Over the last ten years or so my investment approach has moved steadily towards higher quality companies, yet hopefully still purchased at attractive valuations.
This takes quite a bit more time because I have to analyse companies in more detail, but for me this is the right decision as I prefer investing in successful businesses which align with my Quality Defensive Value criteria.
However, during the pandemic I found that researching potential new holdings for the UK Value Investor portfolio, as well as keeping up to date with its existing 34 holdings, was taking more time than I had available.
I didn’t want to shrink the amount of research I was doing per company, so the obvious solution was to reduce the number of holdings. But reduce it to what?
To answer that, let’s start with the following question:
What is the theoretically optimal number of stocks to own?
If 34 holdings is too many, at least for me, what is the optimal number?
Before I even begin to answer that, let’s stop and think about why investors hold multiple stocks in the first place. In other words, why don’t investors just invest all their money in one company?
The answer is that most active investors understand that the future is uncertain and that they are not all-knowing. Their favourite company could do the unexpected and perform badly or even go bust if we run into, say, a global pandemic.
So putting 100% of your money into one company is generally a bad idea. But what about two companies, or three, or ten?
To get the ball rolling, here’s a quote from the legacy version of Morningstar’s Investment Classroom:
“if you own about 12 to 18 stocks, you have obtained more than 90% of the benefits of diversification, assuming you own an equally weighted portfolio.”Morningstar Investing Classroom: Constructing a portfolio
If you poke around the web you’ll find lots of similar quotes. That’s because this 90% diversification from 12 to 18 holdings idea comes from the book, Investment Analysis and Portfolio Management.
However, some academics argue that the 12 to 18 figure is wrong and that a portfolio needs 50 or even 100 holdings to be sufficiently diversified.
In short, there seems to be nothing like an academic consensus on the optimal number of holdings.
Also, even if holding 50 to 100 stocks was academically optimal, it isn’t practical if you’re doing detailed company-specific research, so a better question would be:
What is a practical number of holdings for a portfolio of quality companies managed by a single individual?
Since this is a practical question, let’s see what a real world practitioner has to say:
“If I were running 50, 100, 200 million [dollars], I would have 80% in 5 positions, with 25% for the largest. In 1964 I found a position I was willing to go heavier into, up to 40%.”Warren Buffett
Having 80% invested in five companies and 25% in one company may be okay for Warren Buffett, but that’s definitely too concentrated for me and most other non-genius investors.
However, there is a tendency among some of the best quality value investors to hold very concentrated portfolios. Here’s a quote from Lou Simpson, ex-Chief Investment Officer of Berkshire Hathaway-owned GEIKO:
“What we do is run a long-time-horizon portfolio comprised of ten to fifteen stocks. Most of them are U.S.-based, and they all have similar characteristics. Basically, they’re good businesses. They have a high return on capital, consistently good returns, and they’re run by leaders who want to create long-term value for shareholders”Lou Simpson
So Buffett is happy with five holdings, Simpson likes 10 to 15 and Morningstar suggests 12 to 18 holdings for a “fat pitch portfolio“.
Those are generally regarded as very concentrated portfolios. The more mainstream view is that most stock pickers should have something in the region of 20 to 30 holdings.
A reasonable compromise would be to start off with 20 to 30 holdings and, as experience is gained and skill developed, that number could be brought down to something below 20 if it makes sense to do so.
In my case I’m starting off with 34 holdings today, so I think the middle of that 20 to 30 range is a reasonable initial target as I already have more than a decade of experience (how much skill I have is more debatable).
So here’s my goal for 2021:
- I will reduce the number of holdings in my portfolio from 34 today to around 25 by the end of 2021
That’s almost ten fewer holdings which should definitely free up some of my time.
Some of that time will be spent writing blog posts and the next edition of my book, but some will also be spent doing more detailed analyses of potential and existing holdings.
Or as Morningstar puts it:
“When you own too many companies, it becomes nearly impossible to know your companies really well. Instead of having a competitive insight, you begin to run the risk of missing things. You may miss something important in the [financial results], skip on investigating the firm’s second competitor, and so on. When you lose your focus and move outside your circle of competence, you lose your competitive advantage as an investor.”Morningstar Investing Classroom: Constructing a portfolio
So having fewer holdings should hopefully mean better quality research and better investment decisions.
Another benefit of having fewer holdings is that it helps you focus on the highest quality companies at the most attractive prices whilst minimising drag from lower quality companies at less attractive prices.
Here’s Buffett on this point:
“I cannot understand why [an intelligent and informed investor] elects to put money into a business that is his 20th favorite rather than simply adding that money to his top choices — the businesses he understands best and that present the least risk, along with the greatest profit potential.”Warren Buffett
That makes a lot of sense and if you’re pruning your portfolio it leads to an important question:
Which stocks should you hold onto and which ones should you sell?
The obvious answer is that you should hold onto the best stocks and get rid of the worst. In my case best and worst are based on my Quality Defensive Value framework, and both quality and value are effectively non-negotiable necessities.
This website is called UK Value Investor, so why do I insist on quality as well as value?
The answer is that, in my experience, high quality companies tend to perform better, as long as the purchase price is sensible.
For example, I launched the UK Value Investor model portfolio in 2011. Since then a total of 81 companies have joined the portfolio, 47 have been sold or taken over and that leaves 34 in the portfolio today.
Of those 81 companies, 42 were quality companies according to my Quality Defensive Value criteria. The remaining 39 companies were mostly purchased years ago when I was less focused on quality.
The point is there’s a fairly even split between quality companies and non-quality companies in that list of 81 investments.
But if we look at the best and worst performers, that even split disappears.
Seven out of 81 investments produced a loss of more than 50%. Of those seven, six were low quality companies, so low quality companies have made up a disproportionate number of my biggest losers.
At the other end of the scale, 20 investments produced gains of more than 50%. Of those 20, 14 were quality companies, so quality companies have made up a disproportionate number of my biggest winners.
Looking at my portfolio’s five best and worst performers tells the same story, but to an even greater extent:
- Four of my five worst performers were low quality companies
- Four of my five top performers were high quality companies
Even I am smart enough to spot a pattern here, and that’s why I think focusing on a smaller number of higher quality companies is a good idea.
Okay, here’s a summary of the main points so far:
- Owning fewer companies allows more time to be spent doing more thorough research of potential and existing holdings
- Owning fewer companies means that more money can be invested into the highest quality best value companies with the highest expected returns
- Most quality value investors should own 20 to 30 stocks, while experienced and skilled investors may want to concentrate on as few as 10 to 20 companies
The point about investing more in the best holdings is important, so here’s another question:
How much should you invest in each company?
The size of each investment, usually called its position size, is actually a more fundamental factor than the number of holdings.
After all, you could have 100 holdings, but if 90% of your portfolio is in one company then that isn’t very diverse.
In my case my portfolio has 34 holdings, so the average position size is about 3%. But that average hides the fact that my largest position is 5% while the smallest is barely 0.5%.
This raises yet more questions:
What is the maximum amount you should have invested in one company?
This depends on your risk tolerance, your confidence in your skill as an investor, as well as the potential risks and rewards of specific investments. In other words, it will vary from one investor to another and from one investment to another.
In my case, to keep things simple I tend to start investments off with an equal weighting. With 34 holdings that means putting around 3% into any new holdings, although to some extent this depends on how much cash is available within the portfolio to reinvest.
With my new target of 25 holdings (or thereabouts), the average position size will be 4% or so, which isn’t massively different from what I have today.
However, share prices go up and down, so even if the average position size is 4%, it’s likely that few or perhaps none of the holdings will be exactly 4% of the portfolio. Some will grow larger and some will shrink as their share prices go up and down.
At some point you may find that an investment has grown too large. At that point it’s a good idea to rebalance or trim the holding back to something more appropriate.
In my case, my maximum position size rule is:
- If an investment exceeds double the average position size, rebalance it by selling half
With my current 34 holdings the average position is 3%, so if any investment exceeds 6% I’ll rebalance it. The proceeds are then reinvested into new holdings at a later date.
With my new target of 25 holdings the average position size will be 4%, so using the same rule would give a maximum position size and rebalancing trigger of 8%.
Another way to think about how much money you have invested in a company is to think about the actual cash amount invested, rather than the current value of the investment. In other words:
What is the maximum amount of hard cash you should invest in a company?
As a value investor I’m willing to top up investments where the price has fallen, as long as the company’s prospects still seem to be good over the medium to long-term.
However, if a company’s shares keep going down in value, and if you keep topping the investment back up, then at some point you can have far too much cash invested in that one company.
I did this many years ago and ended up watching a big chunk of my portfolio go to zero because I’d repeatedly topped up a position as the share price fell, fell and fell again, all the way to zero.
So I have another rule:
- Don’t invest more cash into a company than twice the default position size
Most brokerage accounts show you how much cash you’ve invested in a company as well as the overall value of your portfolio, so this is easy to work out.
While maximum investment amounts are the obvious ones to think about, it’s also worth spending some time thinking about minimum position sizes. In other words:
What is the minimum amount you should have invested in a company?
This may seem like an odd question. What does it matter if a position is “too small”?
But it does matter.
It matters because you have to spend time reviewing the company and keeping up to date with its evolving situation, and that takes the same amount of time whether the company is 5% or 0.5% of your portfolio.
Why would anyone want to spend hours and hours staying abreast of a company’s situation, reading reports and articles or watching presentations, if the investment is so small that it barely has any impact on the portfolio’s overall results?
After all, if one of your holdings doubles in a year then that’s great, but if that takes it from 1% to 2% of your portfolio then a) who cares and b) think how much more you could have made if the investment was 5% of the portfolio.
This is something which has definitely affected me in 2020. For example, here’s a chart showing the position sizes for all of the holdings in my model portfolio:
There’s a smooth decline in position size from 5% down to 2%, but then there’s a big drop off to four companies where the position size is less than 0.5% each.
Three of those four holdings are already on my sell list. In fact, they’re only in the portfolio so I can learn more about their problems (unsurprisingly, all of these tiny holdings have had serious problems).
Holding onto companies to learn more about what went wrong is fine, but only so far. At some point the bulk of the lessons should have been learned, and spending time following companies that are not appropriate for your portfolio is time that could be better spent elsewhere.
So expect to see post-sale reviews of three of these small positions in the near future.
The remaining tiny holding is Mitie, which I’ve owned for almost a decade.
Mitie is a borderline case. It has the potential to be a Quality Defensive Value investment, but it has to successfully pull off the turnaround its been working through for the last five years or so.
So what should I do? Should I sell Mitie as it doesn’t already meet my quality criteria, or should I hold on in case the turnaround works out well?
I think a good way to answer that is to ask another question:
Would you feel comfortable topping up a small investment to the default position size?
In other words, if I’m not comfortable with Mitie as 4% or 5% of my portfolio, then it shouldn’t be in the portfolio at all.
More generally, I think this is a good way to manage smaller holdings.
If you wouldn’t top a position up to the default position size, then what is it doing in the portfolio?
This leads to a simple rule on minimum position sizes to balance out the rule on maximum position sizes:
- When an investment falls to less than half the default size that investment should either be a) topped up to the default size or b) sold
This should produce a portfolio where all holdings pull their weight, all are important and none are inconsequential.
While these rules cover what to do when a position grows very large or very small, they don’t say much about what to do in less clear-cut situations where a position seems a bit too large or small relative to its attractiveness.
So here are a few thoughts on:
The benefits of active versus passive position sizing
Historically I have used a passive position sizing strategy. In other words, I didn’t adjust position sizes on a per holding basis.
Instead, all new investments began at something close to the average position size, depending on how much cash was available. After that, position size was driven by share price gains or losses rather than any active decision on my part.
This is similar to the passive position sizing approach used by indices such as the FTSE 100 and 250 (and the passive funds that track them).
It’s okay up to a point, but if you’re managing a concentrated portfolio of quality stocks I think there’s a better way: active position sizing.
With active position sizing you deliberately choose how much to invest in each specific company. In other words:
- Above average holdings have above average position sizes
- e.g. 6% to 8% in my case
- Average holdings have average position sizes
- e.g. 4% to 6% in my case
- Below average holdings have below average position sizes
- e.g. 2% to 4% in my case
In my case, above average holdings are those that combine quality with defensiveness and value. Average means holdings that combine quality or defensiveness with value. And below average means holdings that have only one or none of those quality defensive value attributes.
Here are a couple of quick examples:
You scan the market and find an exceptional business generating consistent double digit growth and returns on capital (a Quality company), operating in the energy supply market (a Defensive market) with a 5% dividend yield (offering good Value). You decide to buy the company and allocate 5% of the portfolio to it, which is more than your average position size of 4%.
Alternatively, what if one of your best holdings runs into minor problems which cause its share price to halve. It might go from 5% of your portfolio to 2.5%. Does it make sense to have just 2.5% invested in one of your best holdings? You decide that it doesn’t, so you top it back up to 5% (as long as that doesn’t break the rule about investing too much cash into one company).
In an ideal world it would be possible to do this with millimetre precision, adjusting each holding to precisely the “correct” weighting.
In the real world this just isn’t possible or practical, because a) the future is uncertain and b) adjusting position sizes will generate costs from stamp duty and broker fees, and if the adjustments are too small the fees will more than offset any potential benefits.
More realistically, it only makes sense to actively adjust position sizes when the adjustment is over a certain size, say adjustments of at least £1,000 and at least 1% of the portfolio (e.g. adjusting a holding from 3% to 4%).
Also, it would be a bad idea to do this every day as it would likely lead to excessive broker fees dragging down returns.
Instead, my preferred approach is to limit purchases, sales or rebalancing adjustments to no more than one or two per month. In other words:
Make regular but infrequent adjustments to improve the portfolio
My old approach to portfolio management was to almost always make one trade per month, typically alternating between selling a holding one month and buying a replacement the following month.
This one-trade-per-month approach stops me from overtrading or getting bored from inactivity, and I’ve been doing it for over a decade.
The idea is to nudge the portfolio towards higher quality companies at better value prices, while taking profits from more expensive holdings or removing weak holdings.
However, alternating between buying and selling does have limitations as there isn’t always something I particularly want to buy or sell in any given month.
In short, I think a more flexible approach would be better.
I still like the rhythm of concentrating on one main investment decision each month, but that decision should be based on this question:
How can I tweak the portfolio to make it better?
If you ask yourself this question once each month, and if you’re building a concentrated portfolio of quality companies with active position sizing, then you’ll probably get one or more of these answers:
- Remove an existing holding that is expensive or low quality
- Add a new holding which is high quality and attractively valued
- Trim back a holding which is oversized for its attractiveness
- Top up a holding which is undersized for its attractiveness
- Do nothing. The portfolio is near perfect.
These actions can be combined in various ways, so a typical month might include one of the following:
- Selling an existing holding and leaving the proceeds in cash
- Buying a new holding using the existing cash buffer
- Selling a holding to fund the immediate purchase of a more attractive replacement
- Trimming back one or two overweight holdings to fund the purchase of a new holding
- Trimming back an overweight holding to top up an underweight holding
- Trimming back an overweight holding and leaving the proceeds in cash
- Topping up an underweight holding from cash
- Doing nothing if there are no obvious improvements to make
A simple way to start these decisions would be to list all your holdings each month along with their position size and a score for how much you like the stock.
In my case I’m trying out a simple system where stocks are given a score of 0, 1, 2 or 3, based on how many of the Quality Defensive Value attributes they have (zero is bad, three is excellent).
Sort the list by position size and you’ll quickly see any anomalies, such as an excellent investment with a small position size (a candidate for topping up) or a weak stock with a large position size (a candidate for trimming back or closing down).
This may seem like a lot of work, but if you limit yourself to one or two trades each month then I think this should be relatively easy to implement.
The goal of these adjustments is that the portfolio should be weighted towards quality defensive value stocks and away from expensive, cyclical junk.
Building a more concentrated portfolio of higher quality better value companies
So there we have it. There is some anecdotal evidence that investors who are focused on high quality companies should run a relatively concentrated portfolio of 20 to 30 companies. And if they really know what they’re doing, perhaps 10 to 20 companies.
In addition, concentrated investors often use active position sizing to tilt their portfolios towards the best holdings with the best expected risk-adjusted returns.
This idea of running a concentrated portfolio makes a lot of sense, and is based on these fundamental assumptions:
- Owning fewer companies allows more time to be spent doing higher quality research per company, hopefully resulting in better investment decisions and better results
- Owning fewer companies allows the portfolio to be more heavily invested in the highest quality companies at the most attractive prices with the best expected returns
I’m going to start this journey towards running a more concentrated portfolio of higher quality better value companies by pruning my holdings back from 34 to 25 or so by the end of 2021.
Who knows; if that goes well, perhaps I’ll be down to 20 by the end of 2022.
The proceeds from these sales are likely to be reinvested back into the portfolio highest quality, most defensive, best value holdings.
Feel free to share your thoughts on position sizing, number of holdings and so on in the comments below.