- Warren Buffett, 1965 Partnership Letter
Anybody who has read Patrick O’Brian’s Aubrey and Maturin canon are quite familiar with concept of carrying too much sail. In the days before steam, all navies were dependent on the vagaries of the wind. Whether it be triple reefed topsails in a gale (meaning sails were made smaller through a series of “reefs”) or becalmed in the doldrums in the Sargasso Sea, ships’ schedules were dependent upon the amount of wind and the amount of sails the ship could carry. It was common for younger officers to over-press or over-canvass the ship. This meant that - counterintuitively - the ship could go faster if the masts carried less sail. Sometimes too much canvas could push the head of the ship downwards thereby creating more drag and slowing the ship down. Great sailors knew when less sails meant more speed. As the traditional saying goes, any damn fool can shake out a sail, but it takes a sailor to reef it.
I bring this up not to simply mention the writings of Patrick O’Brian (though his works rank as some the best literature of the past century), but to point out the concept that less is more is as easily utilized in value investing as it is in an Atlantic gale in the Bay of Biscay. The idea of reducing the number of holdings in your portfolio goes against most major investment theses centered on risk. Many of these state that a greater number of holdings can reduce risk over time. In the next section, I will discuss why that overall negative view is well justified.
For now, I wanted to discuss why my firm takes a different approach than most of Wall Street. At Nintai Investments, we are quite aggressive in limiting the number of holdings in our personal and institutional portfolios. We achieve this by focusing on a very small segment of the total market. This segmentation can be made by any number of criteria: corporate strategy, financial strength, Nintai’s knowledge of the business market and competition, etc. We run a very focused portfolio consisting of roughly 20 - 25 stocks. We do this for several reasons.
The Market is So Big, and My Mind is So Small
As of 2016, there are roughly 109,000 publicly traded stocks in all of the global markets (there are roughly 200 stock exchanges in the world). Nearly 4,000 of these are traded on a regular basis on the two major US exchanges – the New York Stock Exchange and the NASDAQ. Another 15,000 trade over-the-counter (or on the so-called pink sheets). That’s a lot of companies! To truly understand all the aspects of an investment (its strategy, operations, financials, markets, competitors, etc.) we’ve found we can own no more than 25 stocks and have a level of comfort that we completely understand each of our holdings.
My Business Knowledge is Wide….But Incredibly Shallow
To understand a company, an investor has to have considerable knowledge about their business and markets. Through my investing career I’ve found two areas where I’ve developed deep industry knowledge – health care and informatics. Most of the holdings in our portfolios will be in one of those two areas. You may have considerable knowledge about certain industries because of your line of work. Great returns can be made by investing in what you know about. Conversely bad returns can be generated by investing in something you know nothing about. As Thomas Watson Sr. (founder of IBM) said, “I'm no genius. I'm smart in spots — but I stay around those spots.”
My Criteria Rejects Roughly 99.99% of Publicly Traded Companies
I’ve discussed in great detail Nintai’s criteria for selecting portfolio holdings. It focuses on businesses with high returns, little/no debt, deep competitive moats, and trading at a reasonable discount to our intrinsic value. After running a screen with our investment criteria, we are left with roughly 140 - 180 publicly traded stocks around the world. It’s a pretty small pond! We believe the criteria create a portfolio with sound downside protection (owe very little money and are deeply embedded in client operations) as well as upside potential (platform-based with multiple new market opportunities).
It Works For Us
A final reason (without trying to boast) is that it has worked - as configured by Nintai - for over 20 years. Our employees and investors have done quite well against the major indices. (remember: past returns are no assurance of future performance!)
Is Less Really More?
As you read this article, you might think I’m now going to demonstrate that good, old-fashioned, intellectual sleeve rolling helps most focused portfolios generate better returns than the general markets. That would be a misplaced assumption. In fact, the exact opposite is true. Nintai is in a very distinct minority of focused portfolios that has outperformed the general markets over extended periods of time (see the previous warning that past performance is no assurance of great future returns!). As seen from the previous section, we’ve never run a focused portfolio because we think focus - by its very nature - outperforms the broader markets. Far from it. We run a focused portfolio out of necessity, not choice.
It turns out, running a focused portfolio - in general - isn’t an assurance you will outperform the markets. In fact, recent research by Morningstar demonstrates focused portfolios are no better (performance-wise) than broader index funds. However, they are more expensive by far. In Morningstar’s “Portfolio Concentration Doesn't Have Much Sway on Returns”, Alex Bryan writes that their research finds there is no significant relationship between portfolio concentration and gross returns among U.S. equity mutual funds. The idea that allowing an investment manager to focus on his top picks will lead to market outperformance is really just all hogwash. This of course comes as a great surprise to focused investment managers (like me!), investment management companies that market such funds, and investors who put money in such funds.
Performance is Similar to Non-Focused Portfolios
Focused portfolios (as measured by the percent of assets invested in the manger’s top 10 picks) had little effect on gross return when compared to non-focused funds within their respective Morningstar category. Accordingly, the odds of choosing a focused fund that will outperform the Morningstar category average return is very low. In Large (Growth, Core, and Value), Mid and Small-Cap, performance during 2004 - 2018 between the lest-focused quartile and the most-focused quartile was quite similar. In fact, in the total 9 domestic stock categories, only 2 saw the focused portfolios exceed the least focused by more than 1%. When fees are taken into account, most outperformance is washed out.
Focused Funds Can Deliver Great Outperformance….and Great Under-Performance
As a portfolio becomes increasingly focused, the risk of wider swings in performance becomes much larger. For instance, a 100-stock portfolio had drawdowns of over 5% just once every 157 days from 2010 – 2017. A 20-stock portfolio had a similar drawdown every 34 days. Such swings happening at a far greater frequency can play old Harry on an investor’s nervous system. So remember: concentrated funds can deliver greater outperformance, but also greater underperformance. One other important reminder: since the majority of all funds never outperform the general markets, it stands to reason neither do focused funds.
Focused Funds are More Expensive
The average focused fund charged between 25 to 50 basis points more than a traditional non-focused fund. The largest difference was in small-caps - with focused funds charging roughly 39 basis points more. Large-caps had the smallest gap, with focused funds charging roughly 21 basis points more. Looking at performance, it’s not clear paying such a greater amount in management fees is worth it in the long run.
Since founding the Nintai Partners Investment Fund in 2004, I have always run a relatively focused portfolio. Nintai Investments LLC continues that investment strategy. That said, as you look for investment managers it’s perfectly fine to invest with one who maintains a portfolio of 300 stocks versus one who focuses on only 25 individual positions. The key is understanding why the manager believes a focused approach works better and what their record has been in using such an approach. Sometimes spreading a little canvas can be just as effective as shortening sail. It simply depends on the sailor and the conditions.
DISCLOSURES: None, with the exception that I’ve read the Aubrey and Maturin canon (21 books) 8 times over.
 For a far more detailed discussion on how we select holdings – and what criteria we use – please see my article “Our Investment Strategy and Portfolio Selection” which can be found here.
 “Portfolio Concentration Doesn't Have Much Sway on Returns”, Alex Bryan CFA, Director of Passive Strategies Research, North America, Morningstar Manager Research, May 1 2019