The Agony and The Ecstasy, a study of the risks and rewards of concentrated investing by Michael Cembalest, Chairman of Market and Investment Strategy for J.P.Morgan Asset Management (H/T Meb Faber), finds that 75% of all concentrated stockholders would have benefited from some measure of diversification in their portfolios.
A concentrated investment in a company may turn sour due to any number of reasons including unbridled expansion on an overly-leveraged balance sheet, management not understanding changes in industry dynamics, underestimating competition, or bungling an important acquisition. However, crucially, a company may fail because of factors outside its control.
“As difficult as it is to build a company and amass wealth, it is just as difficult to keep fortunes aloft,” says Cembalest. “Our analysis (and others before it) demonstrates the hard reality that, all too often, continued concentration may ultimately destroy wealth.”
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Concentrated investments: Force Majeure factors
And “exogenous forces may overwhelm the things we can control,” as shown in the chart below:
Factors both within management control and outside of it may cause destruction of a company’s business, and the study finds that in the long run “the odds have been stacked against the average concentrated holder.”
Concentrated investments: And you thought diversification was a no-no…
“Diversification is protection against ignorance,” says Buffett. “It makes little sense if you know what you are doing.”
The JPMorgan study found, however, that 320 companies were removed from the S&P 500 (INDEXSP:.INX) index since 1980 because they were complete failures, or because of a collapse in their market value or because of their acquisition post- such a collapse.
However, a more broad-based study of Russell 3000 companies, dating back to 1980, found that as much as 40% of stocks fell over 70% from their all-time high prices, and never recovered. More important, the average investor would have lost 54% had he invested in a single stock versus an investment in the Russell 3000 Index from its inception.
“Two-thirds of all stocks underperformed vs. the Russell 3000 Index, and for 40% of all stocks, their absolute returns were negative,” says the study.
These are pretty powerful statistics in favour of diversification, at least to some extent. The empirical analysis in the study also gives a sector-wise break-up of these diversification benefits.
Concentrated investments: And if you knew what you were doing…
You would have invested in that 7% of companies in the hallowed territory of being “extreme winner stocks” across all sectors during the period 1980 through 2014. These are listed below and are called, appropriately, ecstasy stocks: