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The Merits of Concentrated Portfolios
publication date: Sep 3, 2020
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author/source: Brian Nelson, CFA
My dear friends:
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Many thanks for your continued interest in our work.
---Though uncertainty in the efficacy of any vaccine for coronavirus disease ("COVID-19") remains, the New York Times reported today that the CDC "has notified public health officials in all 50 states and five large cities to prepare to distribute a coronavirus vaccine to health care workers and other high-risk groups as soon as late October or early November," just weeks from now.
---While expected by the optimists, we continue to view this as good news. The sheer amount of resources, both public and private, seeking a vaccine for COVID-19 leads me to believe we'll have one sooner than later, in time to set the economy up for a stronger-than-expected 2021, and perhaps breakneck growth in 2022 as inflationary pressures take hold. We maintain our view that stocks are among the best asset classes to own to combat inflation.
---As input costs rise, the strongest companies price ahead of these higher costs to drive higher profits, which in turn helps to buoy their equity prices. The strongest companies remain in the areas of big cap tech, large cap growth, and the NASDAQ, in our view, as many have net cash rich balance sheets, strong expected free cash flow generation, myriad competitive advantages and are tied to secular growth trends. Importantly, these entities have pricing power, perhaps the best indication of an economic moat.
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I believe we are largely over the hump in the global quest to combat COVID-19, and while we should never let our guard down in any market environment, I do believe that we can all start breathing a little easier. We're going to beat this "terrible thing" thrust upon humanity, and the markets continue to build in normalized conditions to valuations, as they reasonably should. As I wrote this morning, I believe the markets to be fairly valued, now trading at the low end of our fair value estimate range. I humbly reiterate that I do not believe we are in a stock market bubble, even if some individual names have become disconnected from near-term fundamentals a bit.
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There are volumes of academic research on the benefits of portfolio diversification, but when it comes to equity portfolios, concentration among high-conviction names is the key ingredient to outperformance, in my view. My general preference is to have no more than 15-20 names, in aggregate, within any equity portfolio, overweighting the highest-conviction positions, often ones that are underpriced and have tremendous cash-based sources of intrinsic value (e.g. net cash, strong expected future free cash flows). For example, Facebook (+2.4%) and Alphabet (+4.1%) together account for about 26% of the Best Ideas Newsletter portfolio at the high end of their weighting ranges, and both of these outperformed the market significantly today.
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 Image: The performance of constituents in the simulated Best Ideas Newsletter portfolio September 2.
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While I strive to avoid commenting on daily performance because the portfolios are targeted for long-term investing, I find myself with an opportunity today to emphasize the merits of portfolio concentration on high-conviction names. Not all stocks within an equity portfolio should be viewed equally, and investors might expect but a handful of names, perhaps just 2-3 in some years, to be responsible for most of a portfolio's outperformance.
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In many respects, a few well-placed bets on fat pitches may be all that a savvy investor needs to outperform in any given year and sometimes in the long run. That's why the newsletter portfolios are generally low turnover. Our favorite ideas are already in there. If we were to continually add more and more ideas to the newsletter portfolios, we'd start to dilute the expected portfolio returns from our favorite names, as we encounter a dynamic best described as "diworsification."
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Portfolio concentration can be a double-edged sword though. If you end up overweighting underperformers, you can find yourself in a deep hole relative to the benchmark. However, having in-depth knowledge of the intrinsic value of each holding--preferably a competitively-advantaged one with strong cash-based sources of intrinsic value and solid expected future free cash flow generation riding on secular tailwinds--can help to mitigate the firm-specific risk of a concentrated portfolio, in my view, but it can't ever eliminate it.
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To some degree, each investor has to pick their own preference. With widely-diversified index investing, firm-specific risk is largely eliminated as such investors are taking on only systematic risk. On the other hand, investors seeking portfolio concentration are taking on firm-specific risk, in addition to systematic risk. This could either help mitigate broader market movements or exacerbate them. I hope this was helpful, and may today's nearly all-green Best Ideas Newsletter portfolio brighten your spirits. Let us look to even better times ahead.
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Have a great rest of the evening!
--- Kind regards,
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Brian Nelson, CFA
President, Investment Research
Valuentum Securities, Inc.
brian@valuentum.com
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Brian Nelson owns shares in SPY, SCHG, DIA and QQQ. Some of the other securities written about in this article may be included in Valuentum's simulated newsletter portfolios. Contact Valuentum for more information about its editorial policies.
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