Throughout my investing life, I have attributed the quote “put all your eggs in one basket and then watch that basket,” to the great Charlie Munger. But upon further research, I can with 90% confidence attribute it to none other than Andrew Carnegie , one of the wealthiest Americans in history due to his architecture of the American steel industry. When it comes to wealth creation, Carnegie understood the value of concentration. Here at Richie Capital Group, we appreciate and embrace this wisdom in our investing approach. We believe in concentrating our portfolios around a selection of high conviction, ‘best ideas’ or, from our perspective, a portfolio of phenomenal companies. This approach allows us to achieve potentially higher returns compared to more traditionally diversified portfolios.
A concentrated portfolio is one that is invested heavily in a limited number of investments or stocks – typically between 15 to 30, as opposed to more traditional portfolios that may hold hundreds. With a concentrated portfolio, each investment carries more weight and the potential to significantly impact the portfolio’s overall performance.
Our concentrated philosophy is grounded in abundant research. According to a study by Anton, Cohen, and Polk , concentrated portfolios constructed around ‘best ideas’ tend to outperform the broader market. The study emphasizes that this outperformance can be as high as 2.8% to 4.5% per year depending on the benchmark and shows no evidence of mean reversal even years later. A portfolio manager’s (PM’s) best ideas – the stocks they have the most conviction in – are likely to generate all the alpha for the portfolio and outperform the remainder of the positions which are either not as compelling or were added for diversification purposes. Most PMs can speak enthusiastically about one to two investments from their portfolio. But how much knowledge can a single investor have around 100 to 200 investments? If you only have depth of conviction in your top positions, why bother with the rest?
Despite what you read, most fund managers can indeed pick stocks. Their poor performance is more likely due to overdiversification and other institutional forces that encourage underperforming behavior. Even considering the broader market in general, a study from Hendrik Bessembinder at Arizona State University found that most of the stock market’s long-term returns come from a relatively small number of stocks, often concentrated in a few sectors. So, it is unsurprising that professional investors would experience the same phenomenon.
What are the risks to a concentrated strategy?
With fewer stocks in a portfolio, the poor performance of even one investment can also significantly impact the portfolio’s overall return in a negative manner. Whereas, within a large portfolio, losses in a single stock can be mitigated by the sheer number of different investments held.
Another risk with a concentrated portfolio is a perceived lack of diversification. In the investing world, diversification is often defined as the only “free lunch “—it can potentially reduce risk without necessarily decreasing expected returns. In our view, diversification can provide downside protection, but it really protects investors who don’t have in-depth knowledge of the underlying companies they are invested in.
“Diversification is a protection against ignorance. It makes very little sense for those who know what they’re doing.” – Warren Buffett
Our investment process requires an inherent deep understanding of the companies we invest in and a clear view of the investing landscape: the companies, their strategies, and their competitive advantages. Investing with a concentrated portfolio requires, and showcases, skill. While concentrated portfolios may seem to carry more risks, they consistently outperform their more diversified counterparts over the long term, and research proves that the additional benefit of diversification diminishes quickly past a portfolio of 10 to 15 stocks .
1 Tang, ‘How efficient is naive portfolio diversification?’, 2004
If performance is better, and showcases skill, why don’t more managers invest with conviction?
While most clients would be best served by managers delivering concentrated portfolios, there are numerous motivators pushing portfolio managers to larger and (over)diversified portfolios:
- Asset gathering – Like anyone else, portfolio managers are motivated by profit. Given the traditional portfolio management compensation structure of a fixed fee as a percentage of assets under management (AUM), PMs are motivated to maximize profits by maximizing AUM. A concentrated portfolio places inherent limits on how many dollars can be invested in a specific strategy (or company). Too many dollars will affect both liquidity as well as price impact when making portfolio changes. As a manager grows assets, their investment in a single stock will begin to “move the market”. These combined frictions push a manager to more investment names and more diversification. The more names in the portfolio, the more assets the PM can raise. Clients benefit from concentration, while PMs are better off with a larger portfolio where they can collect more fees.
- Legal restrictions – Specific regulations bar overconcentration and widely varying interpretations of standards such as “The Prudent Person Rule” make it more attractive to be more diversified.
- Job security – The performance of a manager’s portfolio will likely be a determinant of whether they keep their job. During a period of poor performance, the end client has no way to assess whether performance was caused by bad luck or lack of skill. And during an inevitable period of poor stock selection (or plain bad luck), the manager risks his job and livelihood. Better to diversify into hundreds of names where he or she is less likely to significantly underperform their benchmark.
- Short term horizons – Portfolio Managers face pressure for short term performance. Many accounts are priced monthly or quarterly (for mutual funds, it’s daily) and reviewed by the client to assess how they have performed over a brief period. A short-term negative deviation from the benchmark, once again, impacts job security.
- Risk aversion/irrationality – For academics, “risk” is measured by variability of rate of return (i.e. volatility). When you invest in a concentrated portfolio, the daily returns are going to be more volatile. And while academic literature focuses on volatility as a measure of risk, at RCG, and for most practitioners, risk is really about earning a poor return. Most professional PMs are graded not only on their portfolio performance, but on various metrics such as the Sharpe Ratio and/or Information Ratio which were developed to assess the skill of the portfolio manager. The Sharpe Ratio attempts to measure the amount of risk a PM takes on for each measure of return they have achieved. If a manager can generate the same portfolio return over a given period as another manager but with less volatility, the manager with the lower volatility will achieve a higher Sharpe Ratio. An easy way to reduce portfolio volatility is adding additional names to the portfolio. The fact that professional money managers are given more credit for reduced volatility flies in the face of the fact that institutional allocators have a longer time horizon and, thus, can afford to take on more volatility in pursuit of higher returns.
Despite the volatility (and perceived risk) of our concentrated portfolios, our team sleeps well at night. If one of our holdings moves significantly in a day, our knowledge of the company and industry informs us as to why and helps us immediately determine what our next action should be.
At Richie Capital Group, we develop portfolios that we consider our highest conviction ideas. There’s a certain beauty to this approach. It is where art meets science in the world of investing. The ‘art’ is the ability to identify these best ideas through deep, qualitative analysis. The ‘science’ is deploying rigorous quantitative methods to ascertain these ideas’ potential value and assess the risks involved.
Our approach isn’t for everyone. Our strategy requires a willingness to sometimes deviate significantly from the overall market’s performance. By definition, the only way to beat a benchmark is to be different from it. And as discussed above, the broader system of professional money management is somewhat working against us. But we believe our approach is the superior way to outperform the broader indexes over time and deliver more value to clients. We believe that for those willing to tolerate short-term volatility in exchange for potentially superior long-term returns, a concentrated portfolio approach can be highly rewarding. We put all our eggs in fewer baskets, and we watch those baskets closely – understanding the companies, their strategies, their competitive advantages, and the industry trends impacting them. We invest in shares of companies we want to own and, ideally, if money were no object, we would happily buy the entire company. Our clients prefer a group of carefully selected, well understood investments over a vast collection of ‘maybes’. We believe it’s important that our clients know that we are thoughtful behind our process of managing their valuable assets.
As we all know, in the world of investing, there are no guarantees. However, by focusing on our best ideas – and not diluting our focus (and time) across hundreds of investments – we believe we’re positioning ourselves, and our clients, for success.
Additional Sources:
Anton, M., Cohen, R. B., & Polk, C. (2019). Best Ideas. Harvard Business Review, 97(5), 100-107.
Berk, Jonathan B., (2022). Mutual Fund Flows and Performance in Rational Markets, Haas School of Business, University of California, Berkeley and NBER
https://news.wpcarey.asu.edu/20180711-most-stock-market-returns-come-tiny-fraction-shares
https://www.sciencedirect.com/science/article/abs/pii/S0305048303001336
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