European Insights

Share:

To concentrate, or not to concentrate?

02 December, 2020

Insights banner

In what to some might appear an absurdity of human behaviour, often the best ideas can be diluted down to the point of ineffectiveness. During the years of particularly unpleasant medical treatment in the early 19th century (think purging and excessive blood-letting), patients and doctors alike could be forgiven for clinging tightly to less invasive medicines that appeared efficacious. One of these was the discovery of quinine — from the bark of the Peruvian Cinchona tree — as an effective treatment for malaria.

This treatment, along with others such as the first inklings of vaccination, inspired a certain Doctor Hahnemann to begin a long journey of complex, but ultimately incorrect, assumptions that in general, “like cures like” and culminated in this work Essay on a New Principle for Ascertaining the Curative Power of Drugs (1796.) By 1815 Hahnemann's thesis was that by diluting the concept of dosing in small amounts to produce symptoms, he was still able to cure patients. Unfortunately he was diluting his medical preparations to such an extraordinary extent that by the fourth dilution, the medicine-to-solution ratio would be 1:100,000,000. Hahnemann countered criticism from other physicians of the time by claiming that his medicines retained their power as long as you shook the preparation incredibly violently, which he called 'potentisation'. He also claimed that the active ingredient would persist as a dematerialised spiritual force.

This bastardisation of concept is not limited to medicine and, in fact, can be seen across almost any sphere of interest or profession. Investing is an extraordinarily diverse and multi-faceted discipline where styles, beliefs and skillsets have taken on an almost religious tone amongst some of its followers. In some ways this explains how promising ideas are often diluted, frequently to the detriment of those involved.

John Maynard Keynes, covered in fanatical detail in almost every investment blog, paper or economic chatroom rant, is revered for his contribution to economic theory. But what some may be less aware of is his track record as an investor: he ran the Chest Fund at King's College in Cambridge. Prior to 1920, King's College's investments were solely fixed-income securities, but Keynes persuaded the trustees to invest in common stock too. Keynes would go on to outline his investment principles in full in a policy report a few years later:

  1. “A careful selection of a few investments having regard to their cheapness in relation to their probably actual and potential intrinsic value over a period of years ahead and in relation to alternative investments at the time.
  2. A steadfast holding of these fairly large units through thick and thin… until either they have fulfilled their purpose or it is evident that they were purchased on a mistake.
  3. A balanced investment position i.e. a variety of risks in spite of individual holdings being large, and if possible, opposed risks.”[1]

Keynes and a number of his peers were what we would now deem as concentrated, bottom-up investors. When one looks back at how investing has morphed and melded itself over the decades, it is interesting to note that equity portfolios tended to be on the more concentrated side - between 30 and 50 stocks - for at least the first half of the century. But it appears that around the 1970s, when the first index fund came into being in the United States, perhaps correspondingly about a decade after Harry Markowitz's seminal work on diversification[2], fund managers began diversifying their portfolios.

Unfortunately, a central tenet of finance theory - that investors can reduce risk without sacrificing return by adding uncorrelated assets - became adulterated as over-diversification became rife amongst managers. This dilution of the principle resulted in tracking error and relative volatility becoming markers of a manager's skill, rather than their ability to invest successfully in companies on behalf of their investors. The reputation of the fund management industry consequently suffered as concerns over 'closet tracking' funds crystallised, impacting active managers in particular. At the same time, the average holding period for publically-listed equities began to fall dramatically and investors' time horizons shrank accordingly. As V. Eugene Shahan noted: “It may be another of life's ironies that investors principally concerned with short-term performance may very well achieve it, but at the expense of long-term results.”

There are innumerable academic studies that purport to show how particular investing styles give the best performance, often contradicting each other from the outset. But what is an almost incontrovertible truth is that the closer and closer a fund resembles an index or a benchmark, the harder it becomes for it to outperform.

The principles of concentration are by no means suitable for all investing styles. For managers who analyse companies from the bottom up, however, it appears to be a route to success if executed correctly. Going back to Keynes' principles set out above, it requires a deep and thorough understanding of the underlying business; not just the company balance sheet, but its competitors, its management (down to individuals), its customer base, and its social and environmental impacts. It is only then that a manager can have the conviction to hold substantial portions of a portfolio in a single company. And even then, it requires a manager to hold that singular skill of being a 'stock picker.'

Ultimately, when discussions of diversification occur, too often they ignore the underlying companies within either a concentrated or 'diversified' portfolio; in other words, concentrated or diversified into what? If an investor owns a concentrated portfolio of companies that are subject to intense competition, have poor management teams and are unable to beat their own cost of capital, then it might be fair to assume that returns will be hard to come by. Alternatively, it is entirely possible to own excellent companies which, importantly, are uncorrelated on other measures.

This leads us to our final point: concentration does not necessarily need to be antonymous to diversification. If certain levels of stock diversification can be achieved by holding between 20 and 30 stocks of excellent companies, then a skilled fund manager should further be able to control market risk from sectors, revenue sources, and investment themes - to name but a few - through careful selection and construction. The risk profile then may be more predictable through a manager's skill, something investors should potentially look for when seeking out active management.

Alas, there is no definitive answer to how to always outperform the market. Indeed if there was, everyone would be doing it. But perhaps there is an answer in the combination of all of the myriad of precursory 'ifs' and 'buts' that come before the ultimate goal. It appears to us that concentrating a portfolio into the best companies an investor can find, over long time horizons, unshackled from short-term noises emanating from the market, and still providing sufficient diversification, well, that might just be the best chance to achieve the returns that investors deserve.


[1] The Warren Buffet Portfolio, Robert G. Hagstrom, 1999.
[2] Portfolio Selection: Efficient Diversification of Investments, Harry M. Markowitz, 1959.

Back to articles

WANT TIMELY NEWS AND UPDATES STRAIGHT TO YOUR INBOX?

Subscribe to our newsletter here

European Equity Strategies

Learn more

This website and its contents (the “Site”) has been provided by RBC Global Asset Management (“RBC GAM”) for informational purposes only and may not be reproduced, distributed or published without the written consent of RBC GAM or its affiliated entities listed herein.

In Canada, this Site is provided by RBC Global Asset Management Inc. (including PH&N Institutional) which is regulated by each provincial and territorial securities commission with which it is registered. In the United States, this Site is provided by RBC Global Asset Management (U.S.) Inc., a federally registered investment adviser. In Europe, this Site is provided by RBC Global Asset Management (UK) Limited, which is authorised and regulated by the UK Financial Conduct Authority. In Asia, this Site is provided by RBC Global Asset Management (Asia) Limited to professional, institutional investors and wholesale clients only and not to the retail public. RBC Global Asset Management (Asia) Limited is registered with the Securities and Futures Commission in Hong Kong.

RBC GAM is the asset management division of Royal Bank of Canada (“RBC”) which includes RBC Global Asset Management Inc., RBC Global Asset Management (U.S.) Inc., RBC Global Asset Management (UK) Limited, RBC Global Asset Management (Asia) Limited, and BlueBay Asset Management LLP, which are separate, but affiliated subsidiaries of RBC.

Nothing contained in or on the Site should be construed as a solicitation of an offer to buy or offer, or recommendation, to acquire or dispose of any security, commodity, investment or to engage in any other transaction. This Site is not intended to provide legal, accounting, tax, investment, financial or other advice and such information should not be relied upon for providing such advice. RBC GAM takes reasonable steps to provide up-to-date, accurate and reliable information, and believes the information to be so when produced. The information, including layout, of this Site, may be wholly or partially suspended, withdrawn or changed at any time. We also reserve the right at any time to immediately suspend the provision of all or any part of this Site to you and/or block your access to this Site.

Information obtained from third parties is believed to be reliable, but no representation or warranty, express or implied, is made by RBC GAM, its affiliates or any other person as to its accuracy, completeness, reliability or correctness. The views and opinions expressed herein are those of RBC GAM and are subject to change without notice.

Any investment processes described in this Site may change over time. The characteristics set forth in this Site are intended as a general illustration of some of the criteria considered in selecting securities for client portfolios. Not all investments in a client portfolio will meet such criteria.

Past performance is not indicative of future results. With all investments there is a risk of loss of all or a portion of the amount invested. Where return estimates are shown, these are provided for illustrative purposes only and should not be construed as a prediction of returns; actual returns may be higher or lower than those shown and may vary substantially, especially over shorter time periods. It is not possible to invest directly in an index. Interest rates, exchange rates and market conditions are subject to change.

The Site may contain forward-looking statements about general economic factors which are not guarantees of future performance. Forward-looking statements involve inherent risk and uncertainties, so it is possible that predictions, forecasts, projections and other forward-looking statements will not be achieved. We caution you not to place undue reliance on these statements as a number of important factors could cause actual events or results to differ materially from those expressed or implied in any forward-looking statement. All opinions in forward-looking statements are subject to change without notice and are provided in good faith but without legal responsibility.

Certain names, words, titles, phrases, logos, icons, graphics or designs or other content in the pages of the Site are trade names or trade-marks owned by RBC or its subsidiaries, or trade names or trade-marks licensed to them. The trademarks are distinguished from one another and accompanied, at first-time use, with the appropriate trademark symbol: ®/TM. These symbols are keyed to their respective legend which describes the owner or licensee of the trade-mark. The display of trademarks and trade names on pages of the Site does not imply that a license of any kind has been granted to anyone else. The information is for your personal use only. Any unauthorized downloading, re-transmission, or other copying or modification of trademarks and/or the contents of the Site may be a violation of any federal or other law that may apply to trademarks and/or copyrights and could subject the copier to legal action. The information is protected under the copyright laws of Canada and other countries. Unless otherwise specified, no one has permission to copy, redistribute, reproduce, republish, store in any medium, re-transmit, modify or make public or commercial use of, in any form, the information.

Cookie Policy
What are Cookies?

A cookie is a small text file containing a unique identification number that a website sends to your computer's web browser. When you visit a website, a cookie may be used to track the activities of your browser as well as provide you with a consistent, more efficient experience. Cookies cannot view or retrieve data from other cookies, or capture files or information stored on your computer. Only the website that sends you cookies is able to read them.

How do we use Cookies on this website?
1. To Improve Functionality

This website uses cookies to monitor and improve operations and functionality. These cookies do not contain personal or financial information. They gather statistical data such as the average time spent on a particular page. This kind of information provides insight on how to improve the design, content and navigation of the website.

2. Site Personalization

This website uses cookies as a means of offering visitors a personalized experience for future visits. For example, a persistent cookie is used to record if you have accepted the use of cookies on the website. This cookie allows you to browse the website in future without being shown our cookie notice every time.

Declining Cookies

It is possible to still browse this website even if you decline cookies. However if you choose not to accept cookies, some aspects of the website may not function properly or optimally. Cookies are widely used and most web browsers are configured to accept cookies automatically. If you prefer not to accept cookies, you may adjust your browser settings to notify you when a cookie is about to be sent, or you may configure your browser to refuse cookies automatically. If you would like to learn more about your cookie options, please refer to your browser's documentation or online help for instructions. To learn more about cookies, including information on what cookies have been set on your computer and how cookies can be managed and deleted, visit www.allaboutcookies.org.