Creating a Concentrated Portfolio

Can we testcheck Mayur and Kaveri on checklist of Concentrated Portfolio for real long term say 5 - 10yearsin their respective threads.

Hi Vimal the checklist is just a broad framework. And it has not be vetted by seniors.Have uploaded a new list. Please have a look…

Chart which shows correlation increases with the increase in number of stocks.

For more on the article

http://www.advisorperspectives.com/newsletters12/Concentrated_Equity_Triple_Play.php


I have been seeing a lot of discussion on capital allocation. I feel with valuepickr portfolio beating almost every other bunch of stocks hands down, in past three years, the next level of refinement is to improve upon capital allocation.

First of all this depends on how much of one’s networth is into equities.

For the guys who have a small amount of their networth in equities, its easy to go with even 2-3 stocks in portfolio bcos they are not too worried about gyrations in portfolio value due to short term changes in stock prices.

But for those having a big amount in equities, I think slightly more no of stocks is desirable… I feel something between 5-10 should be okay for the guys wanting a concentrated portfolio.

Now how to go about it… First put up a list of all the stocks one has chosen… in the order of attractiveness… Those with higher conviction based on quality of business, level of undervaluation, etc…should occupy higher weightage…

I think one can go up to 25-30% max in a single stock where there is high conviction.

2-4% bets in individual stocks usually dont make much sense… Unless the aim is for the sky… If u feel that the stock is going to go up atleast 5-10 times in a fixed time frame then only it makes sense… But that usually is seen only in hindsight… Very few people can predict how much times up the stock will go with certainty.

Coming to stocks… there has been a lot of clamor for including market darlings like page inds, gruh, repco…and so on…in portfolios…

I beg to differ here… Agreed these are proven businesses… But then when we at valuepickr latched on to stories like ajanta,mayur, kaveri, polymed etc… these also were stories which had more than 10 years of history behind them… So these too were not run of the mill companies…

The fact that other people and often markets do not understand small caps should not stop one in investing in small or mid caps… What is important is that the investor himself should understand the company as much as he can… And then if one feels that the company is worth betting on then a good percentage of portfolio can be bet there…Usually if earnings continue for long period of time at some stage markets will take cognisance of the fact and reward its shareholders…

I personally had in the past invested close to 25-30% of my portfolio in stocks like ajanta, kaveri, unichem, mayur etc and never had sleepless nights… And this conviction has often rewarded me quite well

I think the key message here should be not to be swayed by popular opinion and follow the herd… Those who think differently and suceed make much higher returns as compared to the herd.

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I will let WB / Pabrai to quote on Concentration / Diversification

From WB Interview

A few years ago, in 2004, someone told me I should look at Korea. I got a book from Citigroup which had 1 stock to a page. Describes all the publicly traded companies in Korea. Went through it and found about 20 companies (ex. Day-Han flower mills) it had book value, eps, and securities. Didnât tell you anything about the share until you look at the price. Found about 20 like that in an afternoon and bought some of all of them, BUT DIDN’T KNOW ENOUGH ABOUT ALL OF THEM TO LOAD UP ON THEM

From Pabrai AGM

Ben Grahamâs approach was to go to the store and buy whatever was on sale, and Charlie Mungerâs approach is to go to the store and WAIT FOR QUALITY ITEMS TO GO ON SALE

My personal opinion is that Concentration depends on the following 4 items

  1. Availability of opportunities in the market
  2. Your ability to understand and act on those opportunities
  3. Loading up based on your understanding on the business + Amount of cash available
  4. Your ability to sleep well during night despite of high concentration
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I think the right question to ask is - do I really have high convictionon the stocks in my portfolio? IfI have high conviction (on many stocks) I tend tohave diversified portfolio. Whenthe conviction islow that would surely lead to concentrated portfolio.

Please do remember a diversified portfolio of stocks with strong positive correlation canmore or less behave like a concentrated portfolio with similar returns.

convictionon IfI tohave diversified portfolio. Whenthe conviction islow Strangely, my thought process is the otherway around. With limited capital in hand, I would bet heavily on businesses that I know would do well and less on those that I don’t for the purpose of diversifying the risk(meaning betting on a number of businesses with less weights) because I am not sure in first place :slight_smile:

@donald thank you for starting this thread. I am surprised to see that there is not much discussion in this thread. I have been researching about concentrated portfolio strategies and would like to add few points here as well as seek opinions of others.

concentration is a return maximizing strategy while diversification is a risk reduction strategy. An entrepreneur starting a new business is an extreme example of concentration while an indexer is the opposite. A portfolio of 5 to 10 stocks will be somewhere in between. It will have the upside potential that drives an entrepreneur while downside protection of a diversified portfolio.

However, just limiting the stocks in a portfolio to a small number does not necessarily give you upside potential much the same way buying a large number of stocks may not always provide downside protection especially when the stocks in these portfolios are correlated.

Traditionally a diversified portfolio means a portfolio that is diversified across economic sectors. I think portfolio should also be diversified across stock selection strategies. i.e a portfolio should have stocks with

  1. strong earnings momentum, and/or
  2. cyclical stocks that are near the bottom of the cycle, and/or
  3. a turnaround candidate that is about to turn around, and/or
  4. a value play that is being re-rated by the market and /or
  5. out of favor stock that’s actually not so bad

I am trying to build a portfolio of 5 to 10 stocks using 2 or 3 strategies mentioned above however, my picks mostly fall in the category of strong earnings momentum like many of the stocks that are discussed on the forum.

Problem with stocks having strong earnings momentum is that once the momentum is gone, stock just falls of a cliff. Out of favor stocks are less risky but upside is also limited in these stocks. To find cyclical stocks, one needs to have a good understanding of the industry cycles. In my experience, turnaround candidates never turn around and value plays turn out to be value traps or companies with bad managements with holes in their balance sheets.

It will be interested to know how other VPers have build their concentrated portfolios.

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Hi Yogesh,

Forum discussions are dynamic. Check the thread on Portfolio Restructuring
http://forum.valuepickr.com/t/portfolio-re-structuring-25-cagr-business-growth-candidates-for-next-2-3-years/4286
that
carries some of the ideas you mention forward.

The Accent being on Understanding the business so well that you have STRONG
VISIBILITY for next 2-3 years in the business.

How many Stocks one should own - Warren Buffet way ?

Cheers,
Amit

Here is my (simple) rule on diversification/concentration:

If I know two stocks that I think will appreciate by the similar amount in similar time frame then I will split my capital allocation between the two rather put money in one of them.

I have heard people say that tracking more than 20 stocks is difficult. I feel that, with the current level of computerization it should not be difficult to track more companies effectively. Once just needs to figure out the right system that works for them.

Hi Donald

This is very important topic, thanks for bringing this up. No one seems to answer your question on Probability. I think learning and understanding probability is key to betting. Learning probability alone isn’t enough, we must practice to use this on day to day basis. on Charlie’s words:

“If you don’t get this elementary, but mildly unnatural, mathematics of elementary probability in to your repertoire, then you go through a long life like a one-legged man in an ass-kicking contest. you’re giving a huge advantage to everybody else

Let me bringing in Kelly Criterion here:

The Kelly criterion is essentially a progressive betting system wherein the higher your probability of winning, the more you’re supposed to risk; the less your probability of winning, the less you’re supposed to risk.

and i recently come across an article titled: Reflections on the Ten attributes of great investors. authored by Michael Mauboussin. One of the attribute the article stresses is "Think Probabilistically (there are few sure things). An extract of the initial paragraph:

Investing is an activity where you must constantly consider the probabilities of various outcomes. This requires a certain mindset. To begin, you must constantly seek an edge, where the price for an asset misrepresents either the probabilities or the outcomes. Successful operators in all probabilistic fields dwell on finding edge, from the general managers of sports franchises to professional bettors.

Rajesh

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Hi Rajesh,

This is a good link which talks about role of probability in investing.

http://www.pragcap.com/great-investors-think-in-terms-of-probabilities/

Amit

1 Like

This is really nice point. I was trying to use Kelly formula to calculate the appropriate range of portfolio allocation to potential 5-10x stocks in say 2-3 years time range. I got to the same range of 2-4% if I input probability of stock giving such high returns at 12-15% (as such stocks are normally high risk in nature, thus low probability of giving returns). Using the same formula, it can be proved that below 5x potential returns, 2-4% allocation won’t make any sense.

I believe the optimum approach for any individual has to be driven off a process that is iterative, incremental and keeps taking real time feedback into account. Hence concentration/diversification is something that each individual will evolve into over a period of time based on the strike rate, temperament & the amount of success one sees over the years.

There really is no substitute for doing your own thinking, skin in the game and the ability to deal with the occasional hard punches that the market throws at you. Initially the approach needs to ensure that you survive the first 3-4 years as an investor, once the ability to withstand shocks is built in one can afford to then take a call on what approach one thinks best suits him/her.

Once a basic min level of competence and experience is there, I think portfolio sizing and capital allocation make the most difference to eventual returns. To get those two decision right, what stage of life one is at and the net worth are critical inputs.

There more I ponder over this question, the more complicated it gets if I have to come to an answer that is “generally acceptable”. For a specific situation/individual the answer is much simpler

I use the following rules to ensure my capital is reasonably deployed -

  1. Do not invest unless there is a 3X potential from CMP
  2. Unless I am willing to bet 4% of my net worth at cost on a story the eventual payoff won’t take me to the next league
  3. Do not try to be the first one to recognize the potential of a stock, it’s fine to enter after the first phase of re rating is done
  4. Averaging up makes more sense than averaging down, this logically follows from the above points, especially point 3

In short I swear by the concentration approach but this is an outcome of the way my thinking and behavior have evolved, it isn’t a goal I started with

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I have mostly followed having concentrated portfolio.

But from my limited previous experience,

One may diversify when the markets are undervalued. This will spread the risk of a huge downside in case a few companies go bankrupt. As all companies are similarly undervalued, the upside wont be significantly compromised. During Bear markets the reversion to mean is stocks going up hence only few stocks that are fundamentally weak will go bust,

In case of Overvalued market one must exit his overvalued stocks and then concentrate on the few ones that are undervalued and have the highest convictions. Thus in Bull markets since the probability of stock price going down is high we must not allow risky/unknown bets in our portfolio.

I am basing this on previous experience of 2011-2012 undervalued markets where a diversified portfolio might have given the same or better return with a basket full of undervalued companies vs concentrated portfolios.