Warren Buffett once said that “diversification is protection against ignorance. It makes little sense if you know what you are doing.” I guess he knew what he was doing when he piled into Kraft Heinz at what he now admits was too high a price? Fortunately, and perhaps ironically, his investment vehicle, Berkshire Hathaway, is actually quite well diversified.
Unknown unknowns
There will always be unexpected failures that even the best of us can’t foretell, as investors in Metro Bank (LSE: MTRO) know to their cost. I think the so-called challenger banks offer great investing potential, as they’re relatively small players in a very big market with plenty of room to expand, and they’re free of the legacy problems afflicting the big banks. But they carry risk, and the most I would ever commit to them is a small part of a diversified portfolio.
Metro Bank’s troubles came to light in January, when it admitted an accounting error led to some loans, including some commercial mortgages, to be assessed in too low a risk band. That meant there wasn’t enough capital to cover its risks, and there was a hole in the bank’s balance sheet that needed filling.
New capital
Since then, Metro Bank has been trying to raise £350m, and we’ve been assured that the new funding will be in place by June. But with that dragging on, and the share price continuing to slide, fears are growing that any new capital will have to be raised at a big discount that would severely dilute the interests of existing shareholders.
January’s dip was severe, but the Metro Bank share price has continued to fall ever since, and investors are now looking at an 84% loss over the past 12 months. And despite an upbeat Q1 update on 1 May, the shares are down 29% this month alone. I’m steering well clear.
Best in business?
At the other end of the desirability scale, in my view, is Lloyds Banking Group (LSE: LLOY), though its shares remain volatile.
It’s the one I invested in, and the bank’s Q1 update released on 1 May strengthens my belief I made a good choice. Lloyds reported an 8% rise in underlying profits, and that was down to a combination of increased net income and reduced operating costs.
Reducing costs can only go so far, so that part of the equation should have little importance in the long-term scale of things, and net income only grew by 2%. But in the current economic climate, I think that’s just fine.
Assets
I’m also buoyed by a net asset value (NAV) per share of 53.4p. At the current share price of 61.5p as I write, the shares are trading at a modest premium to NAV of only 15% — and to me that seriously undervalues the business itself.
The Lloyds share price has gone off the boil a bit in the past month, but we’re still looking at a 19% rise so far in 2019. And even after that, forecasts still indicate forward P/E multiples of only around eight, coupled with dividend yields of 5.5% and rising — and they’d be more than twice covered by predicted earnings per share.
I still reckon there’s plenty of safety in the Lloyds share price now.
