ADRIAN SAVILLE: Concentrated portfolios don’t work in all markets

Stanley Druckenmiller stands out as one of Wall Street’s great investors, generating returns for clients of just more than 30% a year for 30 years without a single down year.

In producing this almost peerless record he argues that “... diversification is the most destructive, overrated concept in the investment business. Look at George Soros, Carl Icahn, and Warren Buffett. What do they have in common? They make huge, concentrated investments.” But he goes on to suggest that to succeed in this way, you need ruthless discipline. If the reason that you invested changes, then “get the hell out and move on”.

However, what these success stories fail to highlight are the swathes of investors who have lost a substantial amount of their money — and sometimes all their money — seeking the same goal but unfortunately concentrating their investments on “wonderful businesses” that did not pan out. To argue in favour of concentration then, one must consider the potential fallout from a high-conviction bet going awry. This consideration gains relevance in a setting where the world’s largest equity market, represented by the S&P 500, is the most concentrated it has been in decades.

This is not the first time that we have seen market concentration on such a scale. In the case of the US market, we had the Nifty Fifty in the 1960s and 1970s, a group of loved stocks that included Xerox, Texas Instruments and Polaroid. Similarly, in the early 1980s, oil stocks dominated the market. But these instances — and many others — precipitated considerable market declines when these concentrated investments faltered. Perhaps the most notorious case of perverse concentration is Nokia, which made up 70% of the Helsinki Stock Exchange in 2000. While extreme, the episode underscores the inherent risk of overreliance in an investment strategy that is dependent on specific sectors or individual stocks.

In the US today, the risk arguably is amplified as the loved titans make up more than a quarter of the index. And Microsoft, Apple, Nvidia, Tesla, Alphabet, Amazon and Meta trade on forward price-to-earnings ratios of just more than 30 times, which is almost double that of the rest of the S&P 500.

In Valuing Growth Stocks: Revisiting the Nifty Fifty  (1998), Jeremy Siegel shows that stratospheric valuations seldom end well. Even more so in the case of concentrated markets. Arguably, what is most needed to manage risk in richly priced and tightly intertwined markets is not concentration, but diversification. And a way to diversify without compromising the integrity of an investment portfolio’s strategic asset allocation is to move capital into an equal-weighted index, where every holding has an equal shout, rather than a cap-weighted index, where titans rule.

Balanced exposure

To this end, equal-weighted portfolios specifically give the potential to outperform when a cap-weighted portfolio results in extreme concentration in richly priced assets. This was evidenced in Finland, the JSE and commodity counters in the noughties decade. The argument also holds with the SA equity market in recent times. A more balanced exposure reduces the risk of significant downturns in the portfolio when a single stock (or cluster of darlings) underperforms. In such instances, a shift towards equal weighting could provide a better return, as large losses linked to idiosyncratic drivers in the high-weighted stocks have an overbearing effect on the portfolio.

Supporting this view, over the past 20 years, an equal-weighted fund invested in the S&P 500 delivered an annualised return of 10.8%, beating the cap-weighted fund’s return of 10.0%. A material caveat, though, is that the excess return of the equal-weighted fund was generated with volatility of 16.9% a year, compared to the cap-weighted fund’s volatility of 14.7% a year. Therefore, geared to a similar level of risk, the cap-weighted fund produces a better result. This hints that while the US equity market — represented by the S&P 500 — might be considered concentrated by its own standards, the fact that it has 500 constituents evidently mitigates concerns about concentration risk.

This is not the case in all markets. The instance of Nokia is an extreme example. But other episodes of concentration with elevated valuation wave a warning flag. Consider the case of Japan during its “lost decade” of the 1990s. The cap-weighted Nikkei index was concentrated in large, richly priced firms such as Sony and Toyota. These firms faced significant headwinds, and they proved to be a millstone. An equal-weighted Japanese portfolio, by contrast, benefited by avoiding these high levels of concentration, and weathered the economic storm more successfully.

If we bring this to present times, a market-weighted approach would advocate putting more than 25% of your SA equity into just two investments, Anglo American and a Naspers-Prosus cocktail.

These investments represent great firms, but this might be an unwise hefty dollop given the highly sensitive nature of commodity prices that influence Anglo American’s earnings, and that Naspers and Prosus trade on price-earnings multiplies of 160 times and 170 times, respectively.

Here, it is worth underlining that the concentrated nature of the JSE, coupled with the fact that giants have stumbled from time to time, means that over the past 20 years, an equal-weighted portfolio of large-cap stocks has produced a better return than the JSE top 40 index, and it has done so with lower volatility.

This makes the SA equity market a strong candidate for a more balanced approach, where diversification has asserted itself as a valuable tonic for risk management to deliver the proverbial free lunch.        

• Dr Saville is a professor at GIBS and an investment specialist at Genera Capital.