Concentrated Diversification

where oxymoron thrives, the yin and the yang

Building an unassailable position means putting yourself in a position that is a tad vulnerable. A king who wants consolidate power also means that he must delegate power to his loyal followers in which meant the power is never consolidated.

As a wage earner, you want to concentrate your effort in demonstrating your capability in one area while building additional capabilities so that in the event that your company or position goes away or maybe you just wanted that promotion into management.

As an entrepreneur, you may want to be stoic in the face of an uncertainty and destruction but still present a strong emotional response to rally your troops to cross the next chasm and hunt down that next target.

As a writer or a genius, F. Scott Fitzgerald would have said, you may want to hold two opposed ideas in mind at the same time and still retain the ability to function.

The question is not the ability to hold two opposed ideas in our mind as that is what investors are supposedly always doing. We are always weighing our buy decision against the other people sell decision.

The question is the ability to function.

How do we continue to maintain the ability to make decision despite having two opposing ideas in our mind?

The reason we use the word weighted in our publication is that we want to be weighting our position sizing to achieve adequate returns for the risk we are underwriting. Thus, the concept of sufficient concentration and adequate diversification on the portfolio construction process is always not far away from our mind.

At what level do we want concentration and what level would diversification be really be useful?

How do we form a concentrated and yet diversified portfolio so that we can align ourselves with our clients and also adequately diversified to take advantage of various upside and also concentrated enough to make a difference to our life?

The conclusion is surprisingly simple. As usual, things in investing is simple but never easy.

Here goes.

The idea goes back to the concept of compounding.

Let’s create a thought experiment where we have 100 business ideas and in each of the business idea you invest in $10,000.

Each business has its own management and you are just in charge of allocating that $1,000,000 of capital.

The idea is to invest across different companies in which upside is “limitless” (technically but there is some natural barrier to larger size) and the downside is just the amount you had invested. We will buy and hold for 15 years.

The major assumption is that you are able to invest all your ideas at the first day of your portfolio construction (which is simply impossible). But as always, all experiment especially of the mind is just a thought exercise to understand how things could be done better.

We will look at a few sub strategy that we are employing and compare their returns as below.

The Barbell Way (BB):

Let’s imagine a barbell approach to investing where we have a few huge winner, many losers and a large amount of treasury bills.

We will assume that 1% of the pick become 100 baggers, 1 % of the pick turns out to be 25 baggers and 3% of the picks turn out to be 5 baggers. The rest of the portfolio turns into zero or stay invested in treasury bills earning a paltry 2%.

A portfolio like this would have become 2.09x over 15 years period achieving 5.1% annual compounding rate.

Not exactly a scintillating performance but the investor had his fun punting in the market and that excitement should be worth some decrease in returns?

This looks like a portfolio for someone who is already wealthy and he do not mind punting with his excess cash.

Our gut feel is that this is how most retired angel investors portfolio looks like. They wanted some returns but needed the safety net as well.

If we minus out the excitement of investing in start-up companies, maybe it is better to just leave the 50% cash in an index fund and just play with the grandkids.

The Venture Capital Way (VC):

An aggressive method is to invest in the VC way via the public market. Since it is all about investing and getting the multi-baggers, let’s just assume that the portfolio had doubled all their winners and losers.

In VC world, the usual argument is that you just need a couple of winners to turn in some good return. As for applying the VC mentality to the public world, the numbers below suggested that even having 2% of the portfolio achieving 100 baggers is insufficient to generate a return which could turn a portfolio into a market beating one.

A portfolio like this would have become 2.84x over 15 years period achieving 7.2% annual compounding rate.

For a chance of total ruin, the expected return here had been quite a disappointment. Unless your ex-life is a Venture Capitalist who can pick 100 baggers at will, there is not sufficient return for this type of risk.

We had assumed for the worst here at losses of 90%. This is most probably untrue but useful in thinking for the worst case scenario.

From this point onward, we will not assume a buy and forget strategy.

You may have more than 100 ideas and may invest more than $10,000 in each idea.

The special situation way of investing require active management to buy and sell upon the event.

The Special Situation Way (SS):

Instead of investing in the VC way, you could also go for the SS method of investing which we specialise in. It is a constant grind as instead of buying and forgetting, the investor needs to constantly be looking for opportunities to grind out that 6 - 12% gain in the portfolio.

The good news is that we have always been able to find situations where we could deploy cash for a good level of return.

A portfolio like this would have become 3.43x over 15 years period achieving 8.6% annual compounding rate.

For that level of work, maybe we should be better off just leaving that money in an index fund which may just yield more than 8.6% per year? Working for the sake of working is not what we hope to achieve…

Special Situation + Venture Capital Way (SSVC):

Mixing strategy can often produce interesting results. The structure of this portfolio will be 50% Special Situation and 50% Venture Capital type of investing. We will allow a drift in strategy from Special Situation to Venture Capital.

We will also assume a more than quadrupling of total loss (-100%) due to the higher risk involve in searching for the 100 baggers and thus a corresponding achievement of achieving 1% of 100 baggers and 1% of 25 baggers.

Now we are coming close to the aim of at least maintaining a return which is possibly rivalling the index.

A portfolio like this would have become 4.32x over 15 years period achieving 10.3% annual compounding rate.

This is somewhat considered as a decent return. Life is still going to be a constant grind but at least the rewards are well justified.

SSVC Dynamic Weighting Way:

If we are to dynamically weigh the SSVC, and that means that as we are able to recognise the winners and allocate more to them, then we could effectively build 1 position of 5% which could effectively become a 100 bagger and 1 position of 5% which could become a 25 bagger.

This investing method will test our emotional response to be able to keep and grow our winners while pruning our less effective position. We believe this would be an emotional ride.

A portfolio like this would have become 9.04x over 15 years period achieving 15.8% annual compounding rate.

SSVC Dynamic Weighting Way + Lots of Luck:

Ok, we will admit that aiming for “luck” should not be here.

While aiming for luck is technically an “impossible” exercise, we would still like to position ourselves for some luck. We do occasionally move certain position to around 10% of our portfolio when the wind seems to be blowing all in our favour.

The good new is that if we are really in this lucky position, the portfolio would have been up a good 15x since inception achieving 19.8% annual compounding rate. A little luck or compounding can really go a long way!

Oh wait!

We are still below the 24% per year that we are aiming for! Let’s not get too hung up on the details or “underperformance”…

The simple idea remains that you must let your winners run and they must reach the 25/100 baggers status. If not, no matter what you do, you will not be able to get a good rate of return.

Instead of selling your winners, you may want to pile more into your winners.

The question next is how do I know that it is a winner?

But that is for the next post.

The world is getting crazier with all form of yields reaching multi-year low. As special situation investors, we need to continue to grind out some returns every week, while positioning ourselves to have a multi-baggers along the way.

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