Unpopular Opinion: Diversified Portfolio > Concentrated Portfolio

Warren Buffett & Peter Lynch are value investors who have practiced both diversified portfolios and “wonderful business” approaches — the two don’t have to be mutually exclusive.

"Valuations of Wonderful Businesses aren't what they used to be." #QE

Benjamin Graham’s greatest contribution to the global investment community was the widespread recognition that stocks were not just pieces of paper. In stark contrast to Jesse Livermore’s wanton bucket shop trading in the early 1900’s, Graham recognized that stocks in fact represented a claim on the underlying business assets — and proceeded to profit from it by acquiring them at below market value. This approach wowed young Buffett — who purportedly would not shut up about his mentor after reading The Intelligent Investor — and later came to be popularized as the “cigar butt” style.

Both Graham and Buffett made a pretty penny through their careers by taking last puffs from cigar butts — e.g. Sanborn Maps, Blue Chip Stamps, Wesco Financial, Nebraska Furniture Mart, Berkshire Hathaway — but ultimately the style fell out of favor. This was because as the cigar butt style came to be more well recognized by the wider investing community, market prices broadly reflected and eventually persistently surpassed the value of business working capital and book value. Buffett later also heeded the advice of Philip Fisher and Charlie Munger, both of whom were instrumental to his pivot away from “cigar butts” to “wonderful businesses at fair prices”. These include some of his legendary investments such as Coca-Cola, See’s Candies, GEICO, Gillette, etc.

For the longest time, it was an indisputable fact that investing in companies with business moats and long reinvestment runways was a superior strategy to investing in cigar butts. This was only further cemented by the rise of Internet companies, who represented such moats to a T, and eventually became the Tech megacaps of today. It remains arguably true even today that such companies represent the best types of businesses, all else being equal.

However, not all else is equal. Just as the “cigar butt” style stopped being a reliable strategy all those years ago — once markets warmed up to it and arbitraged away excess returns from buying businesses below working capital value — so to has the “wonderful business” style arguably become less relevant amidst the widespread recognition by markets of the advantages of businesses with superior moats. And while strictly unrelated, the proliferation of index funds and widespread implementation of QE by global governments have also contributed to bidding up the valuations of such “moaty stocks” (which tend to occupy the top spots of stock indexes), thus further handicapping excess returns from acquiring shares of such “wonderful businesses” in efficient markets.

How is this relevant to the topic of portfolio concentration? Well, obviously portfolio concentration only makes sense when it involves exclusively “wonderful businesses”. What’s the point of having a portfolio composed of just 1-5 cigar butts? For a concentrated portfolio to make any sense at all, it clearly needs to be composed exclusively of stocks representing “wonderful businesses”.

Herein lies the problem. What’s the point of having a concentrated portfolio of “wonderful businesses at expensive prices”? While it certainly remains possible to find such stocks that are undervalued (e.g. Meta in late-2022), opportunities for excess returns in such stocks only tend to appear precisely when the narrative surrounding them becomes “they’ve lost their moats” (i.e. disrupted) — thus rendering the entire point of investing in “moaty businesses” irrelevant. For instance, you’d have to not care about moats at all to have bothered with Meta in late-2022.

If so, the logical corollary would be that a concentrated portfolio of such “wonderful businesses” has also stopped automatically being the superior choice, as compared to a diversified portfolio. To be clear, I’m not saying that the reverse is true — i.e. that a diversified portfolio has automatically become superior to a concentrated one given recent market developments. I’m just saying that due to the aforementioned arbitrage phenomena of “wonderful business” stocks in particular, the dilutive impact of higher prices on the shareholder returns of a concentrated portfolio of “wonderful businesses at expensive prices” has rendered such concentrated portfolios less invincible than they used to be.

This dilutive hit to shareholder returns has arguably reached a point where even a diversified portfolio of “less wonderful businesses at more wonderful prices” — or even a diversified portfolio of the same “wonderful businesses” — could end up leading to superior LT yields from a portfolio perspective. Anyone who understands macroeconomics, geopolitics, market history and their attendant impact on future market prices (and excess returns) will tell you the same.

This sets the context for why the New Normal has likely transformed into diversified portfolios possessing a competitive advantage over concentrated portfolios over the next generation of value investing. In this article, I’ll try to comprehensively justify why I think so. TL;DR: It’s not your grandpa’s (Buffett) stock market anymore.

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Diversified > Concentrated Portfolios in Modern-Day Markets

Aside from the aforementioned “wonderful businesses at expensive prices” phenomenon undercutting excess returns of concentrated portfolios in modern-day markets, diversified portfolios do offer many other legitimate advantages in comparison:

1. Diversified portfolios are less subject to volatility (i.e. perceived risk), and therefore knock-out risk. This can lead to a reduced ability of giving LT theses the opportunity to play out to their full intended extent.

   1. For instance, someone with a 3-stock portfolio would see their investment net worth dive by 15% if just one position experiences 50% downside volatility — which as the past few years have shown us, is utterly plausible. This can have consequences external to the portfolio, e.g. business going concern, sleepless nights.

2. Diversified portfolios allow more positions, and therefore a higher probability of success in any given position.

   1. For instance, a 3-stock portfolio which gets 1 of 3 positions right would have the same upside probability distribution as a 20-stock portfolio which gets 6 of 20 positions right. Given violently uncertain macro environments, the latter scenario has a far higher chance of occurring at any given time — which is important in an industry where the best practitioners only have a 60% hit rate.

   2. George Soros’ quote (paraphrased) — “It’s not about whether you’re right or wrong that matters, but how much you make when you’re both right and wrong” — implies that probabilities matter as much as outcomes in terms of final investment returns. Diversified portfolios deliver much more optimized portfolio probabilities, which make much more sense in the context of infinite uncertain futures (as opposed to 100% certain forecasts).

   3. This is doubly true in the short-term, where it is far more likely for all 3 stocks of the 3-stock portfolio to be down in any given year as compared to all 20 stocks being down in a 20-stock portfolio. Once again, this can have attendant consequences external to the portfolio.

   4. Buffett has a famous quote, “Diversification is protection against ignorance. It makes little sense if you know what you are doing.” The implication here being that if you’re right on all of your positions, why bother with nothing but your best ideas? On the other hand, how sure are you about being right? (on any given position) In the context of extreme macro uncertainty, diversification remains the best protection against ignorance.

   5. In an industry where downside volatility is often described as “2 years or out”, there are hugely legitimate reasons in certain cases to have a more diversified portfolio.

3. Macro Doesn’t Matter… Until It Does. On one hand, it’s true that good businesses run by good operators will likely deliver good performance over the long-term, independent of macro factors. On the other hand, that’s not the same as saying that you can just draw a straight line from today to positive results in 5 year’s time as long as those criteria are met.

   1. Good business operators are good precisely because they actively recognize that macro matters, and take proactive steps to manage uncertainty stemming from macro. They don’t do it by sticking their heads into the sand and pretending that macro doesn’t exist.

   2. While a properly constructed 2-stock portfolio (e.g. negatively correlated in every possible way) could theoretically withstand outsized volatility, a “just do it” portfolio with 2-3 stocks is unlikely to handle macro uncertainty well. The past 3 years of macro volatility is ample proof of that (without the benefit of hindsight) — this is before we even get into any outright macro shenanigans like QE.

   3. While there are certainly concentrated portfolios which have succeeded spectacularly (e.g. Nick Sleep), history is also littered with the carcasses of concentrated portfolios which have not (e.g. Bruce Berkowitz). If we consider the full dataset of portfolio managers running concentrated portfolios, the jury is still out on whether concentrated portfolios are 100% absolutely superior to more diversified portfolios. This is unlike say, the conclusive time-tested evidence for LT fundamental approaches being superior to ST trading approaches.

   4. The only way I can see a “just do it” portfolio of 3-5 stocks working out is if those “wonderful businesses” were acquired at significantly below fair value. Unfortunately for moat advocates, those types of share price opportunities only appear in “wonderful businesses” precisely when their moats are widely perceived to have disappeared (e.g. Meta in late-2022). This is precisely when most people run in the opposite direction.

4. Diversification protects against blind spots. Whether within a single position or at the portfolio-level, any investor’s biggest risks are their own blind spots — i.e. what you don’t even know you don’t know, or “ignorance” as Buffett puts it above. Diversification provides an ample buffer even against blind spots, simply by virtue of how margin of errors/safety act as a broad risk buffer against anything and everything (at the expense of efficiency).

To offer some credibility that diversification as a superior methodology falls well within the value investing status quo, consider the investment approaches of the following two famous value investors. Buffett’s Rule No. 1 has always been to Never Lose Money — he in fact reiterated this point in Berkshire’s recently published annual report:

“One investment rule at Berkshire has not and will not change: Never risk permanent loss of capital.”

pg.7 of Berkshire’s FY23 annual report

Also, Peter Lynch rose to fame by practicing a highly diversified portfolio of equally “wonderful businesses” in his Magellan Fund at Fidelity. These are value investors who have practiced both having a diversified portfolio and investing in “wonderful businesses” — the two don’t have to be mutually exclusive.

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