Creating a Concentrated Portfolio

Investing Strategies
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I have been meaning to create a discussion thread dedicated to - Concentrated Portfolio.

I have a selfish Agenda - become a better concentrated investor - as we start handling larger portfolios. So be prepared to face a few searching barbs initially…as much to sanitise my own investment philosophy and think hard on whether I know what I am doing. Needless to say I want to make subscribers to this thread also THINK VERY HARD - Do we really know what we are doing? or what we are up against? Have we even contemplated on what the Guru’s have to say on this very important subject?

This thread is obviously intended at Active Investors )- those who have significant amounts invested, and naturally need to have the Bandwidth to be serious about the businesses they invest in! Though others, and proponents of well-diversified portfolios, are most welcome to comment and add food for thought for everyone.

For one, I am a bit concerned on whether the implications of a concentrated portfolio are really thought through here at ValuePickr. I have been seeing most portfolio Q&A in ValuePickr centers around concentrated portfolios - applies equally to beginners, learners, and those with some experience.

To a neutral observer, it would appear Concentrated Portfolio is a style in vogue at ValuePickr, that many folks are aping blindly, without being aware or thinking critically of the Hazards! In Robert G Hagstrom’s words (highly acclaimed author of The Warren Buffet Way and the Warren Buffet Portfolio) “If you take the wheel of a high-performance sports car capable of speeds approaching 200 miles per hour, you would have a responsibility to drive it safely. You would be wise to not only read the manual but follow closely the boldface warnings”.

Robert Hagstrom’s Focus(Concentrated) Portfolio WARNINGS:

1). Do not approach the market unless you are willing to think about stocks first and always, as part-ownership interest in a business.

2). Be prepared to diligently study the business you own, as well as the companies you compete against, with the idea that no one will know more about your business or industry than you do.

3). Do not even start a concentrated portfolio unless you are willing to invest for a minimum of 5 (3) years. Longer time horizons will make for safer rides.

4). Never leverage your concentrated portfolio. An unleveraged concentrated portfolio will help you reach your goals fast enough. Any unexpected margin call will likely wreck an otherwise well-tuned portfolio.

5). Accept the need to acquire the right temperament and personality to drive a concentrated portfolio

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It depends. If one has a competency in a particular sector - say Pharma for example, his odds of making good investment choices is better than an average investor. And in there, if he comes across a mispriced opportunity - say a great business, at a great price and run by a great management - and he loads it up in size, he’ll normally have a great outcome, if he can withstand the volatility.

Essentially, he is batting in a zone where his hit rate is high - so concentration is OKAY.

If one is batting in a zone where his hit ratio tends to be average - it doesn’t make sense to concentrate. He is better of diversifying as he’s liable to miss critical variables or pathways that he wouldn’t miss in his sector of competency.

That’s my take on it.

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Another ValuePickr fad I have been observing - CONVICTION. This is such a critical weapon in our investment armoury, yet it gets treated so lightly.

For most folks CONVICTION takes a severe beating with change in price momentum. As emphasised by Hagstrom we shouldn’t even start talking about concentrated portfolio and/or our “Conviction” unless we have long time horizons. I see the CONVICTION “jumpers” mostly from those with Shorter time horizons. And not surprisingly most are folks who have put in the least amount of homework on studying the business )- even limited to say doing justice to the “gold” that exists in the specific discussion threads, Stock Story, Management Q&A at ValuePickr - more often than not, lip-service is paid.

As a concentrated investor, our goal has to be to reach a level of understanding about our businesses that is unmatched on dalal street. That is why ValuePickr has consciously chosen its niche of small and midsize companies - companies that are typically under the radar ofinstitutionalinvestors, where we can have an early and decisive edge!

If we are willing to work hard at studying ourbusinesses, we are likely to know much more about the company than the average investor. This approach is within the grasp of each one of us - however it does require us to commit our time to studying the process. there is a way to go about it. Short-circuiting the process - or BORROWED CONVICTION )- will catch us out, sooner than later.

Many ValuePickrs would rather spend time chattering about “what the market is doing” or justifying an investmentperenniallywith only high-level comments on “high RoE business, zero debt, good growth momentum, easily should command 20+ PE” type comments, rather than study the AR, hunt for competitor details and pause to think why the competitive edge the business boasts of today, will be sustainable )- that someone with greater resources CAN NOT dismantle, tomorrow. If one is a concentrated portfolio investor and indulging mostly in this, that’s certainly not time well-spent.

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1). part-ownership business.

As you are part-owner of the business, you need to know the partners in the business to the roots i.e. promoters. Never compromise on that.

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Hi Donald,

Being part-time investor, with so many other responsibilities (home/jobs/health/soul etc), it is not possible for an average small investor to spend so much time on researching stocks, so as to develop conviction deep enough to ride through Financial Tech/Wockhardt/Aarshiya type situation.

With not so extra information, with not so extra conviction, it is next to impossible to develop a part-ownership interest in business. The only advantage a small time investor can have is by researching in a collaborative manner like we do in VP, and get some extra edge. The other edge one can have is by investing in under-researched small/mid caps with very high promoter shareholding (which implies less interest by big guys as the pond is too small for their trawlers).

And again with super-market gyrations, where you no longer have falling knives, but falling bombs, with capability of developing a tornado out of a super-serene environment, it is extremely difficult to (and some may find it foolish to) have a 5-10 yr time horizons. Partially profit bookings seems to be the generally accepted practice these days.

To me the primary reason behind having a concentrated portfolio, is that frankly I don’t have time to track so many stocks, and I feel absolutely unsafe/unwise investing in untracked/under-tracked stocks. I doubt whether I am able to give due time to study all 10-12 stocks in my portfolio in a good depth and breadth.

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Thanks Rajesh Jain.

We are essentially in agreement. If you have competency in a sector (you have already worked hard at knowing the business/industry/competitors) or you are a working professional in that sector.

Only then can you take concentrated bets. I agree. Else you are better off with a well-diversified portfolio. And there are folks like Ayush who are doing a wonderful job of Concentrated bets in businesses they understand completely, and minimal-to-average bets where the circle of competence is not that high.

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Absolutely Manish. Thanks for that reminder.

Management Integrity - absolutely, has to be the starting point. Absolute MUST for a concentrated portfolio!

As that.

**

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Well argued viewpoints above, and they have their merits.

However, ValuePickr Portfolio Scorecard Link: …/forum/…/678943340 (public since 2010) is as good a testimony as any, to subscribers of knowing a business in-depth and taking concentrated bets, and staying put in the businesses for the long term - with a caveat, as long as fundamentals and valuations justify. And we have exited businesses like GRP, Balkrishna, Oriental Carbon with zero impact, in time - again testimony to working hard at knowing the business, better than the average investor in the market.

I have a job to do. To make everyone aware of the RISKS involved. **Short-circuiting the process will have its perils, **sooner than later!Be properly fore-warned. Ultimately its their call. There is no right or wrong. One must be comfortable doing what one is doing.

I will only add - Long/short horizons - is as much a factor of temperament and personality. The 5th warning in Hagstrom List to my mind is the most important. Very few give enough importance/thought to this - examine critically one’s investment/trading patterns.

It’s never about lack of time. Its first about acquiring the right temperament needed for the job. Concentrated Portfolio needs the longer-time horizon temperament and patient, hard-worker, deep-conviction personality traits! Can certainly be acquired and developed. I know many working professionals who have made that important switch, when confronted and convinced - with the Process and the Results!

There are no free lunches in life! I am a firm believer in that tenet.

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Gaining knowledge is a journey. Warren Buffet and Charlie Munger took much of their wisdom from people who came before them, sand shaped it into their own mosaic of understanding.

For those interested in thinking deeply/re-examining set-concepts, and/or learning about creating a Concentrated Portfolio, I would whole-heartedly recommend The Warren Buffet Portfolio by Robert G. Hagstrom. Amazingly I had this book locked up in an office drawyer fro over 2 years now, eversince a friend had sent it over for me from US:(

To take the discussion forward, I will be liberally using/quoting from this wonderful book. I remember this was recommended to me by Arpit Ranka long back when I was quizzing him on Capital Allocation. If anyone has other good references on the subject, kindly share for everyone’s benefit.

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I am reminded of a couple of investment maxims here, both essentially meaning the same

1). Goal of investment is first return of capital and then return on capital

2). To finish first, you must first finish

Now if we see ourselves as investors for the very long term, we must first ensure and do everything in our power that we don’t do anything that will affect our ability to participate in the game we all love. A 15% to 20% CAGR return over a long period of time will ensure enormous wealth creation in any case. Firstly by concentration, I am referring to portfolio with maybe 3-5 stocks. As buffett says, If he was to restart his investment game with a small sum, he would go super concentrated. And as the sum increases, incremental diversification should be considered. Another view, that of Lynch is that he would recommend participating in as many stocks as he sees a clear opportunity, as he feels that his returns should be based on him being an investor who understands value and quality of businesses as a whole and not on the fate of a particular stock that would possibly have a 25%-50% concentration.

The way I see it, super concentration should be considered only by individuals who have immense faith in their abilities and are original thinkers. Past performance track record over bull and bear cycles should help. Sometimes people tend to want to emulate concentrated portfolio’s of their seniors/mentors, being sold by their ability to elaborate on why their stock picks make a lot of sense. This can be very dangerous as in the long run, money cannot be made on borrowed knowledge and conviction

I think one should increase concentration with time, performance record and experience. Until then some diversification will ensure you survive to learn from your mistakes.

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Donald paaji

Thanku for initiating the thread on concentrated portfolio. It will help us to know the ‘edge’ seniors have to maintain concentrated portfolio.

Apart from seeing ourselves as part of the business, knowing every tiny bit, long time horizon, patience and temperament what are the other basic things which we need to be aware of ?

For example Buffet had studied IBM for 50 or more years and invested recently. In hindsight we can say he avoided business/stocks which are inherently prone to rapid changes.

Can we have/build some sort of checklist for concentrated portfolio or as Charlie says “All i want to know is where I am going to die so I will never go there”.

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Becoming a Portfolio Manager who hits .400

Hagstrom illustrates the following core methodology. It’s not as if these are unknown to us. If we have followed Buffet and Munger, we are bound to have been introduced to each of these. My idea is to outline the obvious (for first-timers) but spend enough time examining some of the more abstract or not-so-obvious of these.

1). Think of stocks as businesses

2). Increase the size of your investment

3). Reduce Portfolio Turnover

4). Develop alternative performance benchmarks

5). Learn to think in Probabilities

6). Recognise the psychology of human mis-judgement

7). Ignore market forecasts

8). Wait for the Fat Pitch

Do we know how to think in probabilities? Do we? Do we have alternative performance benchmarks, really? Do we have it in us to play Contrarian - recognising the folly of others in the market?

It will be a good exercise for me to try and focus my attention on some of these very important areas, guided by the discussion in Hagstrom’s book and other places.

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Well said Akshay. One couldn’t have put it better!

As a counter-balance to the Concentrated Portfolio, I was thinking of simultaneously launching A Case for the Diversified Portfolio - discussion thread, only I lacked the wherewithal. Was thinking of roping in Ayush (don’t know of anyone with a better performance track from a well-diversified portfolio) to steward that discussion.

Your comments come in handy, and I will take the liberty of starting that thread with your opening comments as below. Hope you will continue to guide both discussions.

1).

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Interesting discussion topic.

There will always be very strong views and arguments in favor of both concentrated and diversified portfolios.

Personally I maintain a concentrated portfolio of less than 10 stocks.

I think there are some aspects that should be sacrosanct in building a concentrated portfolio… the companies chosen should have minimal risk of large scale capital damage…

And for that one has to avoid stocks with high debts, doubtful promoter integrity (very difficult to make out and often realised only in hindsight – but there are some attributes one can gather like good consistent dividend payouts, maintaining high returns, managements which have in the past avoided unnecessary capex or diversification, managements which have guided their companies successfully out of troubled waters ), promoter pledging, cyclicality in business (unless one is at the top of the game in playing cycles), companies dependent on single/few clients (thats where the consumer stocks score), companies dependent on govt diktats, companies with healthy cash flows etc… Most of the current crop of duds which have currently fallen always have had some or other of the above characteristics.

Even after all these considerations one may stumble (e.g MCX, FT) but thats the risk in stocks and there are no free lunches… You always end up paying tution fees to markets from time to time…:slight_smile: Trick remains to come out smiling from these catastrophes with minimal damage.

As donald mentioned previously, one has to know the company’s prospects in and out, and be ahead of the market by gaining as much knowledge about the company as possible.

Akshay Jain has put up very good framework for people to work with concentration/diversification in portfolios… For guys with lesser experience, its better to go slow on concentration as they gain more experience and confidence in investing and better conviction levels…

As to how many stocks should be there in concentrated portfolio, it is one’s own choice but I guess something below 10 should be considered concentrated portfoio.

I wouldnt put up too much on diversified portfolio as it has been aptly put up by donald in the other thread on diversified portfolio… Ayush should be the expert on a diversified portfolio…

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Hello Donald,

I am happy that you mentioned “Conviction” has become a fad.Everyone seems to have a high conviction in stocks that have gone up but suddenly the viewpoints change after a quarter of flat growth.I concur that one should not confuse conviction with borrowed conviction.

I can say that I have followed the seniors on VP and TED to construct my portfolio but at the same time I realized that I dont have a super conviction in all the stocks. I understand all the discussions and triggers but can not come up with them myself. I am very new to investing and hope to do that as I learn more. Till then, I will stick to good quality companies like Page and Gruh and not be too adventurous with new ideas.

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This golden piece from Warren Buffett’s 2007 letter tells lot about value creation :

"We bought Seeâs for $25 million when its sales were $30 million and pre-tax earnings were less than $5 million. The capital then required to conduct the business was $8 million. (Modest seasonal debt was also needed for a few months each year.) Consequently, the company was earning 60% pre-tax on invested capital. Two factors helped to minimize the funds required for operations. First, the product was sold for cash, and that eliminated accounts receivable. Second, the production and distribution cycle was short, which minimized inventories.

Last year Seeâs sales were $383 million, and pre-tax profits were $82 million. The capital now required to run the business is $40 million. This means we have had to reinvest only $32 million since 1972 to handle the modest physical growth â and somewhat immodest financial growth â of the business. In the meantime pre-tax earnings have totaled $1.35 billion. All of that, except for the $32 million, has been sent to Berkshire (or, in the early years, to Blue Chip). After paying corporate taxes on the profits, we have used the rest to buy other attractive businesses. Just as Adam and Eve kick-started an activity that led to six billion humans, Seeâs has given birth to multiple new streams of cash for us. (The biblical command to âbe fruitful and multiplyâ is one we take seriously at Berkshire.)

There arenât many Seeâs in Corporate America. Typically, companies that increase their earnings from $5 million to $82 million require, say, $400 million or so of capital investment to finance their growth. Thatâs because growing businesses have both working capital needs that increase in proportion to sales growth and significant requirements for fixed asset investments.

A company that needs large increases in capital to engender its growth may well prove to be a satisfactory investment. There is, to follow through on our example, nothing shabby about earning $82 million pre-tax on $400 million of net tangible assets. But that equation for the owner is vastly different from the Seeâs situation. Itâs far better to have an ever-increasing stream of earnings with virtually no major capital requirements. Ask Microsoft or Google."

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"Itâs far better to have an ever-increasing stream of earnings with virtually no

** major capital requirements. Ask Microsoft or Google"-Warren Buffet
**

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Guys,

Re: Samir s post which was all over the place! (Now Edited).

If you care to add value to discussions, you must also care to check how you communicate. Before copying and pasting (esp from PDFs and other formatted text) please paste text copied into something like Notepad (or other text editor) - to remove the formatting - check/edit for continuity of text, proper paragraph formation, etc. and then copy the text back from Notepad - before pasting back on the forum thread.

After pasting, re-check that the formatting is okay and that the text is not all over the place. Taking these simple steps will ensure your voice gets heard. All of us have a duty to be a little careful while communicating.

Thanks for your co-operation.

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thanks admin for doing it … i will take care of this

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Feel like exemplifying the more straightforward/well-understood (may be difficult to practice though) methodology planksof the Concentrated portfolio construction, with our Guru’s quotes:).

1). Think of Stocks as Business )- "In our view, investment students need only two well-taught courses - How to Value a Business, and How to think about Market Prices.

Do we really know how to think about Market Prices?

2). Increase the size of your Investment )- "If the best business you own presents the least financial risk and has the most favourable long term prospects, why would you put money into your twentieth favourite business rather than add money to the top choices?

Can we explain in 2 paras to any layman, which are our top 3 choices and why?

3). Reduce Portfolio Turnover )- “An investor should ordinarily hold a small piece of an outstanding business with the same tenacity that an owner would exhibit if he owned all of that business”. “Treat your Portfolio as if you were the CEO of a holding company. A parent company that owns a subsidiary with superb long-term economics will never sell the company’s crown jewel.”

Can we reduce the penchant for booking profits periodically in order to swing heavily at the next promising one?

4). Wait for the Fat Pitch )- “Perhaps it is not that investors are unable to recognise a good pitch - a good business - when they see one; maybe the difficulty lies in the fact that investors cant resist swinging the bat.”

Can we resist swinging all that often?Any new opportunity being considered has to be better than existing ones. Do we have that kind of DISCIPLINE in us?

Want to think about/explore the other three - Learn to Think in Probabilities, Recognise the Psychology of Misjudgement, and Develop Alternate Performance Benchmarks in some depth before taking things forward.

Please keep contributing.

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