Focusing on what matters most

Benjardin Gärtner

Benjardin Gärtner has been head of equity portfolio management at Union Investment since 2015. He is a member of the Union Investment Committee (UIC). The UIC formulates Union Investment’s capital market strategy on a monthly basis, thereby setting out a framework for the tactical management of the funds by individual portfolio managers.

Stock picking during difficult market phases

The question of whether it is more lucrative to invest in a share index or a concentrated portfolio is not new. However, the advantages of broad diversification usually come at a hefty price for investors. Firstly because index investments often generate lower returns, and secondly because far fewer stocks are actually needed to create a sufficiently diversified portfolio than you might think.

Advocates of broadly diversified index investments always claim that risks are minimised under their approach. That makes sense at first glance. After all, someone who invests in the MSCI World, for example, has a portfolio containing more than 1,600 equities. As a result, problems at individual companies are of less consequence. This is undoubtedly true. On the other hand, a fund that is too broadly based cannot achieve the same performance that would be possible if it contained only the best companies. Investment legend Warren Buffett succinctly expressed the criticism of a portfolio that is too diversified as follows: “Diversification is an insurance policy against ignorance. It doesn’t make sense for someone who knows what they’re doing.”

Concentrated portfolios are sufficiently diversified

  • Dwindling advantage of diversification
    (Monthly difference (+/-) between the performance of the equity portfolio and that of the broad equity market index (S&P 500) between 1960 and 2001)
    Source: Daniel J. Burnside, The American Association of Individual Investors, 2004.
  • Source: Daniel J. Burnside, The American Association of Individual Investors, 2004.

What many people do not realise is that hundreds of stocks are not required in order to sufficiently diversify a portfolio and protect against problems with individual securities. Academic studies have found that a fund is well-diversified if it contains more than 45 companies. The risk is around 85 per cent less compared with an investment in a single security. For an investor with 100 different equities, this figure is 89 per cent. Moreover, diversification effects can be achieved in a concentrated portfolio by examining the volatility of each individual security and adding in paper with different profiles. In this way, risk is reduced not through quantitative but through qualitative diversification, achieved by combining cyclical luxury goods manufacturers with defensive utility companies.

Furthermore, a concentrated and actively managed portfolio can deliver a whole host of advantages. Fund managers holding paper from just 50 or 60 companies have a far deeper insight into the quality of those companies and are thus better placed to forecast their business prospects. They can also maintain closer contact with the companies’ senior management, helping the fund managers to understand the business more clearly and develop a good sense of the competitive situation. This enables fund managers to secure an information advantage and to anticipate adverse events, such as profit warnings.

Numerous academic studies have proved this. They show that concentrated approaches are indeed capable of generating a superior return compared with a broadly diversified portfolio. Among those to highlight this finding were the authors of the study ‘On the Industry Concentration of Actively Managed Equity Mutual Funds’ in an article for the respected Journal of Finance. They examined a group of 1,770 mutual funds and categorised them according to the degree of diversification. They found that concentrated portfolios comfortably outperformed broadly diversified portfolios. The authors mainly attribute this success to the information advantage enjoyed by focused managers.

The return of the stock-pickers

Such capabilities are likely to become particularly valuable in the near future, because an increasingly bitter wind is blowing through the markets. A concentrated portfolio of carefully selected single securities can be invaluable to investors in a challenging market environment. After all, there are always individual companies that can buck the trend, even when stock markets are going through a rough patch. It is the job of stock-pickers to find these companies. The term refers to equity investors that specialise in selecting precisely the right stocks and conducting in-depth analysis of companies so that they can pick out the best securities from among the many possible investments.

So instead of buying from the broad market unseen, stock-pickers focus on a manageable number of companies that they can then analyse in detail. This is a challenging task given that the investment universe contains several thousand listed companies. When selecting securities, it is essential to look at the quality of the business model, the capabilities of senior management and the valuation. As a rule, experienced stock-pickers look for undervalued stocks, i.e. shares that are cheaper than those of similar companies in the same sector. They then analyse these companies in order to find a trigger that will push the share price higher and eliminate the undervaluation. Such triggers include faster revenue growth resulting from an innovative product, a change of management or a shift in the line of business that wins over investors.

Disciplined selling also vital

Companies that satisfy all three investment criteria are of course rare but are much more likely to outperform the market as a whole. In any case, investors must be highly disciplined both when they are seeking out the right shares and when they come to sell them again. Once the price of a share exceeds a predefined threshold, it must be removed from the portfolio (provided the other parameters remain unchanged). This is also an important part of successful stock-picking, even though it can sometimes be hard to do.

 

Unless otherwise noted, all Information and illustrations are as at 25 February 2019.