Conviction isn't about concentration - it's about skill
‘High conviction’ investing has captured market attention and become synonymous with a concentrated portfolio of fewer stocks. However, concentration can create greater risks and does not always deliver the alpha that investors seek. Written by Stephen Kwa, Head of Product and Anton Iassenev, Product Manager - Equities.
High conviction investing isn’t really about holding a small number of stocks. Conviction is about the level of surety you feel, and that may be well and good, but given that a stock picker with a 60 per cent success average is considered among the best in the world, it doesn’t follow that placing your bets on 20 or 30 stocks will automatically lead to a better outcome than a larger spread of investments.
Large bets on just a handful of stocks clearly creates opportunity for outsize gains or losses. ‘Conviction’ in picking these stocks can deliver major returns, but there remains an element of speculation, like betting big on red or black on the roulette wheel. Given the relative infrequency of turnover and small number of stock picks, it is difficult to assess whether this performance is the result of skill or luck.
Concentrated portfolios are convenient for the manager — especially the smaller boutiques that lack the investment resources to research the entire market. It’s no surprise boutiques promote concentrated portfolios so they can focus their research on a more limited universe that they can get to know well.
Concentrated portfolios typically hold less than 30 stocks but concentration cannot be viewed in isolation from the universe from which a portfolio is built. A fund manager might pick 30 stocks from the ASX200, but this is actually the same level of concentration as a portfolio of 75 stocks selected from the entire ASX of around 500 companies.
Portfolios comprising 15% of the available universe
We would argue that both the 30 stock and 75 stock portfolios above would have the same level of ‘conviction’ if the same depth of research is conducted across both sets of opportunities. Clearly you would need a larger team of analysts to accomplish this across a larger universe of stocks.
No magic number
The reality is there is actually no magic number when it comes to portfolio concentration.
In what is a classic example of the ‘tail wagging the dog’, stock numbers shouldn’t be the defining characteristic of the investment strategy but should instead be the outcome of what opportunities a manager sees in the market.
If there are opportunities in large cap stocks an all-cap portfolio will likely reduce the number of stocks held, but if opportunities improve in small caps, which often are also much riskier, then stock numbers should increase as it is important to spread your bets around. Small caps are attractive for their growth potential and while they may have a higher chance of doubling in value they also have a higher chance of going bust. As a result individual holdings in small cap stocks need to be risk adjusted and won’t be as large as mega cap stocks - stock numbers will therefore rise if opportunities look better in the small cap area of the market. It should be obvious that final portfolio stock numbers should be the output from the process not the main defining input!
A portfolio with more stocks should be less volatile and contain less downside risk than a portfolio holding just a small handful of positions. Holding more stocks also allows for the inclusion of more return generating themes as well as the ability to build more risk hedges into the portfolio.
However, holding more stocks isn’t just about better risk management — it is also about consistency and generating higher risk adjusted returns.
Like any game of chance where you can tilt the odds in your favour, the secret to winning is not by making a few big bets but by playing the game over and over again — this is a basic rule when it comes to investing. In other words success comes from betting smaller and more often. Betting big only makes sense if done on a ‘sure thing’ but the reality is a ‘sure thing’ never exists in real life.
For an example of where a high concentration approach can fall apart rapidly, we only have to look at the Sequoia Fund and its investment in Valeant Pharmaceuticals. Sequoia, a concentrated high conviction fund in the US, had a reputation as an excellent stock picker, pumped 30 per cent of its exposure into Valeant. The stock plunged 73 per cent — 60 per cent in one day back in 2015 — and Sequoia’s US3.6 billion investment was suddenly worth US$960 million.
Skill rather than conviction is what matters for investors. It’s no use having a high conviction in your stock picks but get them spectacularly wrong! Conviction should be a measure of the skill of the investment team and this is not measured by how many stocks you own, but by the consistency and persistence of beating the benchmark.
The most any manager can hope for is to have a batting average of picking the right stocks that is consistently better than 50:50. The best managers might hit a batting average of 60% but no-one achieves a batting average that justifies the sort of concentrated portfolios we are seeing in markets today.
Australian equity manager rolling 3 year batting average
Schroders has one of the largest equity research teams in Australia. With the resources to cover the entire market of over 500 stocks, we believe investors are best served through an approach that holds between 40-70 stocks, is unconstrained by benchmarks, and has the freedom to invest anywhere regardless of capitalisation.
The Schroder Equity Opportunity Fund has a 10-year track record of consistently beating the benchmark with a batting average that is consistently top quartile on a rolling 3 year view outperforming the majority of more concentrated approaches.
Schroders is able to have conviction across a bigger portfolio of stocks because of the depth of experience of its research team, which is large enough to look at opportunities across the broader market and pick from a larger universe.
This includes looking at stocks of all sizes and from all industry sectors. An all-cap manager has the freedom to move between market cap bands, and avoid the potential overlap or gaps that might emerge when using separate small and large cap managers.
Holding more stocks also provides the added benefit of being able to incorporate positions that are not only attractive from a potential return perspective but have the potential to provide additional risk management benefits to the portfolio. For example stocks that can benefit from the withdrawal of central bank stimulus, currency fluctuations or trade wars.
In all of this, investors should consider the Fundamental Law of Active Management in which the main variables leading to outperformance are: the skill of the manager and the breadth of investment opportunities they can research.
Manager skill is not just about the ability of an individual, but can reside in a larger team of experienced and well-resourced managers working to a sound and disciplined investment process methodology.
Having identified managers with skill, the secret to higher risk adjusted returns then is not to reduce the number of stocks in a portfolio — but to add more.
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