Is diversification (still) the only free lunch in investing?

Stock picking is a fine art. Before you invest in a particular company, chances are you have done a healthy amount of research into it. From the macro factors that affect the stock's potential earnings to the small details in a balance sheet that make it stand out from its competitors. 

But investing takes time and money - neither of which are (unfortunately) limitless. And as Bill Ackman of Pershing Square Capital once said, "you should only invest the amount of money you are able to lose".

And he should know something about investing in equities - and equity concentration for that matter. Pershing Square's flagship fund has less than 10 stocks (including, famously at one point, Canadian Pacific Railway, and infamously, Netflix).

So how many stocks make up the perfect portfolio? How wide does your potential investment universe have to be? And is it a good idea to hop on every opportunity you see? 

To answer some of these questions, and maybe open up a few new ones, two fund managers joined me to discuss the concept of concentration. One fund manager has under 30 holdings in his fund and the other has between 35 and 55 in hers. 

Meet the fundies

Lazard Asset Management's Aaron Binsted is our flagbearer for fund concentration. The Lazard Select Australian Equity Fund, of which he is the portfolio manager, is a highly concentrated list of companies. The fund usually holds between 20 and 30 holdings, though it could be as little as 12. Of the 2000+ listed entities on the ASX, there are only 195 companies that pass Lazard's test.

Managed Fund

Lazard Select Australian Equity Fund (W Class)

Australian Shares

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Alphinity Investment Management's Elfreda Jonker will represent the team for middle-of-the-road concentration. The Alphinity Australian Share Fund holds between 35 and 55 holdings. Like Binsted, Jonker also employs a high-conviction approach to investing. But unlike Binsted, her theoretical investment universe is even smaller. The limit for this fund is the ASX 300 accumulation index.  

Managed Fund

Alphinity Australian Share Fund

Australian Shares

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Why so few (or so many) stocks?

For Binsted, it's all about maximising alpha. That means outperforming the market through a classic but intense selection process.

"The team invests with conviction and confidence due to the strong belief in and understanding of the companies in which we invest, with an eye to the important big picture macro trends," Binsted said.

He added selecting your favourite areas of the market is not actually a bad thing - but rather the way of the future in investing, particularly given how financial markets have performed this year. Lazard would know all about picking their favourite sectors - the largest weight by far in the Select Australian Equity Fund is the energy sector.

"Given the macroeconomic backdrop in Australia and abroad and the still high valuations in some corners of the market, we believe having a portfolio that can avoid the big risk areas and focus in on the select areas of opportunity is a much safer play," Binsted added.

For Jonker, it's all about managing risk. While conviction is an important part of investing, there is no harm in spreading your idea set across a range of sectors.

"Concentrating your portfolio too heavily on one company or sector will leave investors overly exposed to company-specific, sector, or industry risks," Jonker said. 

"A portfolio invested in 35-55 stocks, as opposed to a more concentrated portfolio of 15-20 stocks, should generally expose investors to less volatility/risk, although it may give away some upside opportunity as well. It is the balance between the two that is important."

How do you prevent concentration risk?

Now that we've talked to two fund managers who have relatively concentrated portfolios, the next question is a natural one. How do you make sure your portfolio is not too heavily weighted to one sector or one thesis?

Incidentally, this just doesn't apply at the stock level. It also applies at the index level. Concentration has been quietly increasing in most equity benchmarks. Between Apple (NASDAQ: AAPL) and Amazon (NASDAQ: AMZN), the tech giants make up 20% of the market capitalisation of the S&P 500. In Australia, BHP (ASX: BHP) is now 10% of the ASX 200, and the two largest sectors (banks and materials) make up 40% of the index's weighting.

For Lazard, it's all about active management and having a very rigorous assessment process.

"We undertake detailed fundamental research and modelling on the universe of securities. We rank shares by their valuation discounts and this is our starting point from where we build portfolios," Binsted said.

But how do you deal with that one sore underperformer in your portfolio? Or that company that has been a serial disappointment? Don't be afraid to hit the sell button, Binsted said.

"Managing those is just as important as buying top performers. When to stop adding to a position or exit when the facts change matters too," he said.

For Jonker, it's as much about the process as it is about timing. Every stock is different, so you need to treat every stock's entry and exit points as such.

"Alphinity invests in quality, undervalued companies in or about to enter an earnings upgrade cycle, as research has proven these companies will outperform over time," she said.

"The length of our investment period depends on the length of each individual stock’s earnings cycle."

The last word

While we couldn't give you a definitive answer as to how many stocks make up the perfect portfolio, we did learn three things:

1. Thorough research will set you apart from the crowd.
2. Don't put all your eggs in one basket.
3. It is timing and time in the market which are more important than the number of entities in a portfolio.

And with that, happy and safe investing.

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I'll be in charge of asking the questions to Australia's best strategists, economists, and fixed-income fund managers. If you have questions of your own, flick us an email: content@livewiremarkets.com