The late Charlie Munger, renowned as Warren Buffett's business partner at Berkshire Hathaway, famously dispensed investment wisdom at the company's annual gatherings. He championed the idea that intelligent investors should concentrate their holdings rather than diversify them widely. It is difficult to dispute his assertion, given that he followed his own advice and achieved remarkable success. However, the reality is that very few investors possess the acumen of Mr. Munger or Mr. Buffett. For nearly everyone else, diversification is the wiser path, as it tends to yield better long-term results.
Putting Concentration to the Test with Canadian Portfolios
Today, the concept of concentration is rigorously examined using Canadian value, dividend, and low-volatility portfolios that are regularly tracked by The Globe and Mail. These portfolios have consistently outperformed the market index over the past 26 years, achieving this by selecting just 10 or 20 stocks. Each portfolio begins with the largest 300 stocks on the Toronto Stock Exchange and then filters for specific desirable characteristics.
Deep Value Portfolios
The first pair of portfolios target deep value stocks reminiscent of those favored by Benjamin Graham, Warren Buffett's mentor. The Screaming Value portfolio selects the 10 stocks with the lowest EV/EBIT ratios from the largest 300, while the Free Cash portfolio picks the 10 with the lowest EV/FCF ratios. Enterprise value (EV) represents a company's market capitalization plus its net debt. EBIT stands for earnings before interest and taxes, and free cash flow (FCF) is approximated by subtracting capital expenditures from operating cash flow.
Value with Momentum Filters
The next duo employs different value measures before applying a momentum filter to identify bargain stocks on an upward trajectory. The Dividend Monster portfolio chooses stocks with above-median yields and then selects the 10 with the highest returns over the previous year. The Pink Lemonade portfolio starts with 20 stocks boasting the lowest price-to-earnings ratios (P/E) and then picks the 10 top performers over the prior six months.
Low-Volatility Dividend Portfolios
The final three portfolios concentrate on dividend stocks with low prior volatilities, anticipating continued stability. The Stable Dividend portfolio identifies the 20 dividend payers with the lowest volatilities over the past 260 days. The Frugal Dividend portfolio begins with the 50 dividend payers with the lowest volatilities over the same period and then buys the 10 with the lowest P/Es. The Stable High-Yield portfolio is similar but selects the 10 stocks with the highest yields instead of the lowest P/Es.
One-Stock Portfolio Experiments
Each original portfolio is tested against a one-stock version that uses the same methodology, except it selects a single stock instead of 10 or 20. For example, the one-stock Screaming Value portfolio picks the stock with the lowest EV/EBIT from the TSX's largest 300. In a more complex case, the one-stock Dividend Monster portfolio starts with dividend stocks having above-median yields and then chooses the single stock with the best return over the prior year.
It is crucial to note that one-stock portfolios are inherently risky. Even luminaries like Mr. Buffett and Mr. Munger have experienced disastrous individual stock purchases. Surprisingly, the results defied expectations due to the absence of total disasters. While five of the seven one-stock portfolios underperformed their original counterparts, all of them beat the market index. However, these concentrated portfolios were exceptionally volatile, ranging from 82% to 140% more volatile than the originals, except for the utility-heavy one-stock Stable Dividend portfolio, which was only 64% more volatile.
Long-Term Outlook and Risks
There is strong optimism that the seven regular portfolios will continue to perform well over the long term. In contrast, it is anticipated that some or all of the one-stock portfolios may eventually encounter serious difficulties. The high volatility and concentrated nature of these single-stock strategies underscore the perils of abandoning diversification without the expertise of investing masters.
Norman Rothery, PhD, CFA, is the founder of StingyInvestor.com. For ongoing investment insights, consider subscribing to financial newsletters that deliver expert analysis regularly.
