Concentration in investing.
Do we need a rethink of what has been traditionally done?
Twenty to forty years ago, technology and the internet were not yet readily available and ready for prime time. Businesses tended to be more geography-specific, and growth was limited to the size of the physicality of the markets they operated in. Investments were also much more tangible, i.e., property, plant, and equipment, than currently intangible.
The most successful investing practiced in the past was much more value investing. The GOAT, Warren Buffett, and Berkshire Hathaway are great examples of buying very profitable companies, typically growing at slower rates, using a highly leveraged balance sheet with the insurance float.
Previously, companies tended to perform less correlated or generally more idiosyncratic than one another. As a result, an active investor could take a more concentrated approach (<10 stocks) and still do pretty well.
Fast-forward to the current era. Technology and the internet have reduced the marginal cost of distribution to near zero, allowing companies to rapidly scale and distribute their products and services internationally and beyond traditional physical geographical boundaries. Network effects have become a strong competitive advantage; as one gets bigger, one can stay bigger and stronger than before.
The result is that the winning companies of the last 10-20+ years have become more structurally correlated than ever, driven by strong secular tailwinds. An investor cannot concentrate as heavily as before because correlation has risen significantly, and one needs to own more holdings.
Like the early-stage venture capital market, the stock market is driven by power laws, too. The top 1% of publicly listed companies globally account for 90% of overall net returns, respectively. One must have a diversified enough investment portfolio to own some of these winners. Not being able to own some of these winners will result in underperformance.
The key in our investment approach is to own the correct tail outliers, where a few of them will drive most of the overall portfolio returns. Our investment strategy and approach thus allow us to lean into and leverage the nature of the stock market. We choose to be even more focused within the 1% of winners, knowing what we seek in them. It allows us to find and own the best we think are poised to do well over the years and decades ahead.
Unfortunately, a business's journey is never smooth sailing and linear; it keeps going up. Companies undergo occasional periods of weakness and excesses; they zig and zag occasionally. It means that the markets, being very short-term-minded, will tend to punish them more heavily than often. There will be frequent and significant 30-50%+ price drawdowns.
Owning more stocks allows for diversification and for us to be less fragile, where a significant price decline will not cause the portfolio to be significantly impacted. If we can survive, we can keep playing the game. One can be wrong from time to time. Imagine if one had a 30-40% position in their most prominent position and suddenly it went down 30-50%+ for structural long-term negative reasons; the position might not recover. We don't want to be playing a game of Russian roulette where we might be structurally negatively impaired.
In addition, having a more diversified and less concentrated portfolio (i.e.,>20-25+ positions) allows us to let our winners run versus a highly concentrated portfolio of <10. One would have to be forced to trim their winners and re-allocate to their following best winners. The math would not be in our favor to allow us to outperform and beat the market, as outperformance would be mathematically taken away from us.
In our investing process, we see diversification as a process and concentration as an outcome of how we invest, where the multi-bagger winners increasingly dominate our gains over time. If we invest well and right, our portfolios will become more concentrated over time.
Through our multi-bagger winners, we must earn the right to be concentrated. We can skew the initial allocations higher towards those we think will have a more favorable long-term return-risk tradeoff, but we should do it appropriately upfront.
We are reflecting upon starting Vision Capital Fund a month ago (1 Oct 2024). While we are pleased to see its near-term returns outperforming our benchmarks, understandably, it is seemingly short-term, but I can feel and see what's happening in our portfolio and likely through time.
Notably, Vision Capital Fund (what I currently run with external capital and mine) has lagged behind Vision Capital (previously, which I ran with my capital) for now, which I still hypothetically track. The main reason is the higher relative portfolio concentration of the top 5-10 positions as these biggest winners continue to run.
Concentration and outperformance have to be earned. If done right, with the power of compounding, the magnitude of Vision Capital Fund's outperformance should grow wider over time, just like what we previously experienced. We need patience and time, and we have a very thoughtful and patient set of investors who are invested alongside us, allowing us to do so.
At the same time, one cannot be overly diversified and own 50-100+ stocks. Allocation-wise, some concentration is still needed for an investor to outperform, and we think it should be at least 15-20+ holdings. If one is highly diversified (>100+ holdings with a low concentration of top 10 holdings), outperformance is much more unlikely. One has to be different and right to win. To be different is to be more concentrated than the index, and to be right is to own more of the bigger winners than the losers.
There are many ways for investors to make money and do well over the long run. The key is to know what game you are playing. We have come to recognize and understand what we prefer and why. We prefer to avoid playing a game of buying $1 coins for 60-70+ cents, selling them when they hit 90+ cents, and constantly having to find new undervalued $1 coins to buy.
Instead, we prefer to play a longer game in which we do not mind paying a premium of $1.30-1.50 for a $1 coin now, which can become $10 later. It might be seemingly expensive as we are paying up, but it is cheap on a forward basis. It is a different game and a longer-term investment approach that works better for us.
17 November 2024 | Eugene Ng | Vision Capital Fund | eugene.ng@visioncapitalfund.co
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