When Less is More: The Case for Concentrated Equity Strategies

Jun 1 2015 | 7:59am ET

By Martin D. Sass
CEO, M.D. Sass

Warren Buffet once said, “wide diversification is protection against ignorance. It makes little sense if you know what you are doing.” 

Many money managers underperform due to excessive diversification (essentially closet indexing), hyperactive short-term trading, high fees and an overly timid approach to implementing their best ideas.

In contrast, certain highly skilled money managers with the conviction and courage to hold fewer and larger positions for the long term can demonstrate significant, sustainable alpha.  A recent study by Goldman Sachs found that stocks in 839 hedge funds’ top 10 holdings outperformed the S&P 500 by an average of 73 bps in 66 percent of quarters since 2001. Studies that examine the top holdings of mutual fund managers and separate account managers yield similar results.

Quality over Quantity

Simply holding fewer and larger stock positions in a portfolio does not guarantee superior results. Money managers must have the ability to select stocks that will positively impact performance and eliminate (or short) the companies in the broad indices that are not compelling. Managers who combine fewer holdings with skilled stock-picking and a sound and consistent investment process are more likely to outperform because each individual outperforming stock has a greater impact on the portfolio.

These managers have the courage of their convictions because they conduct deep fundamental research and analysis and vigilantly monitor their investments. This enables them to focus on stocks with greater return potential and less overall risk because these stocks have significant margins of safety. Reasonable concentration can better reduce the risk of permanent loss of capital by focusing on only a select few outstanding undervalued investments which managers understand extremely well. Undervalued issues selling at steep discounts from intrinsic value inherently have lower risk.

A Counterpoint to the Efficient Market Hypothesis

Concentrated portfolios with long-term superior returns challenges the Efficient Market Hypothesis, which theorizes that stocks always trade at their fair value on stock exchanges, so it’s impossible for investors to purchase undervalued stocks or sell stocks for inflated prices.

In actuality, markets are often irrational and therefore provide meaningful opportunities based on sheer fundamentals. In extreme and emotional markets like those of 2008-09, the overall market becomes greatly undervalued due to liquidity fears, margin calls and extreme risk aversion. Empirical behavioral finance studies have shown that investors have a greater emotional response to the pain of losses than the pleasure of similar gains; fearful investors often overreach based on an emotional response to stocks that move against them. They capitulate at the worst possible times, i.e., at the bottom of bear markets and when stocks with good long-term fundamentals sell off sharply due to short-term events (such as a small quarterly earnings miss).

When investors react emotionally, it creates opportunities for rational professionals who adhere to a consistent and sound investment process to patiently wait and then aggressively act when stocks become irrationally priced.

Potential Pitfalls of Wide Diversification

The conventional wisdom is that wide diversification is the “holy grail,” as espoused by Modern Portfolio Theory. In reality, wide diversification can hinder equity performance by failing to capitalize on high conviction stocks with the best risk-reward ratios. Too much diversification results in a tradeoff between diversification and returns and leads to underperformance vs. benchmark indexes. Equity managers often dilute their own security selection skills in order to construct highly diversified portfolios. Each security in a portfolio should be carefully selected because of a manager’s high level of conviction in its underlying fundamentals, rather than simply for the sake of diversification.

Key Considerations for Investing in Concentrated Portfolios

  • Longer-Term Horizons – Long-term investors don’t try to time market moves over the short term, and they avoid hyperactive trading, which is frequently driven by emotions. The best investors approach buying stocks as though they were buying outstanding businesses to own for the long term.
  • Freedom from the Style Box – Many investors use style boxes to build diversified equity portfolios with the combined characteristics of an index, but these can limit managers from using all of their best opportunistic investment ideas to meaningfully add alpha. Constraints (i.e. “labels” of value vs. growth or unnecessary restrictions on market capitalizations) should be removed from certain managers so they have the flexibility to capitalize on a broad range of opportunities with their investment competence.
  • Size Matters – Concentrated managers control their asset growth when it becomes excessive and prefer to achieve their goal of superior performance rather than spend their time on marketing and asset gathering. They “eat their own lunch,” meaning they invest their own capital alongside their clients and share the pain as well as the gain. Many of these managers grow their net worth primarily through investment returns on stocks owned in common with clients, rather than from fees.

Investors feel growing pressure to increase returns, especially in this ultra low interest-rate environment. In order to optimize risk-adjusted returns, they must conduct their own in-depth research and analysis or hire professionals to find skilled, opportunistic money managers with the long-term vision and fundamental analysis capabilities to outperform the overall market.

Martin D. Sass is Chairman and CEO at M.D. Sass, an investment management firm with over $7.5 billion of assets under management. M.D. Sass’s clients include some of the world's largest financial institutions, state and local governments, Fortune 500 corporations, endowment funds, foundations, Taft Hartley funds and high net worth individuals.


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