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Thomas Macpherson
Thomas Macpherson
Articles (154)  | Author's Website |

Sometimes Less Is More, but Mostly Not

Portfolio concentration has been frequently held out as a way to achieve outperformance by focusing on the investor’s best bets. This is mostly hogwash

May 24, 2019 | About:

There is one thing of which I can assure you. If good performance of the fund is even a minor objective, any portfolio encompassing one hundred stocks (whether the manager is handling one thousand dollars or one billion dollars) is not being operated logically. The addition of the one hundredth stock simply can't reduce the potential variance in portfolio performance sufficiently to compensate for the negative effect its inclusion has on the overall portfolio expectation. Anyone owning such numbers of securities after presumably studying their investment merit (and I don't care how prestigious their labels) is following what I call the Noah School of Investing - two of everything. Such investors should be piloting arks. While Noah may have been acting in accord with certain time-tested biological principles, the investors have left the track regarding mathematical principles.” - Warren Buffett (Trades, Portfolio), 1965 Partnership Letter

Anyone who has read Patrick O’Brian’s Aubrey and Maturin canon are quite familiar with the concept of carrying too much sail. In the days before steam, all navies were dependent on the vagaries of the wind. Whether it be triple reefed topsails in a gale (meaning sails were made smaller through a series of “reefs”) or becalmed in the doldrums in the Sargasso Sea, ships’ schedules were dependent upon the amount of wind and the amount of sails the ship could carry. It was common for younger officers to over-press or over-canvass the ship. This meant that – counterintuitively – the ship could go faster if the masts carried less sail. Sometimes too much canvas could push the head of the ship downward, thereby creating more drag and slowing it down. Great sailors knew when less sails meant more speed. As the traditional saying goes, any damn fool can shake out a sail, but it takes a sailor to reef it.

I bring this up not to simply mention the writings of O’Brian (though his works rank as some of the best literature of the past century), but to point out the concept that less is more is as easily utilized in value investing as it is in an Atlantic gale in the Bay of Biscay. The idea of reducing the number of holdings in your portfolio goes against most major investment theses centered on risk. Many of these state a greater number of holdings can reduce risk over time. In the next section, I will discuss why that overall negative view is well justified.

For now, I wanted to discuss why my firm takes a different approach than most of Wall Street. At Nintai Investments, we are quite aggressive in limiting the number of holdings in our personal and institutional portfolios. We achieve this by focusing on a very small segment of the total market. This segmentation can be made by any number of criteria: corporate strategy, financial strength, Nintai’s knowledge of the business market and competition.[1] We run a very focused portfolio consisting of roughly 20 to 25 stocks.

We do this for several reasons.

The market is so big, and my mind is so small

As of 2016, there were roughly 109,000 publicly traded stocks in all of the global markets (there are roughly 200 stock exchanges in the world). Nearly 4,000 of these are traded on a regular basis on the two major U.S. exchanges – the New York Stock Exchange and the Nasdaq. Another 15,000 trade over the counter (or on the so-called pink sheets). That’s a lot of companies! To truly understand all the aspects of an investment (its strategy, operations, financials, markets, competitors, etc.), we’ve found we can own no more than 25 stocks and have a level of comfort that we completely understand each of our holdings.

My business knowledge is wide, but incredibly shallow

To understand a company, an investor has to have considerable knowledge about their business and markets. Throughout my investing career, I’ve found two areas where I’ve developed deep industry knowledge – health care and informatics. Most of the holdings in our portfolios will be in one of those two areas. You may have considerable knowledge about certain industries because of your line of work. Great returns can be made by investing in what you know about. Conversely, bad returns can be generated by investing in something you know nothing about. As Thomas Watson Sr. (the founder of IBM (NYSE:IBM)) said, “I'm no genius. I'm smart in spots — but I stay around those spots.”

My criteria rejects roughly 99.99% of publicly traded companies

I’ve discussed in great detail Nintai’s criteria for selecting portfolio holdings. It focuses on businesses with high returns, little to no debt, deep competitive moats and are trading at a reasonable discount to our estimate of intrinsic value. After running a screen with our investment criteria, we are left with roughly 140 to 180 publicly traded stocks around the world. It’s a pretty small pond! We believe the criteria create a portfolio with sound downside protection (owe very little money and are deeply embedded in client operations) as well as upside potential (platform-based with multiple new market opportunities).

It works for us

A final reason (without trying to boast) is that it has worked - as configured by Nintai - for over 20 years. Our employees and investors have done quite well against the major indexes. (Remember: past returns are no assurance of future performance!)

Is Less Really More?

You might think I’m now going to demonstrate that good, old-fashioned, intellectual sleeve rolling helps most focused portfolios generate better returns than the general markets. That would be a misplaced assumption. In fact, the exact opposite is true. Nintai is in a very distinct minority of focused portfolios that has outperformed the general markets over extended periods of time (see the previous warning that past performance is no assurance of great future returns). As seen from the previous section, we’ve never run a focused portfolio because we think focus – by its very nature – outperforms the broader markets. Far from it. We run a focused portfolio out of necessity, not choice.

It turns out, running a focused portfolio – in general – isn’t an assurance you will outperform the markets. In fact, recent research by Morningstar demonstrates focused portfolios are no better (performance-wise) than broader index funds. However, they are more expensive by far. In Morningstar’s[2] “Portfolio Concentration Doesn't Have Much Sway on Returns,” Alex Bryan wrote that their research found there is no significant relationship between portfolio concentration and gross returns among U.S. equity mutual funds. The idea that allowing an investment manager to focus on his top picks will lead to market outperformance is really just all hogwash. This, of course, comes as a great surprise to focused investment managers (like me), investment management companies that market such funds and investors who put money in such funds.

Performance is similar to non-focused portfolios

Focused portfolios (as measured by the percent of assets invested in the manager’s top 10 picks) had little effect on gross return when compared to non-focused funds within their respective Morningstar category. Accordingly, the odds of choosing a focused fund that will outperform the Morningstar category average return is very low. In large (growth, core and value), mid- and small-cap stocks, performance during 2004 to 2018 between the least-focused quartile and the most-focused quartile was quite similar. In fact, in the total nine domestic stock categories, only two saw the focused portfolios exceed the least focused by more than 1%. When fees are taken into account, most outperformance is washed out.

Focused funds can deliver great outperformance….and great underperformance

As a portfolio becomes increasingly focused, the risk of wider swings in performance becomes much larger. For instance, a 100-stock portfolio had drawdowns of over 5% just once every 157 days from 2010 to 2017. A 20-stock portfolio had a similar drawdown every 34 days. Such swings happening at a far greater frequency can play old Harry on an investor’s nervous system. So remember, concentrated funds can deliver greater outperformance, but also greater underperformance. One other important reminder: Since the majority of all funds never outperform the general markets, it stands to reason neither do focused funds.

Focused funds are more expensive

The average focused fund charged between 25 to 50 basis points more than a traditional non-focused fund. The largest difference was in small caps - with focused funds charging roughly 39 basis points more. Large caps had the smallest gap, with focused funds charging roughly 21 basis points more. Looking at performance, it’s not clear paying such a greater amount in management fees is worth it in the long run.

Conclusions

Since founding the Nintai Partners Investment Fund in 2004, I have always run a relatively focused portfolio. Nintai Investments LLC continues that investment strategy. That said, as you look for investment managers, it’s perfectly fine to invest with one who maintains a portfolio of 300 stocks versus one who focuses on only 25 individual positions. The key is understanding why the manager believes a focused approach works better and what their record has been in using such an approach. Sometimes spreading a little canvas can be just as effective as shortening sail. It simply depends on the sailor and the conditions.

As always, I appreciate your thoughts and comments.

Disclosure: None, with the exception that I’ve read the Aubrey and Maturin canon (21 books) eight times over.

[1] For a far more detailed discussion on how we select holdings – and what criteria we use – please see my article “Our Investment Strategy and Portfolio Selection,” which can be found here.

[2] “Portfolio Concentration Doesn't Have Much Sway on Returns”, Alex Bryan, CFA, Director of Passive Strategies Research, North America, Morningstar Manager Research, May 1, 2019.

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About the author:

Thomas Macpherson
Thomas Macpherson is Managing Director and Chief Investment Officer at Nintai Investments LLC. He is also Chairman of the Board at the Hayashi Foundation, a Japanese-based charity serving special needs children and service pets. The views expressed in his articles are his own and not necessarily those of the firm. He is the author of “Seeking Wisdom: Thoughts on Value Investing.”

Visit Thomas Macpherson's Website


Rating: 5.0/5 (6 votes)

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Comments

snowballbuilder
Snowballbuilder - 4 weeks ago    Report SPAM

hi Tom, interesting article... i have a bit different lecture....

i think quite by intuiton you cant have much different (both in positive and negative sense) result than the market by holding 100 or 1000 stocks

To diverge you have to do something different

So having 5 - 10 stocks his a way to diverge (a lot) from the average. But of course some will diverge in the up and some in the low... so that on average focused investor will again have average result...

But a point remain ... almost all the most succesfull investor are focused one (look at Munger, Hohn of TCI, LiLu, Pabrai, Terry Smith, Akre, Rochon, ecc) ... they are the small group of investor that are focused and diverge from the average on the upside.

So i would not suggest the average investor of being focused but i still think the really talented one , the people who have the traits of the great investors (patience, courage, indipendent thinking ecc) ... will probably, in most case, find theirself focused in what their think are their best idea

Just some thoughts

With friendship Snow

Thomas Macpherson
Thomas Macpherson premium member - 4 weeks ago

Hey Snow. Great to hear from you. I completely agree with your comment. If you have any chance at beating the markets, then a focused portfolio gives you the best shot. BUT, the vast majority of focused portfoios don't beat their benchmark. As an investor, you need to weigh your increased chance at beating the benchmark versus the risk of not beating it at all. The data shows the vast majority of focused investors end up in the latter category. There are certainly exceptions to the rule as you point out, but my point is that investors should know the odds are not in their favor. Thanks for ther comment. It is great to hear from you. Best. - Tom

stephenbaker
Stephenbaker - 4 weeks ago    Report SPAM

Tom, interesting article. Some thoughts: You neglect to address a time frame or holding period. Assuming an ability to evaluate stocks, I would think the longer the time frame or holding period the better your results will tend to be with a focused portfolio. Personally, I subscribe to a rather simple set of criteria, which I believe have outperformed the averages. These criteria are (1) buy only the best companies in the strongest (not short lived) industries; (2) buy shares only when prices are well below the mean using a valuation metric like the case-shiller ratio (3) buy mostly shares of dividend paying companies so impatience does not typically become an issue; (4) buy shares of companies with proven management and a history of strong capital allocation skills; and (5) don't sell, regardless of price, as long as the original investment thesis remains in tact. If this sounds like the Munger approach to investing, well, it mostly is. It eliminates having to make investment decisions at nearly all times and even though accumulating cash is most often the rule of the day, when opportune times arise (and they always will, such as in 2000 and 2009) there is a lot of cash available to invest. One additional thought that is quite important: It helps to have a viable alternative to money market funds for at least some portion of your idle cash. Developing a side gig or enterprise using whatever skills you have to invest idle cash in times of low interest rates like today also helps to avoid making subpar investment decisions in less than stellar stocks.

Thomas Macpherson
Thomas Macpherson premium member - 4 weeks ago

Hi Stephen. Thanks for your comment. The time period was 2004 - 2018 (to include both bull and bear markets). The study doesn't go into holding times for the portfolios. My quess (and it is just a guess) is that turnover is comparative to slightly lower than the average fund. I completey agree with your criteria in terms of investment criteria. For me they key is to let compounding work.In regards to getting another gig, unfortunately my brain operates on only one track! Thankds again. Best. - Tom

stephenbaker
Stephenbaker - 4 weeks ago    Report SPAM

Tom, my bad - you did include the referenced time period. The point is, focused portfolios should outperform [more] over even longer time periods since the results of too-frequent investment decisions are magnified over longer time periods.

With no anecdotal data whatsoever, I suspect that professional portfolio managers who trade infrequently and outperform will be more, not less sought after, even when taking into account periods of relative underperformance. We are living in a time of index investors, many of whom have a single objective of average performance. Long term outperformance with limited tax consequences ought to be a valued commodity in your field.

Thomas Macpherson
Thomas Macpherson premium member - 3 weeks ago

Hi Stephen. I jast saw this. Sorry I didn't reply earlier. Your first paragraph makes perfect sense. Without data my hunch would be the same. However the data from Morningstar over a 15 year period says (on average) long term, little trading, focused investors don't add any value to most (and that's important to remember) of their investors. There are certainly some who do outperform but it isn't that many. I haven't seen the raw data but I'm planning on writing Alex to getter a better understanding. I will update if I hear more.

To your second point, I thought more individuals would be interested in Nintai's low-turover, focused investment style. Indeed, my record compares well to my benhmarks over the years. (no guarentee of future returns though!) But the move to indexing is so strong it's very hard to separate yourself out from the strong pull of that current. Thanks so much the very thoughtful replies. Best - Tom

Nicola Guida
Nicola Guida - 3 weeks ago    Report SPAM

Hi Thomas, thanks for the nice article. I agree with most of the reasons you laid down, and especially with the first ("The market is so big, and my mind is so small"). How could I follow each company (earning reports, 10-Qs, 10-Ks, news, etc.) if I would hold a lot of them?

From my experience, I know that I cannot handle more than 20 stocks, especially because I'm not following them 100% of my time and as I run my portfolio alone. When the market is overvalued, the number usually gets reduced to 10 or even 5 stocks.

Finally, a purely statistical consideration. We all know that even a single stock, held together to many others in the same portfolio, can considerably increase its performance (think about a company which can sustain very high returns on capital for many years..). So limiting the number of stocks is needed only because our circles of competence (and available time) are limited. I think that you could relax a little bit your (quantitative) selecting criteria if you could have the chance/time to analyze ALL of that thousands of companies, isn't it? You are forced to keep them very strict because you want to shoot fishes in a potentially good barrel without analyzing them one by one :)

Thomas Macpherson
Thomas Macpherson premium member - 3 weeks ago

Hi Nicola. Thanks for your comment. In regards to your third paragraph, the key to me is finding companies that earn high returns on capital - considerably higher than their weighted average cost of capital - and then hold to them like a hammerhead shark. This I see as a means for assuring profitability. I also seek companies with a systems or platform approach to their customer, meaning they seek to embed themselves within their customers and/or market. I also like to see them have an agnostic approach to technology to allow growth in adjacent markets. This assures growth. Finally I look for companies with a high conversion of revenue into free cash and also no debt. This assures safety. I see this as a 3 legged stool that allows me to sleep well at night and has worked for my investors over the past 20 years. In short, I'm unlikely "relax a little bit" in my approach ;o). Thanks for your comment. My best wishes. - Tom

Nicola Guida
Nicola Guida - 3 weeks ago    Report SPAM

Hi Thomas, thank you very much for explaining your approach in more detail, this is very good food for thought!

With my assertion I just wanted to say that some of the companies which don't satisfy all your conditions could sometimes be better investments that the ones which comply to them (simply because not every great investment will fall into a basket built with a quantitative method). This could encourage you (or any other investor) to relax that conditions in order to include these potential winners, but by doing that, the number of stocks could grow at a point that analyzing them would not be convenient anymore. I try to solve this issue by looking at various sources (e.g. stocks held by Gurus who I admire) as a starting point, in addition to ones which fall into my checklist. Thanks again for sharing your ideas! Best Regards, Nicola.

Thomas Macpherson
Thomas Macpherson premium member - 3 weeks ago

Hi Nicola. Thank you so much for your reply. I do have a list of funds and managrs who I watch quite carefully for their portfolio holdings. I've actually purchased 4 holdings into my portfolio that didn't meet my criteria but were in several of these individuals' portfolios. The results have been pedestrian at best and disasterous at worst. I guess this is a long winded way to say I'm a stubborn old goat! ;o). Thank you again for your very thoughtful comments. Best. - Tom

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