Buy Low-Correlated StocksThe Acquirer's Multiple
During his recent interview on The Acquirers Podcast with Tobias, Bernard Horn, founder of Polaris Capital Management discussed Buying Low-Correlated Stocks. Here’s an excerpt from the interview:
Buy Low-Correlated Stocks
Tobias: Once you’ve found these ideas and validated them, add it to the portfolio, how do you think about sizing in the portfolio individual names, industries, countries. How does that work?
Bernard: Yeah, that’s a little bit of the art, and there’s a little bit of science to it, but there’s a lot of art as well. We try to make sure that we can– At the very top view, we try to find– Think about constructing a portfolio, where we have minimum variance in the cash flows of the companies, we’ve invested in. Let’s suppose we have a 75-stock global portfolio.
With 75 companies, let’s suppose we merge them all together. Each one of those companies has a stream of cash flow going forward. Now, if they were all in one industry, the cash flows will go down at the same time, they come back at the same time. Obviously, that’s the classic case of diversification. We want to have some cash flows in that industry, and some in another, and some in another, and geographically will also affect that. So, we try to construct a portfolio so that the cash flows in the companies are somewhat low correlated with one another. We do that as much as possible.
Of course, at the same time, the market’s only giving us valuations in certain sectors or countries, which represent good value for one reason or another. That is going to be a big departure from the typical benchmark. From the get-go, we’re going to be away from the benchmark. Now, we just have to make sure that as we are away– so those are by definition of big bets, and so we want to make sure that we’re not outsmarting those big bets by trying to overweight or underweight certain things, because we’re already over and underweight by looking at our screens. What we wind up doing is we equally weight the portfolios in terms of sizing. A lot of the inefficiencies in today’s markets are not in the $100 billion, a trillion-dollar market cap stocks. Maybe those trillion-dollar market cap stocks are really overvalued, but they only go up anyway.
Bernard: It’s hard. [laughs] We’ve all been there on the– Anyway, we equally wait them if there’s some small cap, medium cap stocks, and we can’t put a full position in then we would make it a half position, a quarter position, whatever makes sense for us. So, our 75-stock full positions might drift up to 80-85 companies, because we’ve mixed in some small and mid-cap stocks in there that we can’t put a full position on. That’s what we feel. We know sitting here today that there’s a mistake in some company in our portfolio, we just don’t know where it is, we figure it’s randomly distributed.
A mistake to us is anything that doesn’t perform better than the benchmark. Theoretically, if we were brilliant, and we knew all our mistakes were, we wouldn’t make the mistakes, maybe we wouldn’t be human or would be superhuman, or something like that. But there are some things that are just unpredictable. If an earthquake creates a tsunami, it washes out a nuclear plant in North Tokyo, and they shut down that nuclear plant, and now the cash flows from that company dry up, and oh, by the way, that population gets extremely nervous about nuclear.
So, they shut down all the other nuclear plants in the country, and even if you’re invested in something else, that cash flow changes. That forecast that we had, the future forecasts of the cash flows on some company could be completely unpredictable from anything that we could fathom. I think that that’s something that– We know we’re going to have mistakes, so we try to diversify as much as possible, and we try not to outsmart the randomness of markets too much.
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