Acommon debate amongst investors is how many investments are required in an equity portfolio to provide adequate diversification, where the key objective of diversification is to reduce portfolio risk?
The textbook definition of portfolio risk is the volatility of returns as measured by the standard deviation of returns, as well as a portfolio’s risk relative to its given benchmark, measured by tracking error. While we appreciate the technical definitions, as trusted custodians of client wealth, we define risk as the permanent loss of capital. Diversification for us is not achieved by increasing the number of companies in a portfolio, but rather the quality of the companies, specifically their underlying diversification and how they all fit together in a portfolio. As such we believe our efforts are most effectively spent trying to identify a select few companies that can provide clients with adequate diversification at the individual company level and in aggregate as a portfolio. We feel comfortable that we can achieve this with a maximum of 15 high-quality companies.
One such company is Sika, the 110-year-old Swiss listed specialty chemicals company. We were initially drawn to the company because of its niche position in an attractive global market and because it was overlooked by many growth managers due to its sector classification. When evaluating the investment, we considered diversification from several perspectives, i.e. revenue, costs, management and corporate strategy.
The company’s revenue stream is well diversified, generating revenues in more than 100 countries globally, with the US its single largest market (comprising 16% of sales), helping to reduce single market, economy and currency risk. Cyclical risk is further reduced with solutions for all construction markets since revenues are diversified across new build (~45%) and refurbishment/renovation projects (~55%) through their eight product categories. Products typically account for less than 0.5% of total project costs. Despite this, they command a high-value-to-cost ratio for customers given their structural importance, which is evident in the group’s gross margin of ~54%. Importantly, the product portfolio is patent protected, creating meaningful barriers to entry. We like companies that innovate but we don’t like ‘blockbuster’ products. At Sika, 25% of revenues are generated by products that have been released in the past five years, illustrating a measured pace of innovation and product breadth which reduces the risk of product/technology disruption. Lastly, no single customer accounts for >1% of revenue, mitigating customer default risk.
When we think about input costs and the manufacturing process, we don’t want our companies to be beholden to a limited number of suppliers or manufacturing facilities. In this regard Sika is well diversified with no single supplier accounting for >4% of materials used in the production process, reducing the risk of supply disruptions. The company typically manufactures in locations where they sell, with approximately 300 factories around the world. This helps mitigates the risks associated with production outages, supply chain disruptions and currency, whereby the manufacturing currency is different to the selling currency.
Management and culture are key tenets of our investment framework. We believe that sustainable growth is less likely for companies that are overly reliant on a few key decision makers. Sika has a deep, well tenured management bench, by virtue of their decentralised management structure. Decentralised management is ultimately a form of diversification, as it ensures decisions are best suited to the local dynamics of any of more than 100 markets in which they operate. When implemented with the right balance of supervision from senior management, this style of management reduces the risk of being blindsided by local market requirements and trends. Furthermore, it helps reduce the risk of poor capital and resource allocation at the senior executive level in an attempt to drive short-term growth and profitability, often used to stroke executive egos and achieve bonuses at the expense of the firm’s long-term strategy. Sika’s remuneration objectives are not limited to a select few executives but are down to the general manager level, enhancing the sense of ownership which ultimately helps drives employee engagement.
Finally, beyond revenue, costs and management, we consider diversification of the corporate strategy i.e. does it encompass all stakeholders, or, is it narrowly focused on one cohort or one metric (e.g. shareholders and earnings per share growth)? We look for businesses with strategic diversity, a strategy that embodies consideration for all stakeholders. We believe there is no better example of corporate stewardship for the benefit of all stakeholders than when Sika’s board and management team successfully defended the right to remain independent following an attempted takeover in 2014 by Saint Gobain, the French construction company. The takeover battle lasted four years, highlighted the unwavering commitment of the management team and employees to the company and its stakeholders. Had a sense of ownership and purpose not been present at Sika, it is our belief the outcome would have been different.
In summary, we believe the diversification within Sika across revenue, costs, management and the corporate strategy significantly reduces the risk of any single event materially impairing the earnings power of the business. The concept of diversification clearly encompasses more than just a diverse portfolio ― and as such is an integral part of our rigorous investment due diligence and process. This ultimately allows us to take concentrated positions with conviction, versus simply having more investments.