Diversification - the psychological shield to better investment decisions

IN my last article, I showed that for the past 30 years or so, stock market outperformance has rotated from one region to another every six to ten years. On a three-year rolling basis, US markets have outperformed Asian markets for seven and a half years now. If you are invested only in Asian stocks, it is not hard to see why you would be running out of patience and are entertaining thoughts of throwing in the towel for your Asian equities and shifting your funds to the US.

If you have the urge to do that, you are normal. Humans are commonly afflicted by what is termed "recency bias" - the tendency to overweight recent events/trends and ignore long-term evidence. This leads investors to be attracted to an asset class that has enjoyed strong performance - hence valuations are higher and expected returns are now lower - and to shun poor performing asset classes - after their prices have fallen to much lower levels and expected returns are now higher.

For example, given that the S&P 500 Index has risen more than 300 per cent in the past 10 years and nine months, it is hard to imagine it trailing any other stock indices, let alone the totally riskless one-month Treasury bills. Yet it did. Over the 13-year period ending 2012, the 15-year period till 1943, and the 17-year period till 1982, the US equities index lagged the one-month Treasury bills. Of course, in the periods after the poor performance, it went on to produce spectacular returns - returns that were only earned if an investor had stayed the course.

How then do we prepare ourselves, both mentally, emotionally and in practice, for the inevitable periods when the asset class or even an individual stock that we are invested in underperforms?

Diversify

The top chart shows the five-year rolling price returns of S&P 500 Index and MSCI Asia ex Japan Index, and a portfolio equally weighted in the US and Asia. The average return of the 324 five-year periods (using monthly data) for S&P 500 was 54 per cent or 9.0 per cent per annum. For the Asia index, it was 44 per cent or 7.6 per cent p.a. Note that these are price indices which didn't include dividends. Adding in dividends, the gap in total returns between Asian and US stock indices would be narrower.

Meanwhile, an equally weighted US and Asia portfolio returned 49 per cent or 8.3 per cent p.a. The slightly lower returns came with a significant reduction in volatility. The standard deviation, a measure of volatility, for the 5-year return of S&P 500 over the past 32 years was 56.5 per cent. For the Asian index, it was 69.7 per cent. The standard deviation of the equal weighted portfolio was just 43.2 per cent. In other words, the returns it achieved per unit of volatility are much superior to both the S&P 500 and the MSCI Asia ex Japan indexes.

Individual stocks

When it comes to managing a portfolio of individual stocks, diversification allows one to stick to a disciplined approach without incurring too much emotional toll.

Markets are not efficient all the time. There will be periods of mispricing. As an investor, we try to buy into a stock when we deem the share price to be lower than the fair value. The hope is that, over time, this price will rise to reflect the fair value of the company.

There are two main issues in this type of value investing.

Firstly, your idea of a "fair value" may be different from the market's - be it temporarily or for a prolonged period. When a stock continued its relentless descent after you've bought it, your confidence and conviction would be severely shaken.

Secondly, even if the stock didn't continue to fall, it may flat-line for a long time. You never know when, if ever it will, close the price-value gap. Again, this is going to test your confidence, conviction and patience.

Consider the two examples below:

TPV Technology

TPV Technology is a computer display manufacturer listed in Hong Kong. In the 14 years that it was listed, it grew its revenue from US$2 billion to as high as around US$12 billion. It came into your radar in the second half of 2017, after it had fallen 40 per cent from its recent peak just four months ago. The industry was struggling with overcapacity and severe price competition. TPV had just slipped into the red. But you reckoned that, given its long history, it must have certain competitive edge. In any case, its price was very cheap: at HK$1.40, its shares were selling at 40 cents for every dollar of net tangible assets it owned.

So you picked up what you thought was a bargain. However, the difficult conditions persisted. By the first quarter of 2018, the share price had dropped to about HK$1. That's about 30 per cent lower than your first entry level. By then, the stock was trading at 30 cents for every dollar of net tangible assets. So you bought more shares, confident that the company would work a way out for itself, especially given that it had turned profitable in the last quarter of 2017.

But there was no let-up in the bad news. The trade war waged by Donald Trump against China added to its woes. TPV slipped back into the red, but losses were relatively small, just US$8 million in Q1, 2018, and US$1.8 million in Q2, 2018. Spooked by the escalating trade war, investors indiscriminately dumped the stock and it plunged to as low as HK$0.60 by October 2018.

That's 40 per cent lower than your second entry price and a painful 57 per cent decline from you first entry point. By then, the stock was trading at 23 cents for every dollar of net tangible assets. Surely, the company is an even greater bargain than in 2017? But often, at this point, investors would start to have doubts and start to question if they should sell out and get back whatever's left of their investments.

A disciplined investor, however, should re-evaluate if there is permanent impairment in the value of the company. If not, a rational decision is to pick up more shares at an even bigger bargain to bring one's allocation up to its intended size.

As it so often happened, things started to turn around for the company and it returned to profitability by the third quarter of 2018. The share price staged a steady recovery. And, in August this year, the major shareholders of the company announced a privatisation offer at HK$3.86 per share - 6.4 times the price it was at just ten months earlier!

Nasu Denki Tekko

The second example is Japanese steel products manufacturer Nasu Denki Tekko Co Ltd. It could have come into your radar anytime within the last ten years because, during the past decade, its shares were trading at about 30 cents for every dollar of net tangible assets. Revenues and net profits and cash flows were quite consistent and the company pays 3-plus per cent of dividend every year. But its price just wouldn't move - that is, until August this year. And, in the space of just four months, it has gone up some five times!

If you had bought into the stock 10 years ago and had only 10 years' of dividend to show for it, then just riding the upsurge in the last four months would have made your ten-year wait worthwhile. The return for your entire period, including dividends, worked out to be more than 20 per cent compounded a year.

It would be a tremendous pity if your patience runs out before the pop.

From the two stocks you can see that:

Your decision is not over after the stock popped. The next key question is when to sell. We will be saddled with huge regret if, after holding for 10 years, we sold as the stock was just rising only to see it quadrupled or quintupled in the following three or four months!

Diversification makes managing all the above issues a lot easier emotionally. If you have, say 100 or 200 such stocks, you will be able to maintain a cooler head. A stock drops 57 per cent. Is its value permanently impaired? If not, add more. A stock has risen 100 per cent and is at or above fair value. You sold it. But it went on to double in the next two weeks. It's OK, your fund has been deployed to another stock with perhaps an even better upside potential. A stock is not doing anything except pay dividends. It's okay, we can afford to wait for the big pop while we depend on movements in other stocks.

In short, diversification allows you the chance to enjoy the big pops in stocks, blunt the pain of markets going against you, and reduce regrets of any "wrong" decisions as the stakes of every decision are quite small. As a result, you enjoy greater mental peace and, to boot, a smoother investment return path. That's why diversification is described as the only free lunch in finance.

Now back to the question of Asia vs US, having underperformed the US markets over the last eight to nine years, our view is now is definitely not the time to give up on Asia.