In our last column, we mentioned the danger of stocks such as Nortel being overweighted within a stock index. The primary lesson is to be wary of making an investment where this situation exists. But investors also need to be wary of overweighting in their own portfolios.

Constructing a diversified portfolio that takes into account such factors as age, net worth, future earnings, willingness to accept risk, and a myriad of other factors, is an art too complex to discuss here. But within the confines of our stock portfolio, we have a couple of key rules that come into play.

While diversification is important and advocated justifiably by just about every financial planner on the planet, the danger of overdiversification is rarely addressed. One risk of spreading the asset mix too thinly is that returns may be inhibited. This is because the catalysts that spark positive results in one part of a portfolio can depress the returns in another.

Another problem of overexpansion is tracking all of the investments. When a portfolio crisscrosses the map, it becomes onerous to follow. Simplification allows a more concentrated focus that can engender better returns.

A few years ago, the Contra stock portfolio peaked at 37 positions. The corporate world seemed ripe with bargains and we spread ourselves hither and yon. Now, our goal is to streamline. Currently, 27 stocks are in the stable, and our objective is a further pruning to between 15 and 25 corporations.

One difficulty that can occur when consolidating is that firms purchased at exceptionally low prices are able to dominate a portfolio as their stock price increases. This happened to us in the past with Mitel, as our buy of this stock at levels as low as $1.01 ballooned the weighting to almost 20 percent when the stock went over $10. Chunks of this position were sold at $11.30, $12.15 and $12.55, long before our final sale at $22.45. This was necessary to keep the stock’s influence on the portfolio at a reasonable level.

In December, 2000, Shoney’s (SHOY-OTCBB — a US electronic bulletin board exchange) was added to the stable at an average cost of 37 and a half cents (US). When we acquired it, the company weighed in at about 3.5 percent of the portfolio, but since then the stock has skyrocketed to about 11 percent. While our conviction is that the price will jump further, the risk of overweighting is apparent.

There are multiple reasons to shun Shoney’s. First, the firm is in the restaurant business, an industry that is synonymous with a high mortality rate. And this outfit has been unveiling the tombstones, closing about 100 restaurants over the past few years, leaving around 1,000 covering 28 states. Revenue dropped more than 10 percent on a year-over-year basis to $750 million, and the high debt-load and thin margins have eaten away at the organization. Red ink is the colour of the day, and the company has a negative book value. Their financial position is so tight that to say bankers are leaning over their shoulders turning the pages in Chapter 10 would not be such an understatement.

With a precis like this, why did we buy? Well the company recently made one deal that chopped debt dramatically. Margins and average restaurant bills have been trending up and insiders have been buying oodles of shares. And per usual with stocks that we buy, this one traded at far loftier levels in the past — at around $30 in 1994, which is one reason we are seeking better than a ten-bagger on this one. Our target price is $4.81.

While our plan is to continue holding a major piece of Shoney’s, if this stock climbed to more than 15 percent of the portfolio, 25 percent of our position could be sold. This would not indicate for a millisecond our disbelief in the investment, but conforms with our general rule that when a stock crosses the 15 percent threshold, it’s carefully analyzed to see whether the sails should be trimmed. This represents smart portfolio management, in a world where the axiom about too many eggs in a basket remains pertinent.