Another Take On How Many Stocks Should You Own

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Includes: BJRI, BOFI, BOOT, CVGW, FAIRX, FOX, IPMLF, JOE, LULU, MLNX, SHLDQ, SPY, VICR, VSTO, WWE
by: David Pinsen
Summary

The question of how many securities to hold in a portfolio, and how to weight them, was raised in a recent article by Chuck Carnevale.

Carnevale suggested 20 to 25 as a suitable range for most investors. Depending on the size of your portfolio, my approach might have you holding just 5 hedged names.

I show how this "heads you win, tails you don't lose too much" approach can let you capture the benefit of concentration while strictly limiting your risk.

Performance of a recent hedged portfolio consisting of 5 underlying securities.

How Many Stocks Should You Own?

That question has been on my mind over the last several days, prompted in part by Chuck Carnevale's recent article, in part by Bruce Berkowitz's October shareholder letter for the Fairholme Funds, and in part by the performance of the portfolio shown above. While I agree with Carnevale on the importance of avoiding calamity and with Berkowitz on the advantage of concentration, I have a somewhat different take, due to the addition of hedging, as I elaborate below.

Avoiding Calamity

I like to think of things "from the viewpoint of calamity," to re-borrow the expression Benjamin Graham borrowed from the rationalist philosopher Baruch Spinoza. The calamity, of course, when investing in stocks is suffering a catastrophic loss, which, as I noted a few years ago ("Hedge After Reading"), is disturbingly common: according to the JP Morgan study I cited in that article, 40% of Russell 3000 stocks since 1980 had suffered catastrophic losses, meaning declines of 70% or more without recovering. In his article, Chuck Carnevale noted the benefit of diversification in ameliorating this risk:

For example, an equally weighted portfolio of 30 stocks means that each holding only represents a little over 3% of your total portfolio. Therefore, no calamitous disaster on one holding will affect your overall portfolio very much.

What Carnevale writes there is true, of course, but there's a flip side to it: if one of your 3% holdings does extremely well, the positive impact to your portfolio will be similarly limited.

Although I have disagreed with some of his investment choices in recent years, such as Sears (OTCPK:SHLDQ) shares ("Interview with the Dog Catcher"), Bruce Berkowitz does seem to be cognizant of the benefits of concentration, judging from the current allocation of his flagship Fairholme Fund (FAIRX), as he notes in his October letter:

42.8% is composed of cash, U.S. Treasury Bills, money market funds, and investment-grade commercial paper with an average duration of two weeks. 30.6% is in St. Joe common stock (JOE), 12.3% in the preferred stock of Fannie Mae and Freddie Mac, 8.9% in the debt of Imperial Metals (OTCPK:IPMLF), and 2.9% in the common stock of Vista Outdoors (VSTO). Sears 8% bonds of 2019 compose 1.5% of net assets, with Imperial Metals’ common stock at 0.8% and Sears’ common stock at 0.1%.

Berkowitz's large allocation to cash and cash equivalents could be seen as an attempt to avoid calamity, though the fund is nevertheless down about 21% year-to-date.

Chart FAIRX Total Return Price data by YCharts

A Different Approach: Concentration Plus Hedging

My Portfolio Armor system uses a different approach: it seeks to avoid calamity by hedging each security. And because each position is hedged, it concentrates assets in a handful of them: 2 or 3 names for a $30,000 portfolio and up to 8 for a $1,000,000 portfolio. Here's an example of a $100,000 portfolio I presented to my Marketplace subscribers at the end of April.

The primary securities in this one were BJ's Restaurants (BJRI), Calavo Growers (CVGW), Mellanox (MLNX), and World Wrestling Entertainment (WWE). They were selected because they had the highest potential return estimates, net of hedging costs when hedging against a >12% decline, and they had share prices low enough that you could buy a round lot of one of them for less than $25,000. Boot Barn Holdings (BOOT) was added in a fine-tuning step to absorb leftover cash from rounding down to round lots of the first four names.

Having all of your assets in 5 stocks, without hedging, is obviously risky: assuming equal weighting, if one goes to zero, all else equal, your portfolio would be down 20%. But in the portfolio above, each stock is hedged against a >12% decline. Assuming equal waiting, if one of 5 stocks hedged that way went to zero, your portfolio would be down only 2.4% (Portfolio Armor aims to roughly equally weight its primary positions; the reason they're not exactly equally weighted is because the rounding-down process mentioned above).

Although the maximum impact to the portfolio of one security going to zero is small, the maximum impact of one doing very well is much higher. And that's what WWE did over the time frame it was in portfolio (the plan here is to hold each position for 6 months or until just before its hedge expires, whichever comes first; WWE's hedge expired a week before 6 months had elapsed, so it was exited then).

Chart WWE Total Return Price data by YCharts

Had WWE been one of 30 equally weighted stocks in a portfolio, its performance would have contributed about three percentage points of the portfolio's overall return, but in this concentrated portfolio, the impact of WWE's big gain was close to twenty percentage points (19.5%, net of hedging and trading costs). All together, the portfolio was up 21.9%, as you can see in the chart below.

No, They Don't All Do This Well

Not every $100,000 portfolio hedged against a >12% decline is going to do as well as the one above. The performance will vary, as you can see it has so far, in the table below.

But as you can also see in that table, over time, actual returns tend to average close to the expected returns the system estimates ahead of time, and the results, on average, tend to be competitive. I presented another portfolio using these parameters on May 3rd; it will appear in the version of that table on the Portfolio Armor website on November 3rd, but here's a look at its performance so far:

As you can see, BJRI appeared in this portfolio too, but the other names in the May 3rd portfolio were new: Lululemon (LULU), BoFI (BOFI), Twenty-First Century Fox (FOX), and Vicor (VICR). Nevertheless, the performance here has been strong so far, up 10.24%, while the SPDR S&P 500 ETF (SPY) is only up 1.38% over the same period.

Wrapping Up: Another Difference With This Approach

One point Carnevale made in his article is the importance of knowing the names you own well. I'm sure Berkowitz would agree with that, but it's not a part of my system's approach. Without looking it up, I couldn't even tell you what Vicor does, for example. It appears in the portfolio because it had a high potential return (based on past returns and forward-looking options market sentiment) net of its hedging cost in May. Because it's hedged in the portfolio above, an investor's risk in owning it is strictly limited, regardless of how much or little he knows about it.

I realize this may be a radically different approach than what you're used to. I'm not asking you to take my word for any of this. I would kick the tires, hard, if I were you. But I would also be open to the possibility that this "heads you win, tails you don't lose too much" approach makes sense.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.

Editor's Note: This article covers one or more microcap stocks. Please be aware of the risks associated with these stocks.