From an academic point of view, fund managers need 20 stocks to sufficiently diversify the majority of risk. Beyond that, marginal contribution to risk reduction falls sharply. We can thus propose portfolios are unlikely to handle sharp market movements much better or worse than diversified ones. However, over the long-term, I believe concentrated portfolios can better mitigate capital losses by exploiting bouts of volatility.
We know concentration, by itself, is not a way to protect returns in the short term. The opportunity to navigate fluctuating markets lies, instead, in the very volatility that causes violent market swings. It is at the height of market fear when truly active contrarian investors can exploit indiscriminate selling to find value among quality stocks. Hence, the advantage of concentrated portfolios lies in the long term: when the market finally catches up with bottom-up fundamental analysis.
Capitalising on mispricing
To illustrate this point, imagine a normalised distribution of potential return opportunities provided by the market at any given point in time. The greatest advantage of a concentrated portfolio is that you can selectively pick in the far left of the opportunities set – where mispricing is exaggerated. It also means you can avoid mediocre opportunities towards the middle of the distribution curve, as you are not mandated to choose stocks simply in the name of “diversifying risk”.
This is a major structural advantage concentrated portfolios have over diversified counterparts. Moreover, in times of increased market volatility this advantage widens (graphically, the normalised distribution curve flattens and widens out as stocks become increasingly mispriced in the short term). This diminishes the probability of investing in inflated asset prices.
Identifying competitive advantage
The dominant organisational model in the world is centred on specialisation. People are more efficient when focusing on one task over many – think of the individual positional expertise in a football team. The same is true in investment: focusing on fewer companies not only allows you to understand companies, but also affords you the time to conduct forensic research into risk mitigation.
Concentration also allows you to focus on certain types of business models which can protect on the downside. For example, we focus on buying companies that have strong competitive advantages, i.e., something unique within a business model that can deliver strong returns through the economic cycle. We then combine robust balance sheets that will help harbour these stocks from macroeconomic headwinds.
We can further protect the portfolio by accessing these stocks at attractive valuations. These are times when stocks are out of favour with shorter-term investors. As these points of entry tend to be rare (and we have strict selection criteria) it means patience is paramount to our process.
Diversification is not necessarily your friend
It is also important to stress-test the portfolio in different market conditions. Merely holding a basket of sectors will not necessarily provide diversification – in fact, it can leave you with a false impression of how well your assets are spread. This is because over-riding macroeconomic or sentiment-driven reasons can cause multiple sectors to fall out-of-favour.
We intensively study correlations between sectors so this works in our favour. For example, industrial stocks are highly correlated with the banks over most time periods. We then use this information to our advantage. For instance, we are structurally underweight utilities, telecoms and banks but I know structural overweight in industrials often compensates our lack of banking exposure.
It is also important to note that one equity strategy is unlikely to give you optimum exposure within a well-diversified portfolio. The task of an asset manager should also be helping clients understand structural biases to allow them blend funds with other managers and strategies to achieve the sector allocation they desire.
The volatility of investment markets can test the mettle of any investor. The key is to stay true to your conviction and remain steadfastly contrarian. But above all, be patient and don’t comprise your process.
As Aristotle once remarked, “patience may be bitter, but its fruit is sweet.’
Mike Clements is head of European equities and manager of the OYSTER Continental European Selection Fund at SYZ Asset Management.