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License to Concentrate
Reflections on dogma, portfolio management realities and nature vs. nurture
There exists a concentration dogma that is especially prevalent among value investors, but also permeates much of the broader investing community. The number of pro-concentration statements that have emanated from Omaha over the years has only reinforced the idea that running concentrated is the “right” way to operate a portfolio. I recently had a wonderful conversation on Compounders with Aaron Wasserman of Third Period Capital where he said something fascinating about concentration. He essentially said that his portfolio would become more concentrated over time—mainly due to not selling winners—as he develops more conviction in the companies he deems to have the most uniquely additive cultures. In my experience, very few managers have the self-confidence to say that they are not sure about what concentration level is right for them or to admit that the number of stocks in a portfolio may not always correspond to what was probably a somewhat arbitrary number that was in the original operating docs. Most managers select a certain range of stocks to own at the outset and never deviate, mostly out of the fear that someone will accuse them of style drift. Investment management is a bizarre industry where you are expected to be consistent over time, even if it is to the detriment of your investors.
Aaron’s comments made me take a step back from the pure philosophy regarding concentration and contemplate a slightly more practical question regarding the number of securities that a given manager believes should exist in a portfolio. Why shouldn’t concentrating your portfolio on a small number of bets require a license, kind of like how we require teenagers to exhibit a certain understanding of the rules of the road and a degree of aptitude when it comes to driving before we let them get behind the wheel? That license can either come from overall experience as an investor, or—as in Aaron’s case—deep intellectual history with a given set of businesses. Being a little more precise, is concentration something that should be determined irrespective of age and experience or should the level of concentration evolve with the investor?
I should note that I have grown up within the cult of concentration, the virtues of which were pounded into my head the minute I graduated from business school. However, one of the themes I will be tackling within these writings is the importance of re-thinking certain ideas that many of us hold dear. On that I note, I actually went the trusty Google Scholar site to see if there was any compelling academic evidence that concentrated funds outperform their less concentrated counterparts. I found a paper from 2019 where the authors reviewed a bunch of prior literature and came to some conclusions of their own. I was not surprised to see that the findings were mixed as it relates to the benefit of concentration. My guess is that survivorship bias makes it really hard to figure out comparative historical performance. (If anyone knows of good academic research on this topic, I would love to see it.)
Anyway, I am certainly not trying to become a heretic or be excommunicated from what is sort of a religion among the most devout concentrated investors. I am actually a believer in the merits of concentration. But my experience has highlighted to me that circumstances have to be right. Accordingly, I am going to propose some practical guardrails—many of which were based on my own experiences running a 20-something stock portfolio for outside clients—that hopefully can help managers ponder what level of concentration works for them and allocators figure out if a potential or existing manager has a manageable number of stocks.
Origins of concentration
The nature versus nurture question all parents inevitably confront is also relevant within the investing context. If your formative years were with a mentor who ran a 10-stock portfolio, my guess is that you are going be very “comfortable” running pretty concentrated. On the other hand, if your mentor was someone like Fidelity’s Will Danoff, you might think that a 100-stock portfolio is really concentrated. I doubt any investor’s predisposition towards concentration is purely innate. Sure, people with a higher risk tolerance may be more disposed to having 15% positions. But the context still really matters and my supposition is that it is all relative. We anchor to what we see in our surroundings and soak up the investment cultures we spend time within. If we see other people we respect running X number of stocks, our comfort zone will probably be X plus- or minus-10.
In my case, Cove Street’s founder ran a 30-something stock small cap portfolio and, basically irrespective of anything other than his intuition and preference, it was deemed that my SMID-cap strategy would never would have more than 29 stocks. In fact, the idea that “if you can’t have a 5% position in a certain stock, then it is not even worth doing the research” was repeatedly beaten into my head. He didn’t ask me what I thought and honestly I was happy to take my cues from him. He was more experienced and had raised billions in capital. Who was I to question his business sense and portfolio construction acumen?
I want to be clear that I am not criticizing my old boss in the slightest. My guess is that my situation is not unique—any new strategy will inevitably look something like the other strategies at a firm, unless a client asks specifically for an ultra-concentrated version of an existing strategy. No client really wants to see a firm that values concentration start a 100-stock portfolio. Brand consistency is quite important within investment management, especially within the boutique world.
The more relevant question is what do I believe about concentration? Asking that question is kind of like asking a fish what it believes about water. If all you ever knew was concentration (or water), you would probably believe that it was good or right or the only way to invest. As such, I am not sure I have evolved in any real sense since I started managing money back in 2016. If anything, the portfolio I run today is more concentrated that it has ever been. Have I earned the right to be more concentrated? Or, should the mistakes I have made in position sizing (umm, LUMN) lead me to be a little more diversified to protect against the severity of being wrong in one of my largest positions? My current stance is that my mistakes and the lessons I have learned from them have created the necessary preconditions for me to sleep well at night only owning 20 stocks. I definitely could not have said that 2 years ago.
Consider the context
My basic argument is that context really matters when it comes to how many stocks a specific investor can a) know really deeply and b) risk manage effectively. Some contextual variables that can vary widely by manager and firm include:
The experience level and age of the manager
How long someone has been running a given strategy and covering a certain universe of stocks
The abundance or scarcity of resources that support the manager
The duration of the capital provided to the manager and any outside clients’ willingness to stomach volatility and short-term underperformance
If we just consider the four above variables—and I am sure there are more—how can anyone argue that concentration is either good or bad intrinsically? It simply cannot be that what works for 99-year-old billionaire Charlie Munger makes just as much sense for someone who is starting her first fund at 29. In my experience, at 29, you have not made enough mistakes yet to know all the ways in which investing in public companies can go wrong. Over the next 15 years, you will lose money in ways that you could not have even fathomed. That’s why this game is so infuriating.
I get why emulating the philosophies of successful investors is so attractive. I won’t belabor this topic again because I discussed survivorship bias in great detail in my first post. But, despite the hype, the reality is that running concentrated is a very effective way for a fund to go out of businesses or to lose a seat as a manager. The people you see with solid long-term track records who run sub-30 stock portfolios are the survivors. What you don’t know is the base rate of success.
For anyone not intimately familiar with Mike Mauboussin’s excellent work on base rates, the idea is that before embarking on any new endeavor, it would be really helpful to know the rate of success and failure of all the people who tried the same thing in the past. In the case of running concentrated portfolios, you would want to know, out of all of the people who ran sub-30 stock portfolios for at least 5 years (10 years?), how many of them are a) still managing that strategy and b) have been able to beat the market over that time? I don’t know the specific base rate for this reference class but my premise is that it is low. Now, a thoughtful investor whose firm runs a 6 stock portfolio once said to me that even if the probability of success is low, a manager should run super concentrated because that is the best way to create outsized returns over time. I guess it depends on your definition of success. As I highlighted in the post on survivorship, I am hoping to be one of the survivors—and running a 6 stock portfolio materially reduces the probability of being around in 10 years. A bad start, a bad 18-month period, or a single blowup in the portfolio can knock you out of the game. Such odds do not still well with my personal risk tolerance.
Determining what is “right” for you
The purpose of this piece is to get readers to analyze their beliefs about the merits of concentration, whatever that term means to them. Nearly every investor will see someone running a certain portfolio and say “whoa, those guys run really concentrated.” Even if you run 6 stocks, there is someone who owns 2. My humble suggestion is that whatever you believe, it is likely not intrinsic; it is a product of the environments in which you have grown up as an investor. Most of us cannot separate those influences from our genetic makeup as it relates to risk and the ability to develop conviction. Accordingly, maybe the best any of us can do is come up with a personal list of preconditions that should be present to overweight certain securities within a portfolio, or to simply run with a small number of stocks. As referenced above, here are a handful that are very important to me:
You have been really, really wrong about a stock for which you had a ton of conviction. Nothing humbles you and teaches you lessons about risk management more than losing money.
You have covered the universe of stocks you focus on long enough to be somewhat familiar with the opportunity cost of owning one stock versus another. In other words, you kind of know what else is out there well enough to have some level of conviction that what you own is superior.
You have an unshakeable sense of what kind of stocks fit with your risk tolerance and temperament. Believe me, if you don’t have the risk appetite for deep value stocks and you end up owning them in size, you are going to be miserable in worrying about all the things that can go wrong. I personally needed a North Star that I didn’t truly articulate until I had been running a portfolio for a few years. In my case, that consisted of businesses that I believed would be worth more in 7 years. If that is your line in the sand, you can eliminate a whole universe of companies. But if you don’t have that guiding light, I think it is quite risky to concentrate your bets.
You have ability and the bandwidth to develop a deep knowledge of the companies you own—not just a cursory understanding. This is where getting feedback from colleagues can really help. If you can’t answer a lot of their questions in a meeting, you probably need to dig a lot more before buying the stock and making it a large position. I admit my bias here. I am the kind of guy who takes a long time to make decisions. It means I miss opportunities because my research process is so deliberate. But I still believe that there is a pretty tight correlation between what I would call earned conviction and knowledge of a company or an industry. Sadly, such knowledge is necessary but not sufficient for suggest in my experience.
You have a client base that can stomach some level of volatility of returns and short-term underperformance. The hardest part about pleasing clients as a concentrated manager is that, many seemingly like-minded clients love high active share when returns are good but then are disappointed when your upside capture, for example, trails in a rising market. Which is it Madame Allocator? Do you want a manager to look different from the chosen index or not? Last I checked, being different from the index is the only way to beat it consistently. Owning different securities virtually guarantees that there will be periods in which an active manager, especially one with high active share, will underperform. Accordingly, the less benchmark obsessed your clients are, the more likely you are to be successful running concentrated.
You have developed the ability to seek disconfirming information and admit when you are wrong. We all create narratives about companies as we build a mosaic with all of the information we gather. That is when the behavioral biases, such as the endowment effect and the sunk cost fallacy, really start to show up. Good investors look for reasons why their theses are wrong and are quick to sell when their prior beliefs have been violated. My sense is that there is also a high correlation between large position sizes and overconfidence. Successful, concentrated investors are a paranoid bunch who are always looking around the corner for what can go wrong.
There are definitely some preconditions I am missing. This is not meant to be an exhaustive list. What I am attempting to highlight is that there are certain things that need to be in place before a given investor should feel comfortable operating with large position sizes. Think of these as akin the license referenced above. Getting back to the original point about dogma, my concern is that when you hear an investor extolling the virtues of concentration, you never hear the long list of caveats. You don’t get the laundry list of side effects like you hear at the end of a commercial for a new pharma drug. WARNING, running concentrated may cause:
Premature gray hair and hair loss;
Fantastical thoughts regarding M&A premiums and stock appreciation;
Irritable client syndrome;
Long-term benchmark underperformance; and
(Most importantly) The manager to get knocked out of the game
What to make of this as a manager
If a manager reading this was hoping for some irrefutable advice on how many stocks to own, I don’t have a good answer. Like with many things in life, it depends. All I can suggest, having struggled with this myself, is to first consider where your general impressions about the “proper” number of stocks to own comes from. Once you have established the origin story, think about what suits your general temperament. I am pretty loss and risk averse—but within the context having grown up in an environment where concentration was the gospel. As a result, I operate in a constant state of cognitive dissonance. I run concentrated despite being risk averse. As I have become more comfortable in my own skin as an investor, I have learned to live with that duality. However, I would encourage people to ask: where do I sit on the risk-seeking versus risk averse scale? Next, if you do decide to run concentrated, make sure some of the above preconditions—or ones that are more relevant to you—are satisfied. Finally, give yourself a license to change your mind and evolve. We all change as we gain more experience. Don’t feel the need to stick to something because it is what you said you believed 10 years ago.
What to make of all of this as an allocator
My hope is that my writings appeal to both managers and allocators so I am going to try to put my allocator hat on as much as I possible. The question of how an allocator can ascertain if a given manager is too concentrated—or not concentrated enough—is a tough one. The concentration dogma is as strong among certain allocators as it is within the managers who pray to the alter of concentration. I think that favorable view can lead to a certain blindness that obscures the low probability of success of such strategies. Specifically, it leads to ignorance of base rates. When an allocator makes the call that a manager has “talent” or the requisite skill, in many cases he or she may do so without considering the entire reference class. If I were an allocator who was considering a pretty concentrated strategy, I would look in the mirror and ask myself if I truly believe I can identify a new or existing manager who can defy the base rates. Sure, if the person has outperformed pretty consistently over 20 years, then the probability of that person doing so in the future is higher than it is for other managers. (There are no absolutes here—this is about handicapping probabilities.) Unless of course that person is running 10x the capital now or has had 1 or 2 major incredible winners that are going to be hard find again.
Allocating capital to specific managers is hard. That is why most endowments, pensions, foundations, etc. work with a lot of managers. In aggregate, the allocator owns a ton of stocks even if each individual manager runs concentrated. Diversification is to some extent the antidote to the challenge of determining the probability of success of an individual manager. But if you are going to place capital with concentrated managers, it behooves you to make a list of the preconditions you think should be there. (Please feel free to steal any of mine that resonate with you.) From there, remember that the blow up risk has to be higher and consider whether your career would be impacted if you underwrote the wrong manager. (By the way, I think that problem is especially acute when evaluating the potential downside of working with a smaller, boutique manager.) Lastly, approach the selection process with humility and the awareness that assessing people is by definition an error prone endeavor. Being a good allocator requires a mix of arrogance and humility, just like being a professional stock picker does. You develop conviction that you can pick the public equity managers who are going to be the most successful, even in the face of unattractive base rates—the arrogance part. Just don’t forget that choosing from a group of concentrated managers elevates the probability that some could fail quite spectacularly.
In closing, I have thrown a lot out there on the topic of concentration. Some of it many of you will likely disagree with. As such, I would look forward to this being the start of a conversation about concentration.
Constantly re-evaluating what I thought I knew,