The Dangers Of Portfolio Concentration

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Includes: AAP, AIG, AZO, BAC, CGMFX, DHI, FAIRX, FMCC, FNMA, HD, JOE, LII, ORLY, SEQUX, SHLD, VRX
by: Strubel Investment Management

Summary

Many famous investors advocate concentrated portfolios.

Most stocks are losers which makes picking winners very difficult.

Diversified investments can outperform and also reduce risk.

Many successful investors extol the virtues of concentrated portfolios. However, we think that there is significant danger to that approach especially if one lacks the resources and time to thoroughly investigate companies. After all, how many amongst us have a staff of a few dozen analysts on hand? Additionally, while many successful investors are lauded for their big bets, there is the issue of survivorship bias. While we rarely hear about all of the small funds that may have gone bust running a concentrated portfolio, there are some warning signs amongst famous, successful investors with large followings.

Three Cautionary Tales

The dangers of putting a significant amount of assets in the same or similar stocks are illustrated by three different managers.

The Fairholme Fund (MUTF:FAIRX) under Bruce Berkowitz enjoyed a decade plus of outperformance prior to the financial crisis. Then a concentrated portfolio came back to haunt him. In 2011, the fund had 26% of its assets in AIG (NYSE:AIG) and 11% in Sears Holdings (NASDAQ:SHLD). In 2015, probably the last year prior to the fund starting to experience significant redemptions that forced the fund to start selling its more liquid holdings, the fund was still concentrated with 11% in Sears, 10% in St. Joe Co. (NYSE:JOE), 15% in Fannie (OTCQB:FNMA) and Freddie Mac (OTCQB:FMCC), and 15% in AIG and Bank of America (NYSE:BAC).

The CGM Focus Fund (MUTF:CGMFX) under Ken Heebner was another pre-recession high flier with abysmal performance since. In 2015, the fund had 32% of its assets in a Treasury bond short. The recent rise in interest rates looks to have gotten that position close to breakeven but it's still a ways away from even matching the performance of the stock market.

The Sequoia Fund (MUTF:SEQUX) is perhaps the most storied fund that fell victim to a concentrated portfolio gone wrong. The fund initially invested 13% of its assets (already a large position) into Valeant Pharmaceuticals (NYSE:VRX). By the time, the stock blew up, it accounted for about 30% of the funds value. That one position destroyed a 10-year track record of outperforming the market.

Why Concentration is Risky

The problem with concentrated portfolios is that it is really hard to pick winners. Only a small group of stocks drive the markets returns. Miss out on these and your portfolio can do very poorly.

A recent study found that less than half of all monthly stock returns (that is looking at the monthly return for every stock ever traded since data was kept) were positive. Furthermore, only 43% of the time they beat a one-month Treasury bill. Additionally only about 1,092 stocks of approximately 26,500 in the study universe accounted for all of the market's return. That's about a 4% hit rate. Even more interesting is that the most common outcome for a stock was a 100% loss.

Now, obviously you can look at the data in that study and make arguments for interpreting things slightly differently. For example, excluding OTC and micro-cap stocks would skew the returns more positive. What we are making is that in general winners are few and far between and that there are many losers. Let's look at a real world example of this.

How Diversification Works in the Real World

Let's take the pure-play auto parts retail sector. There are three companies O'Reilly (NASDAQ:ORLY), Advance Auto Parts (NYSE:AAP), and AutoZone (NYSE:AZO). Let's say five years ago, you thought the sector was going to do well and wanted to invest in it. Well, here's how the stocks performed from then until now.

The S&P 500 gained 66.86% in that time period. O'Reilly smashed the market with a 147.19% return while Advance Auto and AutoZone lagged with a 53.15% and 56.14% return respectively. You basically had a one in three chance in picking the winner. However, if you just invested in a basket of all three, you would have averaged an 85.49% return. Yes, you might be saying that O'Reilly is probably widely known for having the best management and most efficient operations so you would have been smart enough to just buy that one. However, sometimes there are risks you can't see. Data breaches exposing customer information, an executive scandal, new tariffs, or an accounting scandal. The point is that even combining the two losers with the big winner, you still come out ahead.

There are plenty of risks out there that very few (if any) person can see coming. For example, we think the new home construction market will continue to remain strong. Instead of just buying one company linked to that market, we bought three. We have a homebuilder in D.R. Horton (NYSE:DHI), an HVAC manufacturer in Lennox International (NYSE:LII), and building products retailer Home Depot (NYSE:HD). They help diversify against a wide variety of risks. If interests rates do shoot up and people stop buying new homes, Home Depot won't suffer as much because there is still (some) remodel demand and Lennox still has the existing HVAC upgrade cycle going for it. Input costs also vary. Lumber is huge input cost for homebuilders while steel and aluminum are big inputs for HVAC equipment. Wage inflation risks are higher for Home Depot than D.R. Horton as construction workers generally are paid more than retail workers. If our main macro thesis is correct, all three should do well, meanwhile we are (hopefully) diversified against several different risks in case something goes wrong.

Summary

We think for most investors, professional and amateur alike, diversification is a good strategy. Sure, it would be nice to beat the market by 10% a year but reducing risk and aiming lower is perhaps more prudent. Even beating the market by even 1% a year is still laudable. Protecting your investments, or clients' investment, against the unknown is always a sound strategy. It's difficult to make money back once it's lost, and we always look to manage risk first and aim for returns second.

Disclosure: I am/we are long DHI, HD, LII, AAP, ORLY.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: We are also long UTX which has an HVAC business; however, our investment thesis for UTX is centered around the break-up of the company.

Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.