Portfolio Concentration: How many companies to invest in?

Portfolio Concentration

People often ask us why we invest in such few companies. It is a good question. The answer is two-fold.

First, we wish to simply own the best companies with the widest moats and there are not that many of them, especially in the P&C insurance sector.

Secondly, we believe overly diversifying is not the optimal way to deal with risk. Instead, heightened knowledge of the companies is our way of de-risking.

Case in point: Progressive Auto

Within the private passenger auto insurance, Progressive is the lowest-cost provider along with GEICO. This means that in a sector where customers primarily care about price, being the lowest-cost provider leads to higher profits and higher top-line growth.

Why would you buy another private passenger auto insurance company when you could buy Progressive? There is no point in buying other private passenger auto insurance carriers, because they are not the lowest-cost provider – most are losing money. Note that in the short-term, you may not outperform the index or the sector, as it may be tough to enter at a low valuation (P/B of 3x is not uncommon). However, over decades the higher rates of compounding book value leads to a significant difference in stock performance.

See below a long-term chart comparing Progressive with other private passenger auto carriers. Note that we have added the S&P 500 (^GSPC), so we can also see PGR versus the index.


Graph 1: Progressive Insurance versus Allstate, Travelers, Mercury, Infinity & the S&P (1990-2017 YTD)

Progressive Total Return.png

Here is a question for you:

From a valuation perspective, how much would you pay for a company that has an ROE of 8% and growth with the rate of inflation? How much would you pay for a company that has an ROE of 15% and a top-line growth of 10%?

How many eggs are too many? How many eggs are too few?

Buffett is quoted in a lecture to University of Florida students in 1998 as follows:

If you can identify six wonderful businesses, that is all the diversification you need. And you will make a lot of money. And I can guarantee that going into a seventh one instead of putting more money into your first one is gotta be a terrible mistake. Very few people have gotten rich on their seventh best idea. But a lot of people have gotten rich with their best idea. So I would say for anyone working with normal capital who really knows the businesses they have gone into, six is plenty, and I probably have half of what I like best. I don‘t diversify personally.

We concentrate in our best ideas. This practice manifests itself via a portfolio of less than 10 companies. This is highly unconventional by many standards of “conservatism” in the investment world. There is the widely accepted notion that higher diversification can lead to a more conservative portfolio as, mathematically, the more names you can add whose stocks have less correlation with each other, the less risky the portfolio. We do not think that way.

NASDAQ defines portfolio diversification as follows:

Investing in different asset classes and in securities of many issuers in an attempt to reduce overall investment risk and to avoid damaging a portfolio’s performance by the poor performance of a single security, industry, (or country).

To borrow Buffett and Munger’s views, we believe that risk comes primarily from not knowing what you are doing. We would rather own 5 or 6 companies that we know extremely well and whose earnings power have significant moats around them than 30 companies which we know somewhat well but whose earnings power may have weak moats.

Buffett goes further in 2008:

If you are a professional and have confidence, then I would advocate lots of concentration. For everyone else, if it’s not your game, participate in total diversification. If it’s your game, diversification doesn’t make sense. It’s crazy to put money in your twentieth choice rather than your first choice. . . . [Berkshire vice-chairman] Charlie [Munger] and I operated mostly with five positions. If I were running $50, $100, $200 million, I would have 80 percent in five positions, with 25 percent for the largest.