A Case for Concentrated Investing

It is our view that concentrated portfolios offer superior risk-adjusted returns over the long term. In this piece, we put forward the rationale for a concentrated portfolio and offer a discussion on some of the existing literature on the subject.

"A lot of great fortunes in the world have been made by owning a single wonderful business.  If you understand the business, you don't need to own very many of them.” Warren Buffett

HOLDING TOO MANY STOCKS IN A PORTFOLIO CAN CROWD OUT RETURNS FROM GOOD IDEAS

At the risk of oversimplifying, assume an investor has one really good idea, and implements it in two equally weighted portfolios – one portfolio holds 10 stocks and the other holds 100. If this good idea doubles in value, it will contribute 10% to the overall fund returns in the concentrated portfolio, but only 1% in the other. Of course, this is a very basic example, but it highlights the simple maths behind the idea that returns can be magnified through having more conviction in a few stocks, than less conviction in many.

GOOD IDEAS ARE SCARCE

Rather than investing in more stocks, what’s more important is choosing the right stocks.

Even if there were scores of great ideas available to investors, there are limits to how many an investor could implement well. Given the considerable amount of research and analysis involved in carefully selecting a good investment, one would expect the investor to spend a significant amount of time understanding the investment to have enough conviction.

COMPETITIVE KNOWLEDGE ADVANTAGE

If a fund manager holds a portfolio of many stocks, say for example 50, chances are the knowledge they possess about these stocks is lower than what a manager might know about their holdings if they held few, say 10 stocks.  Focusing on a select number of investment ideas should allow a manager to capitalise on their knowledge advantage gained from following companies for longer, conducting more thorough research into the industry or competitors, and having a stronger relationship with a management team. Through this knowledge advantage investors ought to have a more thorough understanding of a company and use this to better identify mispricing opportunities in the market.

POSITIVE RISK CULTURE

As custodians of others’ capital, we believe fund managers have a duty to not only grow this capital over the long term, but also to protect it. Holding concentrated positions can encourage a culture of risk management which focuses on downside protection. This can create greater motivation to avoid poor investments and deter managers from taking unnecessary risk that otherwise might be acceptable in a less concentrated portfolio. It may also steer the portfolio towards higher quality stocks.

DIVERSIFICATION ISN’T LOST

There is no consensus in the investment community about what the optimal number of portfolio positions should be. However, the number of stocks you need to reap the benefits of diversification is probably less than you think. Benjamin Graham, the father of value investing, advocates for 10-30 positions. Seth Klarman, in Margin of Safety stipulated 10 to 15 different holdings provide sufficient diversification, Warren Buffet has suggested 5-10, while John Maynard Keynes has suggested 2 to 3.

While it is beneficial to reduce diversifiable risk (according to Modern Portfolio Theory, the market doesn’t compensate you for taking it) there is a turning point in practice where more positions may not necessarily mean greater returns.

In our view, to balance risk and performance most favourably, the ideal number of quality companies in each portfolio would generally be between 0 and 20.