Murray Stahl: “Perhaps A Superior Method To Reduce Portfolio Risk Could Be To Have No Diversification. If You Had Only One Holding”The Acquirer's Multiple
We’ve just been reading the latest Q318 market commentary by Murray Stahl which discusses the possible benefits of concentrating ones portfolio to achieve outperformance. His article illustrates how this concentrated approach led to some serious outperformance by three of the greatest investors of all time, Warren Buffett, Charles Munger, and Peter Lynch saying:
“Paradoxically, perhaps a superior method to reduce portfolio risk could be to have no diversification. If you had only one holding, it would be possible for a portfolio to avoid whichever systemic risk will strike. With a conventional level of diversification, that would not be possible, because you own everything. Of course, you’d have more company specific risk in a one-stock portfolio, but perhaps that is more easily defended against with careful selection.”
Here’s an excerpt from that article:
Diversification vs. Concentration
The accepted academic principle for reducing risk in a portfolio is a high level of diversification, by number of holdings as well as across industries and even across geographies. Hold just several ETFs and you easily own hundreds or even thousands of stocks. (That’s the principle; in practice, you’re not diversified, and you’ll see why later in this presentation.) While that diversification is intended to limit the company-specific risk in a portfolio, it cannot help but expose the portfolio to all of the overarching systemic risks, like recession or inflation, an interest rate shock, or investor flight from equities to bonds.
Paradoxically, perhaps a superior method to reduce portfolio risk could be to have no diversification. If you had only one holding, it would be possible for a portfolio to avoid whichever systemic risk will strike. With a conventional level of diversification, that would not be possible, because you own everything. Of course, you’d have more company specific risk in a one-stock portfolio, but perhaps that is more easily defended against with careful selection.
In prior webinars we reviewed one technique for locating such securities: look among the multitude that have been excluded from the indexation vortex and which might therefore be anomalously cheap, and which might have business models that are not exposed to the same risks.
We described some marine shipping companies, even large-cap ones like AP Mollar-Maersk, some drilling service companies like Subsea 7, non-standard security types like Texas Pacific Land Trust, which is not even a corporation, and so on. They have excellent or even perfect balance sheets, so are not at risk from interest rate or credit market shocks, and they operate in cyclically depressed industries so that they have plenty of positive revenue optionality, as well as profit margin and valuation optionality. In the extreme, if you owned only one, you might not be exposed to any conventional systemic risk.
Concentration on the order of a handful of stocks or a dozen or two is unusual. But it’s not unheard of. It has been associated with some of the most successful investors in history. Warren Buffet is so well known for owning concentrated positions. He has been known to exhort college students to think about investing as if they were each allocated one ticket — like a train pass — with only twenty slots in it so that one had twenty punches that would represent the limit of the number of investments that could be made in a lifetime. And once the card is punched through, one could make no more investments.
It is less well known that his investment partner Charles Munger was chairman and CEO of the best-performing stock on the NY Stock Exchange in the 1990s. The company was Wesco Financial, an insurance company that was eventually acquired by Berkshire Hathaway. Its book value per share compounded at 32.4% per year for the six years ended 1998. How was this accomplished?
Wesco began with the distinction of being probably the most overcapitalized insurance company in the U.S.: it wrote premiums amounting to less than 1% of statutory surplus in 1999, versus about 90% for the average insurance company. Essentially, Mr. Munger was one of the most conservative investors it is possible to identify, willing to avoid commitments for many years until the precisely right business and price came along.
Paradoxically, he was then willing to undertake what seemed to be unusually, some would say irresponsibly, great risk. In 1988, Mr. Munger invested a major part of Wesco’s capital in one stock: Freddie Mac, the Federal Agency mortgage lender.
It was a newly created business with no history, but it was one of the few government-granted monopolies, with a business structure formulated by federal regulation to insure consistent profits and, at the time purchased, had only a zero fraction of the market scale it was designed to ultimately achieve. My rough estimates, based on as-yet incomplete information, is that Wesco invested at least 25% of its shareholders’ equity in this one security, and perhaps much more. At its peak, in 1998, the $72 million investment in Freddie Mac stock was worth $1.9 billion, representing almost three-quarters of the company’s net worth.
There was also Peter Lynch, who ran Fidelity’s Magellan Fund. It was the world’s best performing mutual fund for over a decade under his management, and for the 10 years ended 1984 it had returned six times more than the S&P 500.
During his 13 year tenure from 1977-1990, the Fund’s annualized return was 29%. The public presentation of the Magellan Fund profile always emphasized the huge number of stocks hat Mr. Lynch bought, the number of positions often well exceeding 1,000. He would often regale with a story about how he and his 3 assistants visited 300 to 400 companies per year. But this is not what generated the results, and it is very difficult to find any serious discussion of what did. It was the concentrated positions.
One of these was Chrysler, purchased in 1983, soon after Chrysler paid back the government-backed loans that prevented its bankruptcy in 1979. The shares appreciated by multiples from that point forward. As late as year-end 1995, Magellan held 99 million, or almost 14%, of Chrysler’s shares.
Mr. Lynch had similar success with General Public Utilities, which also flirted with bankruptcy and which appreciated by multiples thereafter. Thus, despite the aura of extreme diversification, the excess returns were due to a handful of companies that were purchased as large positions and which dominated the returns.
You can read the entire Q318 market commentary here – Horizon Kinetics: Q318 Market Commentary.
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Article by The Acquirer's Multiple