Golf, concentration and free lunches

I once worked with a risk manager who was a talented, amateur golfer. Having just won the local club tournament – victorious and enjoying a complimentary meal in the clubhouse – his moment was snatched by a chicken finger sandwich. Fortunately, a successful Heimlich manoeuvre dislodged the offending morsel from the red-faced, risk manager’s windpipe. Alas, the moniker “The Choker” stuck.

Clubhouses aside, the world is a risky place and even “free lunches” need to be approached cautiously. Harry Markowitz said diversification was “the only free lunch in finance” and it’s a concept that has been widely embraced by portfolio managers. However, there’s an alternative, a concentrated portfolio, but we’ll get to that shortly.

At its core, the theory of diversification is that portfolio risk can be reduced by increasing the number of securities in a portfolio. While diversification may theoretically optimise risk versus return, the impact on performance is not talked about as much – that mathematically, as you increase the number of stocks in a portfolio, returns will converge with the market, ultimately guaranteeing average returns.

Outstanding companies are, by definition, scarce. It’s difficult to find high-quality businesses run by talented managers with aligned incentives. In today’s relatively efficient markets, opportunities to buy them at a compelling price are rare.

An investor may spend months, or years, understanding and building a high degree of confidence in a company’s competitive advantages, quality of the management team, capital allocation, its financials and overall long-term prospects. If a truly attractive opportunity presents to buy this company at a 20 per cent, or 30 per cent, or greater discount to estimated value, shouldn’t a well-informed investor take an appropriately sized position?

It’s challenging to generate a meaningful contribution to your portfolio’s overall return with a 2 per cent position. Or put another way, capital allocated to your 20th or 50th best investment likely represents a significant opportunity cost. Why dilute great investment opportunities into mediocrity?

One viable alternative to managing risk through a large number of stocks is through a concentrated portfolio. At a high level, this may be achieved by:

1) Minimising portfolio risk primarily through the quality of the companies you own (not the number).

A portfolio of high-quality companies may be constructed by:

• buying companies with outstanding businesses (that you can and do thoroughly understand), and
• backing talented management teams to run them, who think and act like owners, and
  
• avoiding highly levered balance sheets, and
  
• being patient – buy at a price where the odds are well in your favour, and
  
• being ruthless – when the facts change, or when you get something wrong. There’s no room for companies that don’t meet your investment criteria in a concentrated portfolio. If you wouldn’t buy more when the price is down 20 per cent, sell.
  

This concentrated approach also ensures that the investment manager can dedicate more time and resources to understanding portfolio companies, industries and competitors. Practically, an investment manager can’t achieve the same depth of understanding for 100 companies, that they can for 10.

2) Limited use of diversification.

There are benefits to diversification within a concentrated portfolio. None of us can predict the future. Even the best ideas can run aground due to an unforeseeable event, an oversight or a miscalculation. Large drawdowns risk emotional reactions, which may result in costly decisions that inflict capital impairment .

A portfolio of 10 stocks, comprised of airlines, hotels, cruise ship operators and travel companies would have tested even the most stoic investor’s (and their clients’) commitment over the past six months and potentially resulted in a material capital loss. For a concentrated portfolio, it’s important to monitor the end-market exposures closely. Ideally, companies’ underlying earnings drivers would be uncorrelated. Realistically, correlations should be minimised, so that a portfolio can withstand even a low probability but high consequence event.

But how many stocks should a fund hold?

“…owning just two stocks eliminates 46% of the non-market risk. This type of risk is reduced by 72% with a four-stock portfolio, 81% with eight stocks, 93% with 16 stocks ….and 99% with 500 stocks”. Fund manager and author, Joel Greenblatt.

While these statistics vary across time periods, securities and markets, Greenblatt’s key point doesn’t: that the benefits of diversification rapidly become smaller from additional stocks and that the market risk remains.

Different investors have different requirements and there’s no single, correct or one-size-fits-all investment style. However, an ETF is likely more appropriate than an active fund for those who aspire to average returns (i.e. those of the market).

In his inimitable style, Charlie Munger gets to the nub of a concentrated portfolio:

“They’ve got it exactly back-ass-ward. The whole secret of investment is to find places where it’s safe and wise to non-diversify. It’s just that simple. Diversification is for the know-nothing investor; it’s not for the professional." Charlie Munger

The concentrated portfolio described provides the potential for superior performance, by allowing investors to take advantage of exceptional investment opportunities, while at the same time managing risk through the selection of high-quality companies. It avoids the potential for a “free lunch” to spoil a winning round.  

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Claremont Global is a high conviction portfolio of value-creating businesses at reasonable prices. We consider ourselves true stock-pickers and look to avoid owning businesses that depend on a benign or favourable economic environment. Stay up to date with all my latest insights by clicking the follow button below.