European Insights


To concentrate, or not to concentrate?

02 December, 2020

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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.

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