Why Quality is Essential for a Concentrated Portfolio

As I refine my approach, a critical area I need to focus on is the size of my portfolio.

I’ve decided to aim for at least 12 extremely high quality positions.

Below is a breakdown of how I’ve evolved towards this approach.

My Old Approach: Trading, Not Investing

In the past, I bought and sold many stocks in this account. I owned a lot of stocks (usually 25-30 positions), and I traded them quickly, rarely owning a position for more than a year.

I developed a number of techniques to contain losses – such as selling after a quarterly loss (a kind of stop-loss based on fundamentals). I also sold stocks as soon as I got the multiple appreciation that I was after.

This was a higher octane version of Ben Graham’s advice to sell after 2 years or a 50% gain, whichever comes first.

I was getting pretty good at it. In the last four years, I’ve outperformed my stock screens and I’ve outperformed the small value universe.

The thing is: most of my out-performance was due to good trading, not good stock selection. I discussed this in this post.

The techniques I developed are essential when dealing with terrible businesses. The goal is to get in when they are beaten up, get your multiple appreciation, and move on. If one of them starts falling apart, it’s essential to get out before the face ripping drawdown.

A good example of this is a stock like IDT – one of the first stocks that I purchased for this account. Since I bought it, it’s down 60%. I got out of it with only a 20% loss. Another example is Big Five Sporting Goods. I managed to eek out a 8% gain from that company. Later, Big Five had a roughly 90% drawdown from my purchase price.

Other stocks I owned show why it’s essential to get out of bad businesses and stop losses – I’ve also owned positions like GameStop and Francesca’s. I got out of Francesca’s with an 18% loss – it then went on to have a 96% drawdown from my purchase price. I got out of GameStop down 50% at $11.45. It later collapsed further to $2.57.

I also owned airlines despite the terrible economics of the industry. Fortunately, I got out of stocks like Alaska and Hawaiian with 10% and 26% drawdowns. They later had 60% and 80% max drawdowns from my purchase price.

I also got out of many positions after they popped near highs and made gains by trading. An example of this is Pro Petro. I sold that for a 45% gain at $19 – it later fell to $1.36. I sold Amtech for a 48% gain at $6.60 – it later fell down to $3.55. I made 35% on PLPC, getting out at $68. It later fell to $36.

All of the stocks I bought were optically cheap when I bought them, but obviously bad businesses with poor underlying economics. These were not safe positions to own for the long-term. That’s why a trading strategy was essential to contain losses and lock in fleeting gains. I had to sell when it popped and get out when the fundamentals began to unravel.

And for all of those good trades that I made – I have very little to show for all of that frantic effort over the last four years.

Another thing I did a lot of – trying to predict the economic cycle – is also essential when dealing with terrible businesses.

Terrible businesses are actually the best place to be at the bottom of an economic cycle. A portfolio like that can deliver 200% returns in an environment like 2009.

Terrible businesses are the worst place to be when the economy falls apart. The cheapest decile of price/free cash flow had a nearly 70% drawdown in 2008. This is a major reason I sold so many positions in March 2020. I thought we were only in the early innings of a 2008 or 1973-74 economic collapse.

That’s why I was so obsessed with figuring out the economic cycle.

Knowing our current position in the market cycle was going to be a major factor in my returns. My plan was to anticipate the great crash, then have a pile of cash to buy quality net-net’s when they became available in large numbers. Well, I’ve spent four years waiting around for the great crash. It might have already happened and I might have missed it.

The problem is: how can I know it’s March 2009 and not August 2008? I thought I could tell the difference, but the extent to which I got March 2020 wrong makes me question this.

All of these trading techniques and macro forecasting tools are something I want to move away from.

I don’t want to trade stocks any more. It’s frantic, exhausting, and stressful. I want to own businesses. 

Moreover, I want to own businesses with good long-term economics. I want to hold them in a concentrated portfolio. I don’t want to be a trader any longer, frantically moving in and out of positions.

Why 20-30 Stocks?

I tried to own 20-30 stocks because that’s what the research says you are supposed to do. That’s what Ben Graham and the academics suggest.

Because I like to test things on my own rather than take other people’s word for it, I did my own research on this topic, which I discussed here. The gist of it is that Sharpe ratios get maximized around 25 positions in a low EV/EBIT portfolio, matching the advice of Ben Graham and the academics.

The issue with owning 30 stocks is that it was extremely difficult to keep track of all of those positions and all of the events that were occurring with them.

I’m a hobbyist investor who does this part time as a labor of love. I have a full time job and I manage this account in the early morning hours, at night, and on the weekends. Reading K’s and Q’s at 3 AM was not a lot of fun (particularly when they contained such awful results), but it was essential to keep up with what was going on in my portfolio.

These days, I want to look for good businesses with good economics and buy them when they trade with a margin of safety. These are rare situations. Because they’re rare, I need to veer more towards concentration.

A New Approach: A Dozen High Quality, Deep Value, Positions

Of course: how much concentration is too much?

This is a matter of personal preference. For me, I’m going to rely on my own research and the advice of some great investors.

I’ve decided that 12 positions are ideal for me.

In my post from 2019 about portfolio sizes, I found that 12 positions is where a bulk of the benefit comes from in reducing volatility and containing drawdowns. Starting from 1 position, each stock that is added to a portfolio adds exponentially declining diversification benefits. Sharpe ratios get maximized around 25 positions, but a bulk of the benefits of diversification – in terms of containing drawdowns and lowering volatility – is found in the first dozen positions.

Beyond the quantitative research, I think that a dozen positions will be more manageable from a homework perspective. I ought to be able to keep up with a dozen positions and follow what is happening with those companies.

Fortunately, there are also two superinvestors who seem to agree with me: Peter Lynch and Joel Greenblatt.

Peter Lynch had this to say:

“Owning stocks is like having children – don’t get involved with more than you can handle. The part-time stockpicker probably has time to follow 8-12 companies, and to buy and sell shares as conditions warrant. There don’t have to be more than 5 companies in a portfolio at one time.”

This is what Greenblatt had to say on the topic:

“Statistics say that owning just two stocks eliminates 46 percent of the non-market risk of owning just one stock. This type of risk is supposedly reduced by 72 percent with a four stock portfolio, by 81 percent with 8 stocks, 93 percent with 16 stocks, 96 percent with 32 stocks, and 99 percent with 500 stocks. Without quibbling over the accuracy of these particular statistics, two things should be remembered:

1) After purchasing six or eight stocks in different industries, the benefit of adding even more stocks to your portfolio in an effort to decrease risk is small, and

2) Overall market risk will not be eliminated merely by adding more stocks to your portfolio.”

Combining the advice of Greenblatt, Lynch, and my own research: I’m going to aim to have at least a dozen positions.

It’s also essential because the situations I’m looking for – wonderful businesses at wonderful prices (think Apple in 2016 at a P/E of 10 or defense stocks at single digit P/E’s in 2011) – are rare. A business that is worthy of being held, not traded. Moreover, I want to obtain this business at a compelling price. There aren’t 30 of them in the market at a given time.

Quality

If I only own 12 positions, then they ought to be incredibly high quality positions.

I think that owning 12 positions like Charles Schwab and General Dynamics is a different proposition than owning 12 no moat bad businesses in secular decline just because they are optically cheap at half of tangible book or a single digit P/E.

From a risk perspective, I think that owning 12 positions like Schwab and GD is less risky than owning 30 bad businesses just because they are below tangible book.

As I considered a higher quality portfolio, I recently re-read Tobias Carlisle’s book, Concentrated Investing, which analyzed the track record of investors who ran concentrated portfolios.

My favorite investor from the book is Lou Simpson, who managed GEICO’s stock portfolio.

His track record was astounding and he was very concentrated.

Of course, he didn’t concentrate in high risk situations. He concentrated in companies like Nike.

Carlisle explains in the book:

“In 1982, GEICO had about $280 million of common stock in 33 companies. Simpson cut it to 20, then to 15, and then, over time, to between 8 and 15 names. At the end of 1995, just before Berkshire’s acquisition of GEICO ended separate disclosures of the insurer’s portfolio, Simpson had $1.1 billion invested in just 10 stocks.”

Simpson’s approach – a concentrated portfolio in extremely high quality companies – worked very well. Simpson delivered a 20% CAGR from 1980-2004.

Carlisle also breaks down Simpson’s investment philosophy, which makes a lot of sense to me:

1) Think independently.

2) Invest in high return businesses run for the shareholders.

3) Pay only a reasonable price, even for an excellent business.

All of this resonates me. Simpson’s strategy is similar to the one I want to follow: own wonderful businesses at wonderful prices.

This is a sharp contrast to what I have been doing over the last four years.

Owning a lot of positions gave me comfort because one of the positions couldn’t make or break the portfolio.

However, it also reduced the quality of my portfolio. I’d often think of positions in these terms: “It’s only 3% of my portfolio and I can afford to lose 3%.”

I’d rather not think in those terms any longer. If there is a high probability that the business can completely unravel and it can collapse, then I probably shouldn’t own it at all. I’d rather own a more concentrated, but much higher quality, portfolio going forward.

Position Sizing

As I’ve discovered in the last four years, stock selection and portfolio management is a deeply personal endeavor. Investing in individual stocks isn’t simply a one-size-fits-all mechanical approach. Every individual stock investor needs to find an approach that works for them. No one is the same. Everyone has different risk tolerances and beliefs.

There are some investors who would be comfortable only owning 5 stocks. They have high conviction positions. Some of them will even put 40% of their portfolio in a single stock. I would definitely trim a position before that happened. I think extreme concentration is fine if that works for them, but I’m a bit of a wuss and probably wouldn’t be able to handle that level of volatility.

There are other investors who think 12 stocks is crazy and too small of a portfolio. That’s fine. You do you. There isn’t a one size fits all approach to investing. Everyone needs to find an approach that matches their own preferences and risk tolerances. Hopefully you’ve learned some lessons on my dime following this blog.

Random

Ratt – Nobody Rides for Free. If you don’t like Point Break, what the hell? 🙂

PLEASE NOTE: The information provided on this site is not financial advice and it is for informational and discussion purposes only. Do your own homework. Full disclosure: my current holdings.  Read the full disclaimer.