It’s 13F season. That means institutional investors have reported fourth-quarter changes to their portfolios to the Securities and Exchange Commission (SEC). Because the SEC makes 13Fs public, institutional investors are reporting these changes to you and me.
I frequently peruse 13Fs to see if billionaire money managers I respect might have added an investment or two that might be of interest. At the same time, I make mental notes to get a sense of how they are constructing their portfolios. Over the years, I’ve found that the most successful money managers employ a strategy I have long advocated – concentrated investing.
Ray Dalio runs Bridgewater Associates, a very large, successful hedge fund. If you were to simply glance at Bridgewater’s 13F, you’d think Dalio’s portfolio was very diversified and very dispersed. Bridgewater’s 13Fs reports hundreds of securities. Upon slightly closer inspection, though, you’d find that nearly 88% of Bridgewater’s portfolio is concentrated in only three (that’s right, three) investments. The rest of the portfolio appears to be composed of little more than small-potato side bets.
Prem Watsa of Fairfax Financial runs an investment portfolio composed of 45 stocks. Again, diversification appears to be the order of the day. But when we look closer, we find that two of Fairfax’s holdings account for 66% of the portfolio’s value. Toss in the third-largest holding, and the percentage is bumped up to 80%. Three stocks account for 80% of portfolio value.
Bill Ackman at Pershing Square Capital is concentrated through and through. Pershing Square’s 13F reports a mere seven investments at the end of 2014. One investment – Allergan (NYSE: AGN) – accounted for 35% of portfolio value.
Dalio, Watsa and Ackman are all billionaire money managers. But no money manager is more successful than Warren Buffett. Buffett’s most productive years were also his most concentrated.
From the mid-1970s through the mid-1980s, Berkshire Hathaway’s (NYSE: BRK.a) stock portfolio rarely exceeded 10 issues. At the end of one year, 1986, Berkshire’s stock portfolio comprised only three stocks – Capital Cities/ABC, GEICO, and The Washington Post Co.
At the end of 1975, a Berkshire share was valued at $41. By the end of 1987, it was valued at $2,820. That’s a 47% average annual rate of appreciation.
Since then, Berkshire’s stock portfolio has ballooned to more than 40 issues, while its portfolio of wholly owned companies exceeds 50. Berkshire today is a huge diversified conglomerate. Performance has suffered for it. Over the past 15 years, Berkshire shares are up 280%, which is still good, but not great by 1980s standards.
I don’t suggest whittling your investment portfolio to three stocks. But a portfolio of 10 to 12 stocks can go a long way to improving returns. Surprisingly, such concentration won’t materially increase your risk profile.
An influential 1968 article written for the Journal of Finance titled “Diversification and the Reduction of Dispersion: An Empirical Analysis” revealed that as few as 10 securities can reduce volatility, measured as standard deviation, to a level virtually identical to that of the market.
Balance is key. You don’t want to overweight an individual security or sector. Pick the most promising investment from a sector and don’t dilute with a bunch of also-rans. At the same time, buy stocks with opposing interests. Diversify across sectors and avoid overloading one specific sector.
I’m a fan and practitioner of concentrated portfolio investing. It’s the only way I know to beat the major market indices over the long haul. What’s more, it puts you on the same plane as the best institutional money managers.
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