Don’t underestimate the power of concentration, but not that concentration.
Yes, the ability to focus on the task at hand is a contributing factor to success, but that’s not the concentration I refer to. I refer to concentrating your stock portfolio on just a few issues.
If you vet the investing strategies of the great investors, you’ll find a wide field of stock preferences. Some prefer value, others growth. One portfolio is composed of big-cap stocks, while another is composed of small caps. One investor loves momentum, while another one hates it. The affinity for a certain category of stocks might vary, but whatever the category, you’ll frequently find the focus is on a limited number of stocks.
Today, Berkshire Hathaway (NYSE: BRK-B) is a sprawling conglomerate. It has full or partial ownership interest in over 90 companies. Berkshire’s stock portfolio comprises 47 different issues. Berkshire is not only a sprawling conglomerate, but a well-diversified one.
You could argue that Berkshire is too well diversified. To be sure, Berkshire has a long history of outpacing the S&P 500, but most of that history is the distant past. Over the past five years, Berkshire’s share price has actually lagged the S&P 500. The S&P is up 78%; Berkshire shares are up 74%.
The fact is that Warren Buffett generated his biggest returns for Berkshire when he ran a concentrated stock portfolio. Though most of the 1980s, Berkshire’s common stock portfolio rarely exceeded 10 issues. In one year, 1987, Berkshire owned as few as three issues. Six to eight was the norm.
Over the decade of the ’80s, Berkshire shares appreciated at an eye-popping 42% average annual rate. As for the S&P 500, it appreciated at an 11% rate.
Buffett may no longer practice concentrated investing, but many successful investors still do:
- Carl Icahn has 91% of his portfolio concentrated on 10 issues.
- Bruce Berkowitz of Fairholme Capital Management owns 16 issues, of which the top 10 comprise 99% of the portfolio.
- Lou Simpson of SQ Advisors owns 12 issues.
- Mohnish Pabrai of Pabrai Investments owns seven issues, as does Bill Ackman of Pershing Square Capital Management.
- Charlie Munger, Warren Buffett’s long-time partner at Berkshire Hathaway, runs a four-stock portfolio at the Daily Journal.
- Richard Blum of Blum Capital Management owns a mere three stocks.
Holding so few stocks appears risky. After all, Bill Ackman continues to capture headlines with his infamous Valeant Pharmaceuticals International (NYSE: VRX) investment. Valeant accounted for 30% of Pershing Square’s long portfolio before Valeant’s share price was slashed nearly 50% two weeks ago. Keep in mind, though, that from 2004 through 2014 Pershing Square generated a 692% total return net of fees.
The good news is that a concentrated portfolio is less risky than you might think.
An influential 1968 article written for The Journal of Finance, “Diversification and the Reduction of Dispersion: An Empirical Analysis,” showed that as few as 10 issues can reduce volatility to a level virtually identical to that of the market. The authors found that gains to diversification are strongest up to five stocks. When a portfolio reaches 10 to 15 stocks, maximum benefits are achieved. After that, the curve levels out and risk-reduction gains are minimal.
The problem for individual investors is how to construct a concentrated portfolio. Fifteen gold-mining penny stocks will hardly do. For that matter, 15 of the world’s largest energy stocks won’t do either. You’ll also want to avoid going big on one stock, a la Bill Ackman.
Balance is key: You don’t want to overweight an individual security or an individual sector. And if possible, you want opposed risk: Consider pairing stocks, such as an airline stock with an oil stock, or a consumer-product stock with a tech stock.
Yes, a portfolio of 15 stocks will be more (but not necessarily much more) volatile than a portfolio of 150 stocks, but it also has the potential to be a lot more profitable.
Along those lines, you’ll find 10 of the world’s best portfolio anchors right here.