Concentration

[Uccmal]

I added one new company in 2012 - AIG.

 

My obsevation, looking back over my record is that the very best investments I have made were ones that I entered into slowly over a period of time.  There is a long dating period before we move in together. 

 

I have probably held in the low hundreds of different companies over 15 years but only a handful have ever exceeded 10% of my total portfolio, based on purchase price.  Many I have started off liking but they do something that ruins our relationship, and out the door they go.  Some spectacular disasters in that group.  My biggest holdings and durations:

1) FFH - 15 yrs

2) BAC - 2.5 yrs

3) AIG - < 1 yr

4) Seaspan - 5 yrs?

5) RBS Preferreds - 4 yrs

6) Canfor Pulp - 3-4 yrs

7) WFC - 2 yrs

8) JPM - 2 yrs

 

I have other residual positions or small positions in more conservative accounts that I have had for years such as BMO, RBC, MTL-tsx; Power financial, russell metals.

 

Still amazes me that I bought only one new company this past year.

[ageofsocrates]

Concentration works best with a focus on companies with dominant moats and low capex. However, the issue is such an approach is that it can takes years to build positions as such companies usually trade at a premium. Historically, Buffet has bought KO and WFC in times when these companies were facing issues.

 

A Grahamian approach would require diversification as some companies (i.e trading below book value) are literally value traps and may slide into bankruptcy.

 

Both approaches do well over time. However, the benefits of a concentrated approach are simple. Building a circle of competence and waiting for fat pitches over time would allow one to compound money at faster rates.

 

Cheers,

Ageofsocrates

Singapore

[BG2008]

Some high level thoughts about concentration:

 

1. Big picture, I try to have 5-10 positions in 2/3 of the portfolio with any single position maxed out at 20% at inception.  The other 1/3 consist of event driven/workouts where I expect a return of cash within 12 months.  Sounds familiar?  Yes, Buffett utilized this allocation.  Instead of shorting 20 1% positions, the workout portfolio is in essence my hedge against a 08/09 crash.  It is intended to be like holding 1/3 cash, but earns a respectable rate of return of 8-15% a year. 

2. Situations that involve high cash balance/asset value relative to EV and management is not expect to make an acquisition, i.e. presence of activists or shareholder friendly management teams makes me a bit more comfortable about building a large position.  Obviously cash burn or rapidly deteriorating businesses are exceptions to this rule.   

3. I don't mind being concentrated in liquidation plays where I believe the downside is less than 10-20%.  You're truly shielded from market risk in these situations.  These plays won't make you rich, but the IRRs are nice. 

4.  For higher reward trades with the potential of going to zero, I set a % of AUM that I can stomach losing.  I use the Kelly criterion as a back of the envelope method to calculate a max concentration and then I take that max % down by at least half.  It's a bit of an art, but it's not a bad idea to start with the Kelly formula and your rough estimate of what you think the edge/payout are. 

5.  I also allocate less than 10% toward high conviction LEAP strategies where I am in essence capping my loss at the cost of my premiums, i.e. a 1% LEAP position in JCP.  I'm in essence paying for the benefit of hindsight in 1-2 years while capping my losses. 

6. I avoid having multiple of the higher reward/potential zero trades simultaneously as a 08/09 style selloff can potentially wipe all of them out simultaneously

7. I also try to minimize my holdings in financials as the equity is inherently levered 10 to 1.  I have a healthy respect for Black Swan events and think that the world is caught between the "cliff of deflation and the hell fire of inflation." 

[RichardGibbons]

It's also worthwhile noting that survivorship bias will impact these discussions, and the increased volatility of more concentrated portfolios means that survivorship bias will impact these portfolios more.

 

So, of the people who were extremely concentrated, we probably will only hear from the ones who made piles in Fairfax and BAC, not the ones that blew themselves up three years ago and have never invested a penny in the market since.

 

[PlanMaestro]

How many shares should you own? by Chris Dillow

http://www.investorschronicle.co.uk/2012/03/19/comment/chris-dillow/how-many-shares-should-you-own-QxHIjtztdkvdyX5SXTklcM/article.html

My table summarizes the maths for three different types of portfolio. One is a portfolio of blue-chips, comprising stocks with a tracking error of 20 and a correlation of relative returns of 0.3. I've chosen a positive correlation because defensive stocks are likely to mostly under-perform in good times and out-perform in good. The second is a value portfolio with stocks on a tracking error of 30 and correlation of 0.1. The third is a speculative portfolio of stocks with a tracking error of 60 and zero correlation. I've chosen zero because the chances of (say) a small oil company striking oil should be unrelated to the chances of another small company winning a big order or being taken over.

 

Calculating a portfolio's tracking error

No of stocks "Blue chip" "Speculative" "Value"

1 20.0 60.0 30.0

5 13.3 26.8 15.9

10 12.2 19.0 13.1

20 11.6 13.4 11.4

30 11.4 11.0 10.8

40 11.3 9.5 10.5

 

You can see that, in all cases, the portfolios' tracking error falls sharply as we move from one to 10 stocks, but falls less sharply thereafter. You can also see that a portfolio of 20 uncorrelated speculative stocks has about the same tracking error as five defensives which are slightly correlated with each other.

[Guest longinvestor]

I added one new company in 2012 - AIG.

 

My obsevation, looking back over my record is that the very best investments I have made were ones that I entered into slowly over a period of time.  There is a long dating period before we move in together. 

 

 

Great observation, I've done the same kind of slow courting before concentrating. I would like to believe that the past decade has been unprecedented in a unique (once-in-50 years, borrowed expression from Watsa) way. The courting period lasted a long while and sentiment on the street was negative to very negative for much of the duration for the three I do own, BRK, FFH and LVLT. It allowed me to accumulate at attractive prices over a long period of time (12 years). I doubt if this will ever repeat over the rest of my investment horizon. Also have to remind myself that any screw up will be all my doing with such a long courting time!

[ageofsocrates]

Buffett has always talked about equities as a form of a bond which pays a "coupon"  Naturally, when these "bonds" trade at distressed prices, it would be a good time to invest.

 

Buffett's approach is probably conservative even by value investor standards. All he is looking for is 1-2 good ideas a year.

 

 

[txitxo]

One I thing I learned while working for an auto parts company: Kaizen.

 

http://en.wikipedia.org/wiki/Kaizen

There was a time when auto companies and their suppliers carried huge in-process inventories because they thought defects were statistical … when they weren't.

 

RR: Deming System, that is also relevant for the discussion on Finland's education system

http://en.wikipedia.org/wiki/W._Edwards_Deming#Deming_philosophy_synopsis

 

  Scientists have been doing something similar to Kaizen for centuries. Once in a while people come up with a wonderful idea and you get a new theory straight away, but more often great advances are obtained by incremental, continuous improvements during decades, like the last two Nobel Prizes in Cosmology. 

 

  And talking about Cosmology, most theoretical physicists consider that the most consistent interpretation of quantum mechanics is Everett's Many Worlds theory, where the Universe splits every time entropy increases. So everything is probabilistic by definition.

 

  Kaizen, or any other well thought out, systematic process, can help you squeeze the core of the distribution and thin the tails, but never chop them off. You will still have a fire in your factory, a madman who takes a ax to your most expensive robots, an earthquake, a dirty bomb in the port, a war, world economies deleveraging, etc. I don't think Kaizen would have made much of a difference in Fukushima.

 

The same is true about investing. I remember Pabrai talking about the Kelly Criterion, when he had only 10 stocks in its portfolio and was making returns in the high 20's for many years. It sounded very smart, very bold. Then he went down by almost 80% in 2008. Now he talks about diversification, baskets of stocks, etc.

 

 

[txitxo]

It's also worthwhile noting that survivorship bias will impact these discussions, and the increased volatility of more concentrated portfolios means that survivorship bias will impact these portfolios more.

 

So, of the people who were extremely concentrated, we probably will only hear from the ones who made piles in Fairfax and BAC, not the ones that blew themselves up three years ago and have never invested a penny in the market since.

 

Absolutely right.

[txitxo]

Seth Klarman has averaged ~20% per year, is managing >23B, and it is still able to find 20-30 stocks to invest in. It should not be that hard for retail investors.

 

I think you have your logic backwards here.

 

Seth Klarman, one of this generations best investors, and his team of managers/analysts is able to find 20-30 stocks to invest in . . . I think a retail investor working part time would be nuts to think they could match that.  I might know 20 decent companies well enough to own them, but I don't own them because the right price hasn't presented its self. 

 

I own 5 stocks in my brokerage account because I can't follow 100 stocks closely and I feel comfortable with the safety and future prospects of each.  If I'm wrong my returns will be volatile, but I can accept that.

 

If you buy the stocks in any of Graham screens (net-nets, Enterprising investor, Conservative Investor) you WILL beat the market, guaranteed. The problem is that most of them are companies with <50M capitalization. A retail investor can buy them, but not somebody like Klarman.

 

[txitxo]

Best Ideas

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1364827

 

Abstract:     

We examine the performance of stocks that represent managers' "Best Ideas." We find that the stock that active managers display the most conviction towards ex-ante, outperforms the market, as well as the other stocks in those managers' portfolios, by approximately 1.6 to 2.1 percent per quarter depending on the benchmark employed. The results for managers' other high-conviction investments (e.g. top five stocks) are also strong. The other stocks managers hold do not exhibit significant outperformance. This leads us to two conclusions.

 

First, the U.S. stock market does not appear to be efficiently priced by our risk models, since even the typical active mutual fund manager is able to identify stocks that outperform by economically and statistically large amounts.

 

Second, consistent with the view of Berk and Green (2004), the organization of the money management industry appears to make it optimal for managers to introduce stocks into their portfolio that are not outperformers. We argue that investors would benefit if managers held more concentrated portfolios.

 

  In Physics we appreciate mathematical elegance. Economics papers usually look ugly as hell to me. Every time I read one I get the impression that you could have obtained the same results using a much simpler approach. This paper in particular does so many things to the inputs, that at the end, I don't know whether they truly found an effect or they just contorted the poor data into producing one.

 

  In any case here is a much simple experiment. The guys at gurufocus have created a portfolio which gathers the most weighted holdings of "gurus", most of which are value investors. These guys obviously haven't made their names by being closet trackers, so in first approximation we can forget about tilts and the like and just look at the straight results:

 

http://www.gurufocus.com/model_portfolio.php?mp=hr_largecap

 

You see many names discussed here in the list. But there is barely any outperformance since 2006. Perhaps if you have several decades of data, track things more often, etc. you will see something. But it does not scream at you.

 

[oddballstocks]

Seth Klarman has averaged ~20% per year, is managing >23B, and it is still able to find 20-30 stocks to invest in. It should not be that hard for retail investors.

 

I think you have your logic backwards here.

 

Seth Klarman, one of this generations best investors, and his team of managers/analysts is able to find 20-30 stocks to invest in . . . I think a retail investor working part time would be nuts to think they could match that.  I might know 20 decent companies well enough to own them, but I don't own them because the right price hasn't presented its self. 

 

I own 5 stocks in my brokerage account because I can't follow 100 stocks closely and I feel comfortable with the safety and future prospects of each.  If I'm wrong my returns will be volatile, but I can accept that.

 

If you buy the stocks in any of Graham screens (net-nets, Enterprising investor, Conservative Investor) you WILL beat the market, guaranteed. The problem is that most of them are companies with <50M capitalization. A retail investor can buy them, but not somebody like Klarman.

 

This has been my experience, stocks below 100m are the sweet spot, they're off limits for bigger funds and most retail investors don't feel comfortable investing in something so small. There are some incredible prices though, and a retail investor or small fund manager could do very well for themselves in this area.

 

I believe these are the secondary market stocks Graham talks about in Security Analysis so often, they were his favorite hunting ground as well.

 

For all the moat investors on the board there are some really nice, relatively cheap growth stocks at this level as well. It's a lot easier for a $50m company to go up 100x than it is for a $5b company.

 

[Shane]

 

For all the moat investors on the board there are some really nice, relatively cheap growth stocks at this level as well. It's a lot easier for a $50m company to go up 100x than it is for a $5b company.

 

I am a bit suspicious of this.  How can a company have a history of meaningful growth and stay under $100 million?

[Palantir]

 

 

For all the moat investors on the board there are some really nice, relatively cheap growth stocks at this level as well. It's a lot easier for a $50m company to go up 100x than it is for a $5b company.

 

Any ideas? :)

 

 

[oddballstocks]

 

For all the moat investors on the board there are some really nice, relatively cheap growth stocks at this level as well. It's a lot easier for a $50m company to go up 100x than it is for a $5b company.

 

I am a bit suspicious of this.  How can a company have a history of meaningful growth and stay under $100 million?

 

You have to invest looking forward instead of backward. Also reconsider the math, a company starting out at $10m can grow at 20% annually for 25 years before making it to a billion. It takes them 13 years to climb above $100m, I'd say 13 years of consistent 20% growth is a long enough track record.

 

The trick is to find the next Starbucks and buy when it's still a local company. This is really not my specialty but there are investors out there who do well with it.

[zarley]

Seth Klarman has averaged ~20% per year, is managing >23B, and it is still able to find 20-30 stocks to invest in. It should not be that hard for retail investors.

 

I think you have your logic backwards here.

 

Seth Klarman, one of this generations best investors, and his team of managers/analysts is able to find 20-30 stocks to invest in . . . I think a retail investor working part time would be nuts to think they could match that.  I might know 20 decent companies well enough to own them, but I don't own them because the right price hasn't presented its self. 

 

I own 5 stocks in my brokerage account because I can't follow 100 stocks closely and I feel comfortable with the safety and future prospects of each.  If I'm wrong my returns will be volatile, but I can accept that.

 

If you buy the stocks in any of Graham screens (net-nets, Enterprising investor, Conservative Investor) you WILL beat the market, guaranteed. The problem is that most of them are companies with <50M capitalization. A retail investor can buy them, but not somebody like Klarman.

 

I see your point.  I personally tend not to use screens of that sort; I'm uncomfortable buying baskets of stocks in that way.  That sort of mechanical screening can work, but I'm not sure it's fair to compare that to what Klarman does.

[Palantir]

Re microcaps....I'm studying MIMV as a speculative play....can't figure out how much of my money I actually want to speculate on this guy....

[Shane]

 

You have to invest looking forward instead of backward. Also reconsider the math, a company starting out at $10m can grow at 20% annually for 25 years before making it to a billion. It takes them 13 years to climb above $100m, I'd say 13 years of consistent 20% growth is a long enough track record.

 

The trick is to find the next Starbucks and buy when it's still a local company. This is really not my specialty but there are investors out there who do well with it.

 

Maybe I am wrong to make the assumption, but how many quality $10m companies go public every year?  Seems like slim pickings.  Would you mind sharing one or two names of small companies with a moat that you follow?

[oddballstocks]

 

You have to invest looking forward instead of backward. Also reconsider the math, a company starting out at $10m can grow at 20% annually for 25 years before making it to a billion. It takes them 13 years to climb above $100m, I'd say 13 years of consistent 20% growth is a long enough track record.

 

The trick is to find the next Starbucks and buy when it's still a local company. This is really not my specialty but there are investors out there who do well with it.

 

Maybe I am wrong to make the assumption, but how many quality $10m companies go public every year?  Seems like slim pickings.  Would you mind sharing one or two names of small companies with a moat that you follow?

 

I have a few on a site I run for unlisted stocks, and I know the microcap club guys have a number as well. Like I said above, this isn't really my area of interest at all.

 

Look at CSVI, they did 20% for a long time, stock quadrupled over the past decade, went from 100m to 426m, continue to grow at the same rate.

 

[SharperDingaan]

What concentration really means - in plain language

 

You do not have to be very big before you begin to notice  …… that the cost of your ‘average’ concentrated equity bet is typically getting to be around 1 x annual salary, or more. And if you need to double down - that cost can easily become a material chunk of the value of your house. 

 

At an average cost of 1 x annual salary per investment, most folks would want to know exactly what they have bought - & how they expect it to perform. For the amount of financial (& spousal) risk/stress taken on, a compound 14%/yr (double every 5 years) also just does not cut it. It needs to be a compound 24%/yr (double every 3 years) or better - or go home.

 

Do well & your risk will fall as the number of bets rises to 3-4. Diversification reduces the non-systemic risk, & reduces the leverage multiple if you need to double up. But …… for most people, that decline in financial risk will come at the expense of rising egotism - & your total investment will now be about the value of your house. Do nothing, & the cost of your average investment will tend to rise to about the cost of a condo - & if you need to double up – it is a condo in Manhattan, versus the Bronx. 

 

At an average cost of 1x house per investment, most folks would see you as sick, & most spouse would be looking for somebody else.

 

There is a sweet spot, & you will not blow up if you continuously withdraw any capital accumulation past that sweet spot. Remember the adage: Money is the servant, not the Master.

 

Not for everybody ….. but perhaps something to aspire to as you grow in maturity, & wisdom.

 

SD

 

[biaggio]

http://www.realclearmarkets.com/video/2013/01/04/this_guy_turned_20k_into_2_million_you_can_too.html

 

I thought this might be Eric.

 

Only very few folks can do this.

 

Agree with Sharper's view above.

[ERICOPOLY]

http://www.realclearmarkets.com/video/2013/01/04/this_guy_turned_20k_into_2_million_you_can_too.html

 

I thought this might be Eric.

 

Only very few folks can do this.

 

Agree with Sharper's view above.

 

No, I never use words like "information arbitrage" -- too big for me.  I would be the guy just telling the interviewer that I merely cheated off of the smarter kids in the classroom.

 

 

[twacowfca]

http://www.realclearmarkets.com/video/2013/01/04/this_guy_turned_20k_into_2_million_you_can_too.html

 

I thought this might be Eric.

 

Only very few folks can do this.

 

Agree with Sharper's view above.

 

No, I never use words like "information arbitrage" -- too big for me.  I would be the guy just telling the interviewer that I merely cheated off of the smarter kids in the classroom.

 

That's not a bad methodology.  It's what I've used very successfully after some of the better purchases Warren has made have tanked.  It seems also to work through the wisdom of the knowledgeable crowd here on the board, keeping in mind that smart people can herd as well as cattle.  The secret may be in deciding if or when to join the herd.  BAC at $10? $8 $7 $6 or $5.  Or on the way back up at $6 $7 $8 $9 $10 or ???  :)

[biaggio]

You still gotta be smart enough though to figure out who the smart kids are and which of their work to copy as they are not likely to be perfect all the time.

 

I know because I have copied some things (from guys here which are excellent, but also from guys like Berkowitz) that have not worked, but that's ok as its the nature of the beast. Been fun never the less. Live and learn.

 

 

 

 

[twacowfca]

You still gotta be smart enough though to figure out who the smart kids are and which of their work to copy as they are not likely to be perfect all the time.

 

I know because I have copied some things (from guys here which are excellent, but also from guys like Berkowitz) that have not worked, but that's ok as its the nature of the beast. Been fun never the less. Live and learn.

 

Bruce B. and many on the board weren't wrong, just early.  I popped my head into the party, grabbed a snack and then left before all the fun began.  :)