• Concentrated Investing profiles eight investors with different investment styles to figure out the principles behind their returns. Was it due to their behavior, the source of capital, the number of investment, or position sizing? The authors answer those questions then look at what the data says.

• The idea of concentrated investing is simple: most investors are better off owning their top 10 – 15 ideas, instead of spreading money across 50, 100, or 1,000s of ideas, but…

There are two caveats: (1) Concentrated investing is not for everyone. (2) The book is a roadmap, not a benchmark.

• Lou Simpson

  • Managed GEICO’s investment portfolio from 1979 to 2010 averaging a 20.3% return, beating the S&P 500 by 6.8%.

  • Was willing it to hold a small number of positions with little turnover, including concentrated sectors bets — multiple stocks from one sector, did M&A arbitrage, and was willing to hold a cash position absent opportunities.

  • Investment Philosophy:

    • Think Independently: Be skeptical, avoid irrational behavior that drives market prices to excess, don’t avoid unpopular companies.
    • Invest in shareholder-friendly high-return businesses: uses cash flow as a yardstick, negative free cash flow “chews up owners’ equity,” management owns a sizable stake in the company, is willing to sell off unprofitable operations, and is willing to buy back shares over chasing “less profitable endeavors.”
    • Pay only a reasonable price, even for an excellent business: “Even the world’s greatest business is not a good investment if the price is too high.” Uses P/E and inverse E/P or earnings yield, and P/FCF as a gauge to value companies. “A helpful comparison is the earnings yield of a company versus the return on a risk-free long-term United States Government obligation.”
    • Invest for the long term: The short term is too unpredictable to guess the swings accurately but would increase transaction costs and taxes.
    • Do not diversify excessively: “An investor is not likely to obtain superior results by buying a broad cross-section of the market—the more diversification, the more performance is likely to be average, at best.”

  • Often traded around a core position.

• John Maynard Keynes

  • Prior to the Crash of ’29, Keynes was more of a top-down macro speculator, betting on commodity and currency moves, and doing it on margin. After ’29, he transitioned to more of a concentrated value investor. Though, he continued to use margin in his personal account.
  • Keynes ran the Chest Fund and a second Fund B for King’s College, as well as advised on the portfolio’s of two Insurance Companies. The Chest Fund earned a 9.12% annual return compared to a UK index of -0.11% over the same period 1928 – 1945.
  • Keynes wrote that most investors would never get past the “day-to-day fluctuations in the profits of existing investments, which are obviously of an ephemeral and non-significant character, tend to have an altogether excessive, and even an absurd, influence on the market.”
  • On worrying about certain risks: “some of the things which I vaguely apprehend are, like the end of the world, uninsurable risks and it is useless to worry about them…” — Keynes
  • On the risk of concentration: “[My] theory of risk is that it is better to take a substantial holding of what one believes in than scatter holdings in fields where he has not the same assurance. But perhaps that is based on the delusion of possessing a worthwhile opinion on the matter.” — Keynes
  • On a diversified portfolio: “The theory of scattering one’s investments over as many fields as possible might be the wisest plan on the assumption of comprehensive ignorance. Very likely that would be the safer assumption to make.” — Keynes
  • Warren Buffett on diversification: “If you are a professional and have confidence, then I would advocate lots of concentration. For everyone else, if it’s not your game, participate in total diversification. If it’s your game, diversification doesn’t make sense. It’s crazy to put money in your twentieth choice rather than your first choice.”

• Charlie Munger

  • Charlie Munger realized that the biggest problem with most fund types is the ability of clients/partners/shareholders to withdrawal capital at sub-optimal times. Having permanent capital removes that problem, which also helped people like Buffett, Munger, Simpson, Keynes, etc. by not having to think about beating a benchmark or short term returns. Instead, allowing them to maintain a concentrated portfolio with a long term focus.
  • Munger and Buffett found permanent capital via the float of insurance companies and Blue Chip Stamps.
  • Munger on price: “The desirability of a business with outstanding economic characteristics can be ruined by the price you pay for it. The opposite is not true.”
  • Munger on concentration: “My own inquiries on that subject were just to assume that I could find a few things, say three, each which had a substantial statistical expectancy of outperforming averages without creating catastrophe. If I could find three of those, what were the chances my pending record wouldn’t be pretty damn good. I just sort of worked that out by iteration. That was my academic study—high school algebra and common sense.”
  • Munger on where he looked: “I tended to operate, as so many successful value investors do, not looking at Exxon and Royal Dutch and Procter & Gamble and Coca-Cola. Most of the value investors, if you analyze who’ve been successful over a long time, have operated in less followed stocks.”
  • Munger on companies that bought back stock: “Lou, Warren, and I would always think the average manager diversifying his company with surplus cash that’s been earned more than half the time they’ll screw it up. They’ll pay too high a price and so on. In many cases they’ll buy things where an idiot could see they would have been better to buy their own stock than buy this diversifying investment. And so somebody with that mindset would be naturally drawn to what Jim Gibson used to call “financial cannibals.””

• Joe Rosenfield’s investment principles (as summed up by Jason Zweig):

  • “Do a few things well: Rosenfield built a billion-dollar portfolio not by putting a little bit of money into everything that looked good but by putting lots of money into a few things that looked great. Likewise, if you find a few investments that you understand truly well, buy them by the bucketful.”
  • “Sit still: Patience—measured not just in years but in decades—is an investor’s single most powerful weapon.”
  • “Invest for a reason: Rosenfield is a living reminder that wealth is a means to an end, not an end in itself. His only child died in 1962, and his wife died in 1977. He has given much of his life and all of his fortune to Grinnell College.”

• Kelly Criterion

  • The goal is to optimize position size for maximum gain while avoiding catastrophic loss, but only when you have an edge. Without an edge, no bet is made.
  • The simplified equation = edge/odds
  • “The purpose of the Kelly Criterion is to maximize the expected value of the logarithm of wealth period by period, but its suggested bets are often very large, and it can be very volatile in the short term. Seeking to avoid the big swings of the Kelly bet, some investors halve the size of the bet recommended by the criterion. This so-called half-Kelly bet achieves three-quarters of the compound return of Kelly with half the volatility. 36 It never pays to bet more than Kelly. Kelly is already the maximal bet for any given edge and odds. Overbetting does not increase the return, but increases the risk to such a degree that it’s likely to reduce growth.”
  • Ed Thorp popularized Kelly betting but only recommended fractional-Kelly bets for two reasons: 1) full Kelly bets could produce bigger drawdowns than most could handle, 2) full Kelly bets are likely overestimated due to an underestimated (or error) probability of a catastrophic event (i.e. Black Swans).
  • Thorp recognized that Kelly failed to consider the opportunity costs of other positions. He said, “We need to know the other investments currently in the portfolio, any candidates for new investments, and their (joint) properties, in order to find the Kelly optimal fraction for each new investment, along with possible revisions for existing investments.”

• The question of a concentrated versus diversified portfolio is the tradeoff between reducing risk through diversity or potentially maximizing returns via concentration. The more diversified you get, taken to an extreme, means a greater likelihood of earning market returns. The more concentrated, taken to an extreme, means a greater likelihood of deviating from the market return but also increases the risks associated with any single stock. So the right number of stocks to own depends on the individual, their skill level, and their ability to handle not only higher volatility that comes with a concentrated portfolio, but permanent losses from any one stock.

• Permanent losses are the most important risk to protect against.

• 1977 study, Risk Reduction and Portfolio Size, showed most of the benefits of diversification regarding risk reduction (idiosyncratic risk) was achieved when owning 20 to 30 securities. Owning more produced a minimal increase in benefits. However, the more concentrated portfolios tend to produce a wider range of possible returns that deviate from the market average.

• Robert Hagstrom, in The Warren Buffett Portfolio, found with portfolio concentration “that reducing the number of stocks in a portfolio increased the chance of generating returns that beat the market. He also found that it increases the chances by the same amount that an investor underperforms.”

• The authors repeated Hagstrom’s study. Using the universe of S&P 500 stocks, they assembled 1,000 randomly assembled portfolios of each of 250, 100, 50, 30, 25, 20, 15, and 10 stocks. The results show that the average return of each portfolio cluster falls in line with the market average, but the range of possible returns increases as portfolios became more concentrated. So the smaller the portfolio, the more likely its return deviates from the market average. “All that this exercise demonstrates is that concentrating a portfolio improves the chance that the performance of the portfolio deviates from the performance of the underlying index, not that it improves the performance over the underlying index. The expected return of a randomly selected portfolio is still the underlying average. We’re not interested in matching the average. There’s no point attempting to deviate from the market if we don’t intend to outperform it.”

• By combining a concentrated portfolio with a factor like value, that has shown a history of potential outperformance, increases the chance that the portfolio outperforms the market average in the long run.

• Patrick O’Shaughnessy shared updated data with the authors from 1964 to 2015: “O’Shaughnessy’s value portfolios ranged in size from as many as 100 stocks to as few as 1 stock. To qualify for selection, each stock needed a minimum market cap of $200 million (inflation adjusted to 2014 dollars). He ranked each stock in the universe on the basis of its fundamental value, defined as an equal weighted combination of its P/E ratio, price-to-sales ratio, enterprise multiple (EBITDA/EV), FCF/EV, and total shareholder yield (its dividend yield plus or minus any shares issued or bought back). Each portfolio was rebalanced on a rolling annual basis to remove any seasonal biases and make the test more robust… O’Shaughnessy found the one-stock portfolios generated the best raw returns at 22.8 percent per year compound. As the number of portfolio holdings swelled from one, the raw returns fell off in rank order. The 25-stock portfolios generated the best Sharpe ratio—a measure of risk-adjusted returns—at 0.85. As the portfolio holdings increased beyond 25 positions, the risk-adjusted returns diminished in rank order. O’Shaughnessy’s research shows that portfolios perform better as they become more concentrated on the most undervalued stocks.”

• A concentrated portfolio, based on a solid value strategy, only works in the long run, if the investor accepts the likelihood of higher volatility and underperforming the market average in the short run.

• The right temperament is key

Quotes

“The more broadly a portfolio is diversified, the more likely it is to match the performance of the averages, and the more concentrated a portfolio becomes, the more likely it is to deviate from those averages, either positively or negatively.”

“The more concentrated an investor becomes, the greater the portfolio volatility, and performance diverges from the market’s performance.”

“A goal is not always meant to be reached, it often serves simply as something to aim at.” — Bruce Lee

“When times are good, portfolio concentration is popular because it magnifies gains; when times are bad, it’s often abandoned—after the fact—because it magnifies volatility.”

“The singular trait that unites these investors, and separates this group from the herd of investors who try their luck on the stock market is temperament.”

“He believes that a record is built as much on what an investor doesn’t buy, as it is on what he does buy. “We are sort of the polar opposites of a lot of investors,” Simpson said. “We do a lot of thinking and not a lot of acting. A lot of investors do a lot of acting, and not a lot of thinking.” If an investor doesn’t do anything stupid, they can come out well ahead.”

“I get more and more convinced that the right method in investment is to put fairly large sums into enterprises which one thinks one knows something about and in the management of which one thoroughly believes. It is a mistake to think that one limits one’s risk by spreading too much between enterprises about which one knows little and has no reason for special confidence.” — J.M. Keynes

References

• concentrated investing
• https://novelinvestor.com/notes/concentrated-investing-by-benello-van-biema-carlisle/