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"Any year that passes in which you don't destroy one of your best loved ideas is a wasted year. " -- Charlie Munger 2004

Well. I destroyed one of my most cherished ideas this year: Diversification.

I started 2006 with about 100 stocks, some were wild weeds going nowhere like Friendly's Ice Cream (<5% after 1.5 years) or Samsonite (<5% after 2+ years) ; some were new stocks currently in a mechanical investing experiment (see my beautiful chart here ), some were old friends going through growth pains like Buffalo Wild Wings, and finally there were stalwarts like Coca Cola and the lone Brk-B hovering at 2800 for the past few years.

This is what I learnt about Diversification:

* It works when you are a newbie in investing. Stocks are risky assets and there are inherent risks investing in them, and sometimes it is difficult to foresee problems or mistakes, for example, I chose American Pasta (PLB) over Mccormick (MKC) because of its almost linear EPS and Sales for the last ten years. Well, if I had more experience and skills in investing, I would have known that people do not really care about generic pasta, but people have a affinity to spices, specially when Mccormick commands its own spices shelf at the shops. PLB went on to about a -70%. But like all my investing failures, I recovered because I diversified the risks away. (and I do mean alot of failures: LF KKD BDY PLB FRM CDIC FDP TIVO ESPD OSUR FRN SAMC EXAS BPA DHB CRYO OSTK ESCL LGBT )

* It works when investing in Small Caps Reading up on the investing masters like Charles Royce, Shelby Davis, Peter Lynch and even "fertile fields for growth" T Rowe Price, it is clear that small caps are in the most exciting aspect of their growth, which is also the most dangerous. Since investing in TMF's Hidden Gems, there were several stocks which experienced initial growth but then wandered away unable to compete when new entrants arrived (like QLTI -50%) or Regulations ruled against it (like TALK -40~50%) or they had promotional management (CDIC, -40%). Of course this has to be contrasted with some spectacular gains from CNXS, BLWD, FORM, PRAA, SCSS etc). I invested in them all. As the good Mr. P. Lynch once said, out of five stocks, one or two will wilt, two will go nowhere, while one or two will be multi-baggers. And the handsome rewards from the multi-baggers would make investing in small caps worth it.

Well. I have over the past few months begun pruning this garden. My current portfolio has 18 stocks. The purpose of creating a concentrated portfolio is Two-fold:

Firstly, To safeguard against mediocre stock selection. When my portfolio had 100 stocks, to invest in one additional stock wasn't too terribly hard because the downside risk was small. This created an tendency to follow ideas without doing my own due diligence. Now that each stock has nearly 5x the concentration, I have to make sure that (a) I read up all about the company (b) wait for the best valuation to create the widest possible margin of safety. (c) Keep track of the stock.

Secondly, To Beat the index. Sounds obvious but when the portfolio had 100 stocks, it resembled the index S&P 500 or the Russell 2000 and I hated the thought that my portfolio resembled the index, an automatic basket of stocks grouped together and weighted by marketcap. Of course I can't tell if the current market is at the top as this chart suggests ( ) or is it the start of a bull run as Arnold Van Den Berg of Century Management recently commented (in the freebie sample from OID.COM), but I know that some of the best investors have gathered market-beating returns from investing in a concentrated portfolio of undervalued stocks without worrying about the market.

This is my current porfolio:
Stocks Percentage %
BRK.B 21.61
BWLD 5.47
C 1.83
DEO 0.73
FNM 0.52
KO 9.97
KONA 2.35
LGBT 0.43
MA 19.88
MORN 1.30
MSFT 2.52
NWEC 0.67
NWS 0.78
PFE 0.62
PRAA 1.84
TASR 1.47
WU 2.79
WWY 0.47
WWYWB 0.09

Cash 24.66
Total 100.00%

Well, it isn't perfect yet. I probably went overboard with BRK-B while MA just couldn't stop growing. I am still sitting on almost 25% cash waiting to slowly build up my positions.

A couple of additional notes:

* NWEC is a Risk-Merger arbitrage, with about a 4% spread + 3% dividend yield. Will last till 2007.

* Kona is the most speculative pick, wildly popular concept restaurant fusing Sushi with Grill (Yummy!) with great margins due to higher alcohol attach rate, negative cash flow, negative EPS, and growing rapidly, it has only 14 restaurants!

In conclusion, after three years of diversification, I am ready for the next three years of scary focused investing. I hope to report back with good success this time next year on the progress.



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