Book Review: Concentrated Investing
Reviewed by Todd Wenning, CFA
Amid the rising popularity of low-cost, passively managed investment products, active managers feel pressured to prove their worth to investors. Naturally, the most powerful demonstration comes from achieving consistent, material outperformance on an after-fee basis. Doing so is easier said than done, of course, and studies have shown that most of the current generation of actively managed equity funds have struggled to outperform their benchmarks.
For some active equity managers, the answer may be as simple as owning fewer stocks and knowing those investments extremely well. The portfolio data presented in Concentrated Investing by investors Allen Benello, Michael van Biema, and Tobias Carlisle, for instance, show an inverse relationship between the number of portfolio holdings and the odds of market outperformance. To illustrate this concept, the authors backtested randomly selected portfolios of various sizes consisting of S&P 500 Index companies and compared their returns with those of an equal-weighted S&P 500 portfolio.
The results are noteworthy. From 1999 to 2014, a 10-stock portfolio had a 35% chance of beating the market by 1% or more on an annualized basis. In comparison, a 250-stock portfolio had just a 0.2% chance of outperformance. Moreover, the 250-stock portfolio never outperformed the benchmark by 2% or more on an annualized basis, but the 10-stock portfolio had a 22% chance of doing so. Although 35% and 22% chances of success are not overwhelmingly high, it stands to reason that a particularly skilled investor should have a fair shot at outperforming the market in the long run by holding just a handful of stocks.
To better understand how investors might achieve this end, the authors profile a number of highly successful concentrated investors, including John Maynard Keynes, Lou Simpson, Warren Buffett, Charlie Munger, and Glenn Greenberg. Commendably, these profiles include informative interviews with Simpson, Greenberg, and Munger, among others, adding unique insights to the broader discussion. In addition, the book is well researched, with nearly 750 references. Readers will want to keep a pen ready for note-taking, as the book contains many insights that will challenge and improve their investing process.
A key section examines position sizing using the Kelly criterion, a formula developed by physicist John Kelly to determine optimal bet sizes given specified odds. Originally applied to card games, the Kelly criterion helps gamblers decide how much of their bankroll to bet in a given scenario so as to maximize their winnings. Concentrated investors have also applied the Kelly criterion to determine how much of their portfolio to put behind a given investment.
Kelly’s underlying principles make logical sense in asset allocation — invest more in the ideas with the highest expected value. Strictly adhering to this method, however, produces non-optimal results in the financial world, which lacks the fixed set of probabilities found in a card game. To illustrate, if an investor thinks she has a 70% chance of being right when she really has only a 40% chance of winning, following Kelly’s formula will lead to a much bigger bet than is warranted, exposing her to the possibility of large losses. Some investors have devised modifications to the Kelly rule to reduce the risk of betting too much on a single idea, such as committing half or some other fraction of what the formula recommends. In short, although the Kelly criterion could be considered a fair baseline from which to determine position sizing, it hardly provides a definitive answer.
The authors aptly note two broad takeaways from their concentrated investor profiles. First, these investors had permanent sources of capital, such as insurance float or university endowments. They were thus less susceptible than most investors to detrimental behavior that tends to intensify when markets become volatile. Because open-ended mutual fund shareholders often add capital following strong performance and withdraw it during downturns, an open-ended mutual fund manager would find it extremely difficult to match the performance of a concentrated investor who has the benefit of an ideal structure. The profiled investors generally could keep their capital compounding in a variety of market scenarios — a valuable edge, given that their performance records reveal that many had at least one particularly bad run of underperformance, sometimes for a year or more. By contrast, most firms would find it massively challenging to keep even the most loyal clients happy after a year or two of disastrous results.
Second, the profiled investors had the right temperament for holding concentrated portfolios. That is, they could remain confident in their investment theses despite holding unpopular stocks. At a lunch with Warren Buffett in 1997, for example, Glenn Greenberg (then of Chieftain Capital Management) asked Buffett’s opinion on the cable television stocks that Greenberg held in his portfolio. To his surprise, Buffett disagreed with him about the economics of the cable business, expressing concerns about the industry’s ability to generate free cash flow. Not many investors could have kept the faith on a stock idea that “the Oracle of Omaha” shot down, but Greenberg did exactly that — and he proved to be right. Humans are hard-wired to follow the crowd, so true contrarian thinkers are rare. Importantly, the few standouts within that already select group are not simply being contrarian for the sake of being contrarian. Rather, they have sincere, nonconsensus convictions and are willing to stand behind them in the face of setbacks and criticism.
An understated third factor to consider when evaluating concentrated investors is the role of luck. Hindsight makes it easy to tell whether an investor’s track record is the stuff of legend. Financial history, however, is replete with stories of once-legendary investors who fell from grace by betting big and losing. Including a profile or two of concentrated investors who failed would have provided a more comprehensive picture of concentrated investing’s possibilities and pitfalls.
To their credit, the authors note that the prerequisites of the right structure and the proper investment temperament mean that concentrated investing is not for everyone. “It requires a lot of hard work and a significant amount of knowledge to produce market-beating returns,” they note, adding that “if you do not have this, it is to your benefit to diversify and index.”
Multi-author books often lack consistent flow, and Concentrated Investing is not an exception. Some quotes by the profiled investors are repeated, and chapters briefly dart off topic. The overall wealth of knowledge conveyed is impressive, however, making the book a valuable addition to any active investor’s library. In particular, practitioners with clients who are willing to accept more active risk in exchange for higher potential returns will profit by familiarizing themselves with these authors’ concepts.
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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.