The case for concentrated portfolios

What is the rationale for a concentrated high conviction approach to investing?
We are often asked by clients why we believe in running a concentrated global portfolio (35-40 stocks) and whether this makes the strategy riskier? In a world of proliferating investment choice (active, passive, quant), these are pertinent questions. We believe that to remain relevant as an active fund manager, we need to provide our clients with the best chance of success (long-term outperformance).
1. Markets are broadly efficient; compelling investments are rare
There are thousands of buy- and sell-side analysts covering stocks. The biggest companies can have more than 40 analysts pouring over every financial report, company statement and news report. As such, price discovery is generally fast and effective. That being said, we strongly believe that pockets of inefficiency do exist. These are generally caused by investor psychology, sentiment and behaviour. Compelling valuation anomalies (where the price of a security is materially below intrinsic worth) are rare. This lends itself to a having a concentrated portfolio allowing us to back those rare anomalies with conviction.
2. Adding more stocks dilutes your best ideas
As noted above, compelling investment opportunities are rare. Thus, growing the number of holdings risks diluting the long-term return potential of the strategy. While the common argument is that diversification can reduce risk, we believe that, beyond a certain point, it actually adds to risk as you are inevitably forced to add more marginal ideas. We seek to maintain strong competition for capital and judge each new idea on its own merits. We also weigh up new opportunities against stocks that we already own. This disciplined approach to capital allocation is crucial to maintain long-term alpha creation. In simple terms, the more stocks you add to your portfolio, the more you resemble your respective index. The more closely you resemble the index, the lower your odds of delivering a different (hopefully better) outcome then the index.
3. Circle of competence
A concentrated portfolio with low turnover only requires a small number of compelling new ideas to be generated each year. This means that we can set our standards high in terms of valuation and quality thresholds. We are able to avoid companies that are hard to understand, analyse or indeed opaque unless we feel there is adequate compensation in terms of potential reward. This way, we also don’t need to be experts on every company, sector or country – we believe that remaining within our circle of competence is an important way to reduce risk.
4. Better in-depth knowledge
By focusing on a select few companies, more time can be spent understanding each business, analysing their financials, meeting management, getting to know their products, customers and competitors, ultimately leading to a more informed investment decision. On the flip side, a fund that owns too many stocks may increase the possibility of failing to spot important new information relevant to the investment thesis. Holding fewer stocks also facilitates maintaining a relatively small team, which can be highly functional, collaborative and agile in its research focus.
5. Academic conclusions
There are a number of papers that support the thesis that more concentrated portfolios are likely to outperform: from ‘Fund Managers who take Big Bets’1 to ‘Best Ideas’2 to ‘In defence of active management’3. Perhaps the most influential was the Petajisto and Cremers paper in 20064, which introduced the ‘Active Share’ term. The paper concluded that those with high active share (smallest overlap with their benchmark) are expected to outperform those with low active share (biggest overlap). By definition, a concentrated global portfolio (35-40 stocks) is highly likely to have a high active share when judged against the MSCI ACWI benchmark of several thousand stocks.
What about volatility?
Edwin J Elton and Martin J Gruber, in their 1981 study: ‘Modern Portfolio Theory and Investment Analysis’, concluded that increasing the number of stocks in a portfolio can reduce the portfolio’s standard deviation i.e. its volatility. However, they show that the vast bulk of volatility reduction is achieved by diversifying from 1 to 20 stocks. The reduction in volatility beyond 20 stocks is minimal.
A concentrated portfolio has bigger position sizes in individual stocks (relative to a more diverse benchmark). This allows the fund manager to express their conviction, but it also means individual stocks can potentially have an impact on both upside and downside volatility in the short term. If volatility versus a benchmark is your preferred measure of risk, then perhaps you should seek to avoid active management entirely. If you seek to achieve long-term alpha, then we would argue that an actively managed, concentrated portfolio could be a good starting point. Risk is a term that means different things to different people. To us, we think of risk as the risk of a permanent impairment to our client’s capital. That’s why our investment process is highly attuned to assessing the risk of permanent loss at a stock level and at a portfolio level.
Footnotes
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1
Source: Baks, Klaas P., Busse, Jeffrey A., and Green, T. Clifton. “Fund Managers Who Take Big Bets: Skilled or Overconfident.”
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2
Source: Cohen, Randolph B., Polk, Christopher, and Silli, Bernhard “Best Ideas.”
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3
Source: Sanford Bernstein, May 2016
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4
Source: Cremers, Martijn, and Petajisto, Antti. “How Active is Your Fund Manager? A New Measure That Predicts Performance.” August 2006.
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