Putting all your eggs in a very few baskets | A perspective on Concentrated Investing

In pursuit of building an investment portfolio, one often hears, ‘Don’t put all your eggs in one basket’. Especially when investing in equities, it cannot be denied that each company out there runs an idiosyncratic risk of its own. One may (and some do!) be successful in building a fortune in the markets by investing in just one company, which eventually will become a multi-bagger. However, the same company, if tides turn, could go downhill and the investor could see his wealth getting wiped out in almost no time.

Enter, diversification! Prudent portfolio management, along with other things, is about allocating money across multiple securities and asset classes. The more the number of securities in the portfolio, the lesser the possibility of all securities falling simultaneously in value. Thus, diversification achieves the objective of reducing downside risk while capturing a moderately high return on investment. Diversification becomes critical for the safeguarding of capital, particularly when building an investment portfolio to meet future financial needs.

It should, however, be noted that higher diversification will also limit the upside one can make on the portfolio. For example, even if an investor held a stock, say Stock A, that tripled in value (ie. gave a 200% return), her overall portfolio return would be minuscule if this stock were a mere 1% of her total holding. If, on the other hand, she had invested 20% of her portfolio in Stock A, her portfolio return would have been a massive 40%. Indeed, some of the most successful investors of all time have been able to generate phenomenal returns in the markets by managing focused portfolios – holding very few but thoroughly evaluated securities. This creed of investors follows what we call ‘Concentrated Investing’.

Concentrated Portfolios generally comprise of a very few (generally 1 to 15, or maybe more) stocks. It is not uncommon for investors to build portfolios that have as few as 3 stocks comprising over 60-80% of their total holding. It goes without saying that these investors perennially run the risk of losing huge sums in the markets. Let’s just say, that if their chosen stocks work, they build a fortune, else their capital takes a huge hit.

History is replete with stories of individuals who placed huge bets on a few selected names and eventually generated huge returns on investments. For example, in the mid-1960s, a young Warren Buffett took the call of investing ~40% of Buffett Partnership Ltd.’s portfolio (before his Berkshire Hathaway days) in a single stock, American Express (‘Amex’). Amex was embroiled in the salad oil scandal back then and saw its price fall below its book value. Perceiving this phase to be a short-term crisis for a high-quality business, Buffett placed his bets on Amex. The stock doubled in less than three years, and Buffett ended up with excellent medium-term returns. Similarly, in the mid-1950s, Claude Shannon, the renowned mathematician, built a portfolio that had ~25% of its corpus invested only in Teledyne. This one stock alone returned 19,338% over a period of 30 years, significantly increasing his portfolio value.

While these examples do sound inspiring and fascinating, one must realize that alongside every successful investor there exist scores of people who may have made mediocre returns, or at worse, seen their wealth getting eroded as a consequence of taking concentrated positions. Even in cases where this strategy has worked over longer periods, huge swings in portfolio returns in the short to medium term are inevitable.

Consider the below numerical illustrations:

• To assess the effect of concentrated investing over longer periods, two hypothetical investment portfolios have been constructed. The performance of these portfolios over a 15-year period has been analyzed. Portfolio returns are compared with that of the NIFTY 50 Total Returns Index (the benchmark).
• Each portfolio comprises of 4 stocks from the NIFTY 50 universe of stocks. Both the portfolios have a starting value of ₹100,000 invested equally in the 4 stocks. The initial investment is made on January 01, 2004. No changes have been made in the portfolios since then.

The following stocks have been chosen for the hypothetical portfolios:

• Portfolio 1: Eicher Motors, Reliance Industries, HDFC Bank, Sun Pharma
• Portfolio 2: Maruti Suzuki, BPCL, ICICI Bank, Cipla

The following are the performance metrics of the portfolios/benchmark:

The following is the relative performance of the two portfolios vis-a-vis NIFTY 50 TRI from January 01, 2004 up to July 30, 2019:

Comparative Analysis:

• We can see that Portfolio 1 has been able to multiply the initial investment by close to ~33 times. On the other hand, Portfolio 2 has grown only ~8 times, which is only slightly more than the benchmark (~7 times).
• The substantial difference between the returns generated by the two portfolios is on account of the selection of stocks. As can be seen from Table 1, all the chosen stocks in Portfolio 1 significantly outperformed NIFTY 50 TRI over a 15-year period. In the case of Portfolio 2, however, two (BPCL, Cipla) out of four stocks underperformed NIFTY 50 TRI, while the other two stocks (Maruti Suzuki, ICICI Bank) generated only a small alpha over NIFTY 50 TRI in the 15-year period. The result was an overall return more or less in line with the benchmark.
• Another point to be considered is the risk associated with both the portfolios. The Standard Deviation of Returns for both the portfolios is higher than that of NIFTY 50 TRI. This is indicative of the higher volatility in the returns of these concentrated portfolios.

Conclusion:

John Maynard Keynes, the father of Keynesian Economics, is credited with achieving superior returns for King’s College endowment by employing concentrated investment strategies. In one of his letters, the following thoughts appear:

“I get more and more convinced that the right method in investment is to put fairly large sums into enterprises which one thinks one knows something about and in the management of which one thoroughly believes. It is a mistake to think that one limits one’s risk by spreading too much between enterprises about which one knows little and has no reason for special confidence.”

Concentrated Investing requires, research that is deep and thorough, choices that are rigorously evaluated, a conviction in chosen companies that is very high, and more importantly, trade-offs that are rock solid and crystal clear. Please note that this write-up is presented only to provide a perspective on a style of investing. Readers are advised to weigh all the risks while choosing appropriate investments.

References:

Allen C. Benello, Michael Van Biema, & Tobias E. Carlisle. (2016). In Concentrated Investing - Strategies of the World's Greatest Concentrated Value Investors. John Wiley & Sons, Inc.