This post is going to be a bit different from the previous posts. It’s going to be less data-heavy and unrelated to COVID-19, but it’s about an important topic that I’ve been thinking about recently.
A portfolio management strategy can be described across two axes: frequency and concentration. Frequency correlates inversely with holding period for companies in the portfolio, and concentration measures how much money is put into each position.
The frequency axis can range from microseconds (high frequency trading) to years and decades (buy and hold). Since most high frequency “investing” is really trading, and more often than not these days, is done entirely by computers, I won’t focus on it here. The focus on this blog is multi-year and multi-decade investments.
For these investments, I think concentration is the more interesting factor to look at. Most wealth in the world has been created by holding a high proportion of one’s net worth in appreciating assets for a long period of time. Think entrepreneurs and their companies, hedge fund/private equity/venture capitalists and their general partnerships, real estate investors and their real estate.
However, there are only so many assets out there that appreciate for long periods of time. The reality is that most assets, whether they are companies or real estate, are not “compounders”. I recently read in Constellation Software’s 2017 annual letter that only 4% of stocks generated all of the market’s excess return in excess of T-bills over the last 90 years. Even more interesting, over 50% of public companies generated negative returns for shareholders during their entire lives as public companies. In other words, the vast majority of companies are crappy.
This is where thinking about portfolio concentration comes into play. Assuming you have some ability to identify the 4% of businesses that are superior, how should you size your positions? Well, if your entire portfolio is in your highest-conviction idea, there’s a reasonable chance that this one position is one of those 4% (again, assuming you have some stockpicking ability – if you don’t think you do, you probably shouldn’t be an investor in the first place). But if you now have 20 businesses in your portfolio, what is the chance that all of them are in that 4%? Very low, no matter how good you are.
Buffett and Munger have talked about a “punch card” rule. You get a punch card with 20 slots, and every time you make an investment, you have to punch a slot. Once you’ve punched all the slots, you can’t make any more investments for the rest of your life. And they contend that all investors would be better off if they were forced to follow that rule. You would wait until times like 2008, and then deploy large amounts of capital into highly concentrated positions.
This is easier said that done. People have a temptation to do things. It’s incredibly hard to study 100s or 1000s of businesses for years on end, and then invest in none of them. It’s also made more difficult by position limits and herd mentality among investors.
Investing is a unique field in that doing more does not necessarily correlate with better results. Investing is about making the right judgements. If you’re patient and make the right calls at the right moments, the best thing you can do is sit and wait. Pushing yourself to invest in something even if the opportunity is not a “no brainer” for fear of missing out, selling a winner because you want to “diversify” into new ideas – we’ve all done these things (or maybe you haven’t – good for you). Those are the psychological tendencies that tend to kill.
Of course, there is always some element of randomness with predicting the future, so by putting all your money into one idea (much like an entrepreneur), you expose yourself to potential Gambler’s Ruin, no matter how good your research is. This is why people diversify. It ensures that you can always live to invest another day.
However, you don’t need 10+ positions to diversify. You probably only need 3-4 positions, if they are all high conviction, “no brainer” investments. If you don’t see such opportunities, it is perfectly fine to sit on cash.
So all of this leads to the following conclusion. To truly outperform as a long-term fundamental investor, you must:
Be very patient, investing only in “no brainers”
Concentrate heavily in your “no brainers” and know those companies so well that you have the conviction to concentrate
At least that’s my thinking right now. It’s all subject to change.