The Mathematics of Diversification and Wealth Building

When I bought my first company I'll never forget the first time I got a dividend check (electronically). It occurred to me "Man this is so much better to be the owner of the company than having to worry about losing my job or working my back off doing some hard labor job". It was a whole new way of viewing the world, even though the amount of money was very small it occurred the impact it had was priceless. "Someday this 5 dollar check will be 50 dollars than 500 if I keep adding to it or reinvest it." I have been changing my parents views on investments as well. They have wonderful hearts and have worked very hard in physical jobs, it has been very shocking to see the main obstacle for them has been getting over mental barriers believing that stocks are only for rich people in big houses or what that small dividend check could be someday.

Even though there is still much work to go in changing there views the effects changes are evident. I knew when my dad asked me for the first time "Is Scott toilet paper a stock I can own?" that the seeds had been planted. My fathers 2 best companies he liked to own are Kimberley Clark & PepsiCo. My Mom loves reading medical related things, thus she loves Johnson & Johnson & Becton Dickinson & Company, but the first company she ever asked about was about her mother who smoked Marlboro her whole life & she knew how powerful tobaccos hold over its customers were & she asked if Marlboro was a stock, that little inquiry from my Mom led me to Philip Morris Company the greatest company of all time in my opinion. (After the breakup I like the International spinoff the best).

All in all, dividends changed the way I view & how my family views life and wealth. I used to think after 2008-09 you had to be super smart to understand stocks, and do well in them. It's been incredible to realize the best investments are right in front of you. After all it wasn't Wall Street or some super smart person that gave me my favorite company it was my Mom. 🙂

Philip Morris Co shows us how truly stupid people are. I find it spectacular that anyone smokes cigarettes these days after everything we know about them. Then people get cancer and act like they have no idea how it happened. Plus they become odious to everyone around them because of the smell. It really is amazing.

The faster growing PM (Philip Morris International) shares instead of MO (Altria) are more attractive at the moment. I work at a place that interacts with people from all over the world. Southern & Eastern Europe and China especially still see huge percentages of the population smoking tons of tobacco.
Full disclosure - I owned Philip Morris before Kraft split off and then it split into KRFT and MDLZ.

You mention 'no one firm representing more than 10% of the public equity portfolio at cost.' This is something I was discussing at work the other day but could not articulate why weighting on cost is better than weighting on value...or if it is just merely personal preference. Is one empirically superior to the other?

Yes, one if empirically superior to the other. I'm working on a post about it now using Wharton's research on the matter. The short version is that, for various reasons we'll get into later, if you were constructing a portfolio directly, you could add ~1% of surplus outperformance historically over the S&P 500 index itself by 1.) buying at an equal weight during the initial construction, 2.) allowing natural market capitalization weightings to develop as the component performance began to diverge.

There are all sorts of factors influencing the math. One reason is that the equal weight initial methodology results in more assets being exposed to smaller firms, which tend to grow faster relative to their size; e.g., adjusted for splits, you would have gotten more Apple for a few bucks a share back in the 1990's, which singlehandedly made up for a lot of other bankruptcies and sub-par results.

I'm going to try to get that post up sometime in the next few days, either here or at About.com. I have a family commitment this evening but I'm mostly done with the writing and just need to edit, now.

In response to your article on the S&P 500 changes, I looked into the 4 index funds I own and their underlying benchmarks to see if any other indices used this "float adjusted" capitalization and to my dismay, they all in fact did. Even the turnover was high, my lowest being a fidelity spartan fund at 2% (okay not terrible) and the highest, a Northern Index fund at a staggering 41%, and I haven't figured out how an index fund generates that kind of activity, especially when its benchmark only turned over 2.4% in the same period. Either way, while I've been a huge proponent of index funds, I find myself leaning towards simply making my own index to achieve nearly zero turnover and equal weighting so I can rest a little easier knowing that my "index" really is "dumb" money, and not a secret active fund.

Joshua, an idea for you to consider. Why not offer a sneak peek at your portfolio for $5 - 10 a month recurring charge. I don't know how many blog readers you have but I bet a ton of us would pay this. Say 10,000 x $5... $50,000 a month or $600,000 a year. Put that right into more stock.

You can block out dollar amounts for privacy. Just list the name of stocks and precentage size of your portfolio. You send it out once a month. No stock recommendations, it's just simply a snapshot.

Virtually no work for you and I can promise a bunch of people on here would pay for that. To me this seems like the easiest money you could create and you could monetize this blog even more.

If you don't like this idea I'd be curious what your reasons would be.

Thanks
Tim

Bender.

Have you heard about the cortical modem, Joshua?

Seems pretty cool. I'd be worried about hacking though hahaha ... (but no really).

Forget Google glass and the Oculus, they seem primitive already.

I watched The Machine in the middle of the night yesterday evening, which left me in this bizarre space of reflecting on the question of whether the villain is actually, in the context of human evolution, the hero, which, despite his significant flaws, I think is the case.

I'm just not sure about how I feel regarding trans-humanism. I think it will come down to a trade-off decision. If something like this development allows humans to see in the dark, switch to infrared vision, immediately estimate distances and calculate estimated weights, broadcast live video (say they were being kidnapped or something), pull up stored databases of information (what to do in an emergency), I think the upside could more than makeup for the downside, leading to a sort of cascading everybody-has-to-get-one sort of environment. Like you said, though, hacking would be a problem. Biological weapons, which are the organic equivalent of a hack, are much harder to deliver and contain. It would be a concern.

Thanks for your reply. You made some good points.

I'm sorry, but this article is absolutely ridiculous.

There is simply no way that the average investor can do this well. 4/5 stock picks as major winners? No way, sorry. Of course it's easy to find great stocks in retrospect. Picking winners NOW is not so easy for professional investors, let alone the average person, even if he/she takes the time to really learn the subject. If you have a magic formula to pick 80% big winners, please do share with us.

Until then I remain convinced that the average family should do keep it all in index funds.

You consider 5.78% p.a. to constitute a "major winner?"

This is an example of what I'm talking about.

Until then I remain convinced that the average family should do keep it all in index funds.

... So, exactly what I preach exhaustively nearly all day, every day for the past 14 or 15 years?

1. Nowhere in the post did I say an investor should hold only 5 or 6 stocks. Keeping the number manageable in the illustration saved me a couple hours of additional mathematical calculations had I introduced a reasonable number of components. One of the major themes in the post is that holding such a small number of stocks is often a stupid idea; how people like Warren Buffett who say they are focused investors aren't, really, when you look at how small each position is relative to their balance sheet.

2. The last paragraph promises to look at the academic evidence of what has proven, historically, to be the minimum number of equity holdings necessary for safety in a soon-to-be-published follow up with links to the studies themselves. (Spoiler alert: Generations of mathematical analysis from some of the best academics working in finance has always put the number of required equity holdings at somewhere between 10 and 50 before all benefits of diversification are exhausted, corresponding to each position taking up 2% to 10% at cost; the declining utility beyond that point provides virtually no additional upside).

3. The equity index funds reflect those findings and are largely as concentrated. With a Nasdaq index fund, 50.86% of your assets are in the top 10 stocks, with a DJIA index fund (which has beaten the S&P 500 over my lifetime by a half point margin, which adds up to a lot of extra money), 47.2% of your assets are in the top 10 stocks, and with the ordinary market-cap weighted S&P 500 index fund, 17.3% of your assets are in the top 10 stocks. Expand that to the 50 holdings, still within the diversification threshold, and you find that they represent practically all meaningful net assets in those indices.

4. The first portfolio used as a model for convenience sake is not in any way, shape or form a winning portfolio. It is mediocre by definition, modeled so it roughly matched the broader equity market returns despite roughly 40% of the initial invested capital originally being put into businesses that came close to, or actually, failed to keep pace with inflation and taxes in the real world. The failure rate of this portfolio was substantially worse than the failure rate of the three indices over the same time period. It's "bad" investments were a much higher percent than those indices. I don't know in what world you would consider most of those firms as winning. The second portfolio, which contains such a lottery ticket, explicitly disclaims that you can't predict those ahead of time nor can you rely on them, which is why diversification (adding more potential outcomes) is wise; you have a better shot at getting your hands on one and they can make up for a lot of trouble elsewhere.

5. The sub-text of all of this was explaining one of the primary reason index funds work in the first place and why I advocate them for individual investors. I'll spell it out, though: A.) Most of the net positive returns have been caused by a handful of specific businesses that do extremely well and B.) you likely cannot predict them ahead of time so it's stupid to put all of your money into just a handful of stocks.

In other words, the entire point of this post is to demonstrate why index funds, and well-constructed, diversified portfolios of directly held stocks, tend to beat people who throw all of their money into a handful of companies.

From what I can tell, you don't actually disagree with any of that so I'm not sure what, precisely, you find objectionable.

Joshua,

You need to ignore the trolls and people who are unfamiliar with your work and continue writing for individuals such as myself who find your work incredibly beneficial.

You wrote "The headache of dealing with things like this isn't worth it from a time management perspective given that I benefit almost nothing from teaching it."

I understand you personally derive little to no short-term benefit by teaching us but think about the difference you are making in our lives. Most of the readers of this blog are young, well-educated, high income individuals who have decades of compounding ahead of them. Even if one of us go on to make millions/billions by taking advantage of your teachings and donate the money to charity/science research/education, your work would have indirectly caused enormous long-term benefit to society.

tl;dr.. keep being awesome

Agreed!! Some people will argue with you no matter what you say. Just know that there are several of us who are very happy reading these posts, even if we a silent majority.

FWIW, what I have read of these studies is in agreement with what Joshua said.

Sorry. It's true, we do agree on the question of indexing and the importance of diversification. And I'm not trolling, I'm a huge fan of your blog. A few points:
1. I was a little drunk when I responded to your post 🙂

2. The tone of your post bothered me a bit because it sounded like you were saying "it's so easy to make money picking stocks, you just have to diversify a bit and you'll be rich!" It was the premise, the setup, the "pledge." It is in fact incredibly hard to do this reliably, to the point that poor stock-picking (and buying-high-selling-low) is just as big a problem for average stock-pickers as lacking diversification.

Anyway, I see now the point of your post was a mathematical exercise. I shouldn't have been such a dick, so I apologize.

500,000 invested in Vanguard 500 index fund in March 1982 is worth $20,912,150
500,000 invested in Dodge and Cox fund in March 1982 is worth $34,567,350
500,000 invested in American funds Washington Mutual is worth $25,490,250

Sorry, past results are irrelevant for future returns when it comes to mutual funds.

True, I am just stating what a person would have made if he invested in Mutual funds and SP 500 index fund. That can also be said about individual stocks, and Index Funds. Both American Funds and Dodge and Cox have been around longer the S&P 500. Both fund family's have had consistence returns of over 80 years. It is the Culture in which they operate in.

Couple clarifications

1) "Job number one is to not lose money" Don't you mean
value? If that was truly job one you would have stop losses on everything. I
hear warren make the same comment but he doesn't seem to mean money, he means
value. During the 2008 crash you didn't care about losing money on Wells Fargo because you knew you weren't losing value. Correct?

2) As far as Home Depot and your Wells Fargo stock are
concern I am reminded of Lynch's comment "Let your flowers grow and pull
your weeds". You seem to be pulling your flowers by selling Wells Fargo.
Does that really make sense? It's like having five tomato plants, and one is production
50% of the produce, but you pull that one up and leave the others. You will
never have a "Home depot" event if you do that (23%/year over
decades). And there is no real risk by not selling, since your other
investments are doing pretty good. I just don't get that behavior I guess.

My guess is that WF had reached Josh's estimate of its intrinsic value, and so converting a portion to different, more attractive opportunities made sense, especially as it diversifys his risk - he probably did it in an account that didn't have capital gain consequences

What great questions!

1. Your heart and mind are in the right place, it's just a terminology difference. You're falling into a trap that economist Irving Fisher called The Money Illusion back in his 1928 treatise. You're defining money as equivalent to fixed units, in this case dollars. It's not. Dollars are dollars. Money is value, often expressed as purchasing power. That is a lens through which you should be viewing the world if you want to amass financial capital.

That means I don't consider the quoted market value of a stock to be money as defined. It's not real until realized; it's just a bid and and ask there for my exploitation or to be ignored in a given fixed unit, in this case dollars. Rather, when I say, "Don't lose money", it's shorthand for, "Don't expose yourself to an asset that has even a modest probability of significant reduction in after-tax, inflation-adjusted purchasing power 60+ months from now". Short-term volatility is meaningless to that definition. I'm looking 5-10 years out in the future and trying to weigh probabilities as to what collection of cash generating, productive assets will give me the most after-tax, inflation-adjusted purchasing power with the least chance of real, permanent capital impairment.

This is about the time someone counters with, "Yes, but if you were forced to sell your shares." I religiously adhere to the Ben Graham camp here when he asserted, "the true investor is rarely forced to sell his shares". I don't invest with borrowed money. I don't permit situations that could result in large liquidity drains on my cash flow statement to exist. We maintain more than adequate insurance coverage. I have plenty of other sources of liquidity and income.

Let's use Diageo as an example since I've talked about it on the site in the past. Right now, making a few adjustments and assuming a more ordinary exchange rate, a single ADR should generate, with a high degree of reasonableness, somewhere between $8 and $10 in after-tax earnings 36-60 months from now. When I started buying it around $110 per ADR, getting a great balance sheet as part of the deal (it should be able to weather another 2009 meltdown easily without any equity dilution or problems), that's all I was thinking about, along with the probable ~4% or so dividend yield on cost that would exist along with it.
If, tomorrow, something like a 9/11 happened and the shares went to half their value on the London Stock Exchange, sending the ADS down with it to, say, $50 each, I haven't lost any money because I have virtually zero probability of being forced to sell my proportional ownership in the firm under practically any condition. What I've lost is dollars if I wanted to take up others on their offer to buy my shares. I haven't, yet, lost any money because the probability of much higher purchasing power from my cost, $110, still exists. If anything, people would be likely to drink more.

As a matter of habit, I'll nearly always use money interchangeably with value, not the nominal currency. Money is long-term purchasing power probability to me, not the fiat. I don't want the fiat. I don't care about the fiat. I want more purchasing power. I want more money and assets that produce money, no matter how they are quoted in the fiat at any given time.

2. The Peter Lynch quote is being taken out of context because he elaborated much more beyond that snippet. He was talking about a certain type of investor who had a habit of selling an investment simply because it went up, without any reference at all to its future earnings picture, growth potential, remaining market-share-to-be-captured, or any other relevant point; the type of shareholder who would say, "Oh! This stock has doubled! Let's sell it and put it into our lowest returning stock" without any evaluation of the facts beyond market price.

Capital allocation is, at its core, about utility trade-offs and risk assessment. Buying Wells Fargo at a significantly lower price than its current market value was a case of a few-times-in-a-generation deal caused by mass panic and forced liquidation. The bank has $1.7 trillion in assets and is one of the five largest banks the United States. It still offers a good deal for long-term owners (within the last two weeks, I had my own mother buy shares at the current price for her IRA) but the question for me was, "Is the potential future growth in earnings per share over the next 25 years worth the significant risk of having so much of the portfolio in a single firm which also correlates with some other holdings in the portfolio due to the financial nature of the economic engine?"

The answer: No. If I had gotten something rolling out across the country - say, Chipotle - at 1/5th or 1/6th of its value during the crash, I would probably not be selling it even if it were overvalued at the moment. Home Depot in those early decades was opening stores throughout the country and had not, yet, come to dominate its market and saturate most neighborhoods. It is mathematically a near impossibility for Home Depot to compound at 23% from here out due to its size. Wells Fargo is in the same boat. Its outstanding common stock alone is valued at nearly $300 billion. Under virtually all reasonable probability scenarios for the next 10-25 years, short of some remote positive or negative event, the absolute best return I might enjoy would be 8% to 12% per annum under most conditions. That's good. That's satisfactory. But if I can get the same risk and growth file from several other businesses, lowering firm-specific and industry-specific risk, it's time to engage in what I call "horizontal" risk shifting. It's akin to Graham switching out bonds for comparable bonds with near identical prices but better interest coverage ratios.

If you pull out your copy of Lynch's famous One Up on Wall Street, he, himself, made this distinction. Wells Fargo is a slow-growing, quintessential "Stalwart"; a sort of royalty-level blue chip that should make its owners rich but has almost no chance for rapid growth. He advocates selling them far quicker than I do, explicitly stating on page 105, "Stalwarts are stocks that I generally buy for a 30 to 50 percent gain, then sell and repeat the process with similar issues that haven't yet appreciated. I always keep some stalwarts in my portfolio because they offer pretty good protection during recessions and had times."

I didn't sell Wells Fargo solely because the panic subsided and it closed the discount-to-intrinsic value gap that was clearly excessive and driven by fear rather than rationality. I sold part of it (again, part - it is still a huge, ridiculously large portion of the portfolio) because I saw other things that offered comparable risk/reward profiles and could estimate, with a high degree of certainty, I'd generate roughly the same compounding outcomes while lowering my chances of permanent loss were something devastating to happen to any one business or sector of the economy.

@disqus_w0WZUAv4i6:disqus is correct, too. I prioritize tax-free sales whenever possible when making these sorts of shifting moves so I can still take advantage of the deferred tax liability that builds up in taxable accounts. In a case like Wells Fargo, that mattered a lot given the size of the capital gains.

Btw, this post has some more information on the philosophy.

https://www.joshuakennon.com/mail-bag-what-is-the-maximum-portfolio-allocation-for-a-single-stock-or-investment-that-you-consider-prudent/

I'm still coming to grips with the idea of weighing everything based on cost as I'm afraid it will lead to mental accounting errors in regards to thinking about the unrealized gains . But, as you've said before, much of these factors are dependent on the utility of extra gains and the risk that extra gain entails. For example, if you had close to $600,000 generating close to the median household income in the most prosperous nation the world has ever seen, is it really worth putting that at risk to generate an incremental 2-4% of annual compounding but greatly increasing the downside factor?

The real secret is creating that economic engine and adding more to the asset base, not reaching for yield. At least, that's the foundation of the policy I hold now.

Hi Josh, I'm a relatively new reader and young novice investor with most of my money in Vanguard index funds, so I apologize for my lack of complex understanding, but I was wondering about your thoughts about regularly rebalancing your portfolio. It seems that in your hypothetical situation of 6 stocks, the vast majority of your gains was driven by Home Depot's fantastic returns. However if you had regularly rebalanced the portfolio so that Home Depot didn't dominate such a huge percentage of your portfolio in the later years, you wouldn't have had such high returns relative to the other stocks that you would be buying into (if I'm understanding rebalancing correctly). With that in mind, what's the role in regularly rebalancing your portfolio?

Rebalancing should fit your needs. It depends on your goals and outcomes, only you can truly know what fits for you.

Using Home Depot as a example: The pie could be cut so many ways it almost endless. On one hand Home Depot was a fast growing company for almost 20 years and honestly there was no reason to sell it or "Regularly Rebalance" during that rapid expansion period. That's a very long period for growth and there was no need to rebalance. However a dividend focused investor perhaps NEVER sold Home Depot because the company has NEVER omitted or cut the dividend (even during the recession) and also it varies if they reinvested it or not. However, a value/fair value investor may have held for decades but during the dot com bubble when Home Depot was grossly overvalued may have sold everything and during the 2008 recession bought back a significant amount because of the cyclical bottom. Someone may never have sold because of the MASSIVE capital gains tax you'd incur if not sheltered. Or more likely someone did a little bit of each of these over long periods of time.

As you can clearly see there's no right or wrong answer and to a certain extent that's the fun part about investing not just in stocks but in anything. You'll figure out over time what works and what does not and at the end of the day if you have no success or find reclassification too much just buy some treasuries and index the S&P 500 in a sheltered account and get rich on autopilot.

Happy Returns Friend!

You can always use new money to rebalance your portfolio. This can be either dividends or cash from other sources that your investing into stocks. This way you don't have to sell anything but you still lower your risk. The example of investing $500,000 at one time is probably used more for ease than anything else.

@Joshua: If you're writing up about diversification, you may appreciate this comment thread between Larry Swedroe and myself, and the four academic papers we discussed.

http://seekingalpha.com/article/1917651-have-index-funds-become-too-popular#comment-27748681

- "How many stocks make a diversified portfolio?", Statman, M, JFQA 1987
- “Diversification and the Reduction of Dispersion: An Empirical Analysis.” Journal of Finance 1968.
- “Diversification in Portfolios of Individual Stocks: 100 Stocks Are Not Enough,” Financial Review 2007.
- “How Much Diversification is Enough?” Burton Malkiel 2002.

Intuitively, it seems more diversification is always helpful in the indexing context where one does not really have an edge. However, one has to take some of these studies with a grain of salt because the authors have a particular investing style (indexing) that is their agenda.

In practice, I later switched to a more concentrated portfolio because I found some good investment techniques that work for me.

The best theoretical sizing for both indexing and active investors I think would be given by a Kelly betting criterion formulation that includes risk due to the predicted (future) covariance of stocks. Here is a link to the Wikipedia discussion of that (I fixed an error in one of Wikipedia's formulas by looking at the source paper):

http://en.wikipedia.org/wiki/Kelly_criterion#Application_to_the_stock_market

Indexing investors could just use the equity risk premium* for their "edge" and the measured trailing stock covariances. This would give I suppose something similar to equal weighting all stocks but without weighting too much any one sector.

* Minus management fees and turnover costs.

Anybody else think this has become an asset allocation rave party? Highly enjoying it.

Greenblatt has discussed that "correlated risk" declines massively as you go between 1-6, and less and less beyond 8 stocks (different industries/sectors I should add).

A lot of the value investors keep between 8-25 stocks with heavy emphasis on the top 5.

I am personally only in 6 stocks, but I am in mid 20s w/a high monthly cash-flow so a paper loss of 50% is a risk I am willing to take.

Hey, newbie here.
So if you hold a single stock long enough, it could, with capital gains and dividends realized, have the ability to go to a negative weighting on cost, right? If that is so, should one continue to track negative or hold the weighting at zero?

If you do track negative, will an additional purchase of the same security somehow mathematically reduce perceived gains on the original invested capitol?

Or should one just track the weighting on cost to zero, and start a new weighting if additional purchases of the same security are to be made in the future? This option may give a better understanding of ones more recent decisions.

As always, thanks Joshua. May your heart of a professor never grow weary of the ignorant.

Allowing capital gains and dividends to affect cost basis means you're not really looking at your portfolio at "cost". Cost is what you paid for it. If you want to be more precise, you can track returns based on lots instead of by security

This is my personal opinion, while cost is good for a historical returns look and the deferred tax liability you have stored up (in case of stocks held in a taxable account), it isn't as useful when looking at your diversification/risk management. The more useful value is market or market minus deferred tax liability (exit price). Joshua's written a few articles on his annoyance at the quick climb up on some of his investments, the reason being market value has driven the market weighting for some holdings to be beyond his risk tolerance for portfolio concentration (the topic of this post): https://www.joshuakennon.com/i-am-starting-to-make-some-strategic-asset-shifts-in-the-krip/

Joshua, I wonder why the idea of tech angel investing has never appealed to you. Is it because you consider it close to speculation? Or do you dislike taking risk? Thanks in advance for your answer.

Interesting question. I am very curious to read Joshua's answer in respect to this.

I sincerely hope you decide one day to write that book of investing from the perspective of a father teaching their child. Your wealth of knowledge is such an asset and has helped me tremendously. Another very interesting post, many thanks.

Hey Mr. Kennon what do you think of the new company Heinz-Kraft Company? Does this fix the unique management problems at Kraft foods? Or does this create problems for H.J. Heinz?

I believe the new entity will be public once again which is a very exciting prospect to me for dividend growth.

I slept in today (actually, only slept for 4 or so hours but went to bed at around 5 a.m.), woke up to a cup of coffee and the MacBook being handed to me, and your comment was the first I had heard about it.

I'd put quite a lot of it in all of my retired family member accounts so they are having a very good day on paper. The $16.50 cash dividend is going to result in some hefty incoming deposits, which I will reserve and put back into the new Kraft-Heinz super-company, all else being equal.

As for the management problems, most of the worst offenders on the bad management / shareholder-unfriendly front went with Mondelez when Kraft broke itself apart. Unfortunately, Irene Rosenfeld is still running that place. I'd be willing to pay a lot more for the stock if she weren't in charge.

I'm thrilled Heinz will be publicly available, again. I hated that it was taken private in the first place.

The combined company is a lot more attractive to me than Kraft was last night when I went to bed.

A $16.50 special dividend is a nice carrot to dangle in front of KRFT shareholders, but should it concern them that they just swapped half of their future earnings for half of Heinz future earnings? Heinz is a nice business, but the long term earnings of Kraft have to be enormously higher, aren't they? On first glance it appears Buffett won again.

Don't think of it as trading half of their earnings for half of Heinz's earnings because it's more complicated than that. Here's a visualization that might help.

Imagine you owned 100% of Kraft. Last night, you went to bed and your business was valued at roughly around $31.48 billion.

This morning, a guy walked into your office and said, "I have a proposal". He suggests that:

1. He gives you $10 billion in cash

2. You form a new business. You contribute all of your Kraft business (you've already been paid $10 billion so the net difference here is $21.48 billion for which you still haven't received compensation). You'll get 49% of the shares in the new firm.

3. He will contribute all of his Heinz business, which he bought a year ago for $23.2 billion (plus debt assumption). It's an incredible company that has 26% global market share and 59% domestic market share. They've been slashing expenses and completely reorganizing it to bring it into the 21st century in the time they've owned it. In fact, it's so good that in the ~50 years after the S&P 500 was founded in 1957, it beat the index itself by an incredible 3.8% compounded annually, leading to a mind-boggling, staggeringly huge increase in wealth over the broader market. (It kept up the outperformance but I am about to go take a break and don't want to calculate the 2006-2014 period to the CAGR decimal point so please forgive the approximation as I only have the 1957-2006 figures on hand.)

As part of doing this:

1. They will take over the new, combined super-business and engage in the same ruthless expense management they had at Heinz, taking the lumbering, slow-to-change Kraft to task for behavior that it gets away with due to its culture and legacy. Nobody is safe now. Everything has to be justified down to the budgets. (3G famously uses "zero-based budgeting", for example, to combat departmental bloat. That sort of thing makes a difference over time.)

2. The additional scale of the two enterprises, which will put it behind Nestle in revenue as the 3rd largest food conglomerate on Earth, should result in an extra $1.5 billion in profits as processes are rationalized and expenses cut.

3. You get to diversify the business, which is good considering a lot of your products are struggling under cultural death as they are no longer relevant to how people live their lives. Your best brands were raided in the Mondelez break-off and you've been sort of in super-dividend mode why you try to fix the slow-growth grocery business so that you don't, God forbid, become what Sara Lee did 15 years ago.

In this case, though, you are one of many outside owners so there will be public float in the shares. That means if you really want to keep your ownership stake largely intact, you can use your part of the $10 billion in cash buyout proceeds to acquire additional shares in the post-merger business (which is almost assuredly what I'll have my parents and in-laws do). Wait for the check to show up and place another buy order. Sure, if it's in a taxable account, you're a little worse off by the tax differential and the valuation multiple adjustment (assuming it is upward) but it isn't the end of the world.

I'm not usually a fan of the musical chairs the food business engages when times get rough but, in this case, I think 25 years from now, an owner of Kraft will be richer than he or she would have been had the deal never materialized.

It's a fair deal with synergies and 3G will put them through boot camp, and I do understand the increased value being together, but I'm just left questioning (not the first time) why Kraft doesn't trust their core business more. Staying the course they would have $10 billion in net earnings in roughly 5 years. Why spin off Oreo, Nabisco, and Cadbury to supposedly become leaner, only to take on more brands and get bigger shortly after? Why overpay for Cadbury then spin it off like they never wanted it? Why give away a frozen pizza business that perfectly complemented the cheese business they're known for? Maybe getting 3G to control them will put an end to the head scratchers.

That's because Kraft Foods may have had one of the most idiotic management teams of the last few years in corporate america. That's not a hyperbole.

And I hope your right that 3G and Berkshire Hathaway and Heinz can purge the place. I love the possible growth with the Kraft brands using Heinz's distribution and infrastructure internationally. This saves billions and while there will be bumps the brands should penetrate very nicely. It' easy to forget you can't get any Kraft Food products outside the U.S. & limited in Canada. I'm hoping the dividend can see above average growth with this expansion. I need to do WAY MORE research into each entity. I haven't taken a serious look at Kraft, and I never bothered with Heinz because it was just taken private when I started out roughly. Though I am aware of the brand portfolio which is ridiculous.

And thank you very much for the reply Joshua. Appreciate it.

I've thought of 57 different ways to say this in the most polite spin possible.

The bottom line: It's because Irene Rosenfeld is hands down, without reservation, one of the most arrogant, shareholder-unfriendly, consumer-oblivious executives I have ever witnessed in either my own lifetime or any of the historical case studies I've done. I'm generally very hard to get riled up but I have nothing but contempt for her. She is everything that is wrong with corporate America. She is an intrinsic value destroyer. She is the living embodiment of the Peter Lynch rule, "Buy a business so good that any idiot can run it because sooner or later, one will." She has no respect for anyone, or anything, and is a master of buzz-words, fake smiles, and lots of "activity" that makes her look like she's achieving something when, in fact, she's spending your money in ways that, time after time, somehow end up making you demonstrably poorer than you would have otherwise been. And, don't worry, because somehow, she'll find a way to complete the deal in the most tax-inefficient way, while diluting your equity in the process.

To put it in concrete terms, I mean what I am about to say literally.

If I were the controlling shareholder of the old Kraft (pre-Mondelez breakoff) and were about to go into a coma for 10 years, I would rather have the board of directors fire her, divvy up her responsibilities among the leaders of each division with the compensation system tied to a combination of market share and profitability so everything was handled at the operating entity level, go down to the local animal shelter, adopt a cat, name him "San Francisco Marmalade", and appoint said kitty to the post (complete with kitty desk, kitty bow tie, and full-time secretary who handled sending the executive meowmos) until I regained consciousness.

I have more faith that I would return to an intact, highly profitable enterprise with President Marmalade in charge than I do with Rosenfeld still running the place. He, at least, wouldn't do anything but sleep, pounce, and purr all day. That would be a significant improvement over what she's been doing in her office the past few years.

Irene's newest move is to take what amounts to an institution in the United Kingdom - Cadbury chocolate - and cheapen the chocolate recipe on the Cadbury eggs, taking out the dairy in the dairy milk, and shrinking the package from 6 eggs to 5, all while maintaining the same price. While, as you point out, going on an acquisition binge. The stupidity ... I just have no words for everything she does.

She has to be the front frunner for most short-sighted, would-be, talentless empire builder in the past decade. She has added zero value. Her presence has been a considerable negative.

That's the nice version, anyway.

This is the most glorious thing I have read all day.

Nice 57 reference.

Am I the only one who thinks the $1.5 bn in synergies kind of - I don't even know how to put it, really - bullshit?

So much of that is going to be driven purely by changing the capital structure of Heinz. They're going to shed $720mm in preferred stock dividends, to be replaced with let's say half that ($360mm) in deductible interest on debt. Assuming a 33% effective tax rate, that would be $120mm in tax savings. So that's about $480mm in cash savings, but $240mm less in Net Income. So how are they even counting that? Is that where one-third of their "cost savings" are coming from, or is that extra, and they're really expecting a $1.74bn reduction in (net) GAAP deductions?

Because if they're counting the cash savings - which is what I think they should be counting - a majority of the synergies are going to come from fixing problems with the capital structure at Heinz...

So is 3G bragging about the fact that, while Heinz was under their control, they employed a sub-optimal capital structure? I don't get it.

Those are definitely excellent points and there's truth in it. On the other hand, I think Heinz's subsequent performance improvements, looking through the merger proposal documents for the past few days, is greatly obfuscated. There was a fairly massive currency hit of 7% due to the strong dollar and the cost structure itself has been fundamentally changed so that when everything clears out, it's way more profitable even with the higher debt. Judging by Nestle executive's concern, and passing comments that they think the improvement might have been as much as 800 basis points on a normalized bsais, which would be industry shattering and require a fundamental restructuring of the entire sector, I'm inclined to say Buffett's enthusiasm, and willingness to line up for yet another deal with them given the inside numbers he sees, is probably justified.

If they are able to pull off the same thing at Kraft, within a 5 year period, the business itself should be incredible. Plus - and this is entirely conjecture - but I get the sneaking suspicion this whole thing is being done to create a public vehicle through which 3G and Berkshire can consolidate and rationalize the food industry, having both cash from operations, future cash infusions from the sponsors, and Kraft Heinz's own stock as currency all available in the arsenal. It wouldn't surprise me if they try to create the Berkshire Hathaway of foods as they'll have enough control and flexibility to take a long-view; gobbling up other firms in their entirety. (I'd actually be thrilled if somehow, someday, somewhat they managed to wrestle Mondelez out of Rosenfeld's hands and merge it back into the business. It would be sweet, sweet justice and poetically beautiful.) Under the right circumstances, it wouldn't surprise me to see Berkshire attempt to someday acquire the whole thing outright like it did with GEICO as there are hints and similarities between the way it was brought into the fold. It's almost certain 3G is going to want a liquidity event prior to Berkshire ... it would make sense for him to buy them out, creeping up his ownership over time. If it ever did become a wholly owned subsidiary, the capital structure savings alone could be huge.

Man, that would be interesting to see ... 3G fixes it, 10 years later, it's a wholly owned Berkshire subsidiary ... I wouldn't put it past the realm of possibility. It would be one of the last mega-deals possible before they had to go into dividend distribution or buyback mode.

If it ever did become a wholly owned subsidiary, the capital structure savings alone could be huge.

The fact that so much of the potential gains seem to be driven by capital structure manipulation make me think this will ultimately be much more attractive as a fixed income opportunity than an equity opportunity. I don't know what the new bonds are going to price at, but BRK has made multiple cash injections in a very short time span already, and they're going to (probably) convert their preferreds into common equity, so that'll effective be a third one.

This is looking like a GSE situation. There's already an implicit suggestion from BRK that they'll be willing to inject new cash as needed, with an eye towards achieving and maintaining a certain rating. I look at this, and I say "this is BRK debt, and should be priced as BRK debt today." If it doesn't get priced as BRK debt, I think that's an opportunity (not for long-term debt, but for short and intermediate maturities, I can't see a difference, pragmatically).

But as for the equity? No. I want to see what this looks like when they're done with it, first. They say that in a couple years, once they get their debt ratio where they want it, they'll start buying back stock. So they're admitting in the proposal that they used a suboptimal structure for Heinz; they're admitting that when the deal closes, they think the structure will still be suboptimal. But hey, it's ok - they hope to fix it later.

I'll take a look at it in three years, when they stop saying "we're choosing to do things we don't think make sense!" And they're probably going to make a killing between now and when they get the structure to where they ultimately want it. But for me? For an equity investment? I can't sign off on this.

Joshua, what do you think about the new SEC rules regarding crowdfunding? Will this change your investment behaviour?

I think it is probably the most incredible change to the securities regulations in my lifetime in terms of potentially, and in a fundamental way, altering the landscape of capital formation. Now, for better or worse, I don't have a clue, but I'm cautiously optimistic. I might even take advantage of it myself sometime as it adds one more potential tool to the toolbox. I need to read a lot more about it, though, and spend time thinking about it in quiet to really figure out where it could go.

expect
mucho
fraud

3 words

Was the About.com article regarding diversification ever published? I don't see an update on this post and am looking forward to reading it once finished. Thank you.

It hasn't gone live on their servers, yet. I'll update this page when it has.

It is published now. It's called How Much Diversification Is Enough? and provides links to the four most important studies on the topic as well as my personal thoughts. It's sort of long (2,000+ words) but it's an expansive topic that is hard to do justice in a summary version.

Sounds great, looking forward to reading it. Thank you for the update.

Joshua, this is a great article! however as I'm currently focused on learning the individual security analysis part of investment & portfolio management (which is the main focus of CFA level 2 exam) I will just say that I intend to revisit this article next year , hopefully, with a lot of questions (given that I clear the level 2 exam)

As you might be aware that CFA level 3 is mainly focused on the portfolio approach, I'm super excited to cracking my level 3 curriculum next year, god willing. I must admit that my portfolio management concepts are quite rusty at the moment and I will need to give it a lot of work to get it up to par. I will probably be turning your about.com articles inside out when i'm preparing for portfolio management next year.

Till then...... prepare to be questioned inside out on portfolio management! sayanora sensei! =)

I am so glad I've got the opportunity to read your blog and to learn so many things about investing! Thank you very much for your efforts - PRICELESS!!!