own a piece of everything, like index funds or our closet index peers largely because there’s evidence to show there’s benefits to holding a relatively small number of stocks, say between 20 and 40 at most. In fact, investment managers whose portfolios are concentrated in their best ideas have consistently outperformed more highly diversified portfolios often without added risk.* Seeking safety in a pie rarely leads to investment success. We’d suggest safety lies in well-researched investment ideas because the more you know about a business, the greater your advantage over others. This helps in identifying mispriced securities, which creates opportunities to outperform while decreasing risk. Even a single business can provide all the diversification you need assuming it’s varied enough in its holdings and operations and you bought it at the right price.

Don’t get us wrong, we believe diversification is important though we believe diversifying by business idea is a much more effective way to manage risk especially when compared to colours on a pie chart. Each one of our investments is based on a well-researched proprietary idea. Our investment managers go to great lengths to ensure that the collection of businesses in the portfolios isn’t based on the same or similar ideas. Thus, our portfolios – while concentrated – are diversified. Any way you slice it, investors shouldn’t focus too much on owning a bit of everything but instead owning the right things.

*Randolph B. Cohen, Christopher Polk and Bernhard Silli, Best Ideas, MIT, London School of Economics, Goldman Sachs, May 1, 2010.