A defence of long lists
Some investors believe that a small number of stocks held with strong conviction is the optimal way to build a portfolio. In this piece, Portfolio Manager James Henderson discusses why he thinks otherwise, presenting his case in defence of the ‘long list.’
6 minute read
This piece first appeared in the Financial Times.
The story of 20-year-old student Jake Freeman, who made $110mn trading shares in Bed Bath & Beyond, seems to have angered a surprising number of people. He invested in one single stock every dollar he and his friends could scrape together – $27m of them it turns out. People seem undecided between being most irritated by his wealth or his luck. The outcome could have been very different.
The story does raise the question of how many stocks an investor should hold. Academic research typically suggests that 20 to 30 provide enough diversification to restrict the impact of a single stock imploding while offering potential for reasonable returns.1
It is also popular to argue that investors have only a limited number of best ideas. For strong performance they need to back those ideas with strong conviction. Consequently, yet again, portfolios must have only a short list of holdings. So ubiquitous is this argument it may seem curious that I am now going to argue the opposite.
Early in my fund management career I was reprimanded during an annual review for my lack of bad performance.
It had been a strong year for the portfolio. When my senior colleague asked which companies had been disasters, I was quick to reply, rather smugly: “None!” His response took me by surprise. “You can’t be taking enough risk, then. It’s like tennis – if you don't serve some double-faults you’re not trying to hit the second serve hard enough.”
While it is frustrating when a holding disappoints, an investment that goes wrong can cost your portfolio only the amount that was put in. Successes, on the other hand, can generate many multiples of the original price.
Over the years I have experienced failure and success many times. I still smart over construction company Carillion, whose real debt position was understated in its accounts.2
But I can look back on some big winners. Perhaps one of the best was Croda, a Yorkshire business that extracted lanolin – the grease found in sheep wool – for cosmetics, leather dressing and as a waterproofing agent. It grew into a multi-national specialist chemical business. I bought the shares at £1.70 in the early 90s. It is around £67 today.3
Smaller cap investing is often a binary outcome – great success or abject failure. By holding 100-120 stocks I mitigate the potential damage of failures and increase my chances of unearthing winners. This is the opposite of focused investing but is not investing without focus.
To boldly go
Longer lists allow you to be more pragmatic. They allow you to become bolder – to serve harder. With a long list you can test a more diverse array of companies early in their path to growth – opening the door to some of the best potential returns from running your winners. You can wait patiently for the slow burners to ignite – I think of Serica Energy, whose share price went sideways for several years but is up 120 per cent in the past year.4 You can slowly add to holdings as confidence builds and back managers you trust who are attempting to change the fortunes of a flagging or stagnant company. In every market cycle many of the best returns come from companies that are turnarounds.
A good example is former High Street laundry chain Johnsons Service Group (JSG) which, awash with debt, faced a near-death experience in the 2008/9 financial crisis. We had a small holding and participated in a rescue rights issue, taking on extra shares. The focus of the business shifted to textile rental – table linen, towels and bedding and workwear for various industries. It has been a good recovery story. Covid and recession fears mean it has come back sharply from its £2.15 high in February 2020, but at 91p it is still much higher than the 2008 rescue rights issue price of 20p.5 Fortunately we took some profits near the highs.
High-conviction investment managers will likely want more reassurance and certainty that a company is as it appears, enabling them to tick all the process boxes. They will prefer companies and management to have a long-term track record, making it harder to back early-stage companies.
They will want substantial evidence that turnarounds are turning. This is probably sensible if you are running a small number of stocks. But the problem with this approach is that once all the boxes are ticked the valuation of the company tends to be high. Share prices climb a wall of worry in investor perceptions. To get a bargain it is usually necessary to buy before all the issues are resolved and build your position while doubts remain.
The impact of failures is less damaging if holdings are small but that does not mean you can become lax about good investment disciplines. Each company you hold will face challenges and risks. It is important to ensure they are not the same risks – that your portfolio is diversified. When a holding becomes expensive – or when confidence is lost in the management – a long list must not be an excuse for hanging on and hoping. Every holding must matter and be closely watched.
This brings me to one of the perceived problems with long lists – how to properly follow lots of companies. I could flip this concern the other way. How does a high-conviction manager – or a DIY investor – with a short list of holdings know that the stocks are relatively good value if the manager is not looking at and understanding the alternatives in the market?
Running long lists, I have had to learn to trust good analysts and colleagues for their advice on some holdings. There are areas and companies where I am confident of my judgement and others when I know my co-manager and colleagues have more insight. It is important to recognise your own strengths and weaknesses as an investor.
Running long lists can be hard for a DIY investor. It takes time. The costs of trading stocks in smaller proportions undermine profitability, too.
I think 10 good large-cap stocks is enough to form a core equity portfolio for most private investors who have the time and expertise to do their research and monitor their portfolio. I assume they will hold other assets – some bond funds, cash, property – so they have portfolio diversification beyond these stocks. They might then have some ‘long-list’ funds run by managers specialising in small- and mid-cap companies.
My core argument here is not to say how a portfolio should be run but to try to rebalance much of the modern commentary that I believe overemphasises the benefits of ‘short-list’, high-conviction investment. There is no one correct method to construct a portfolio.
Each investor needs to find an approach that suits their temperament, time and talent. Unless, of course, this leads you to throw every penny you have at one stock. Mr Freeman’s experience notwithstanding, that is a strategy far too likely to leave you without a bed but in hot water.
James Henderson is co-manager of the Henderson Opportunities Trust (HOT) and the Lowland Investment Company.
3 https://www.google.com/finance/quote/CRDA:LON?sa=X&ved=2ahUKEwisypOyjZT6AhVJTcAKHV7vAvkQ3ecFegQIKBAa as at 8 September 2022
4 https://www.google.com/finance/quote/SQZ:LON?sa=X&ved=2ahUKEwirmMvojZT6AhUcTEEAHTPcAfEQ3ecFegQIIhAY as at 8 September 2022
5 https://www.google.com/finance/quote/JSG:LON?sa=X&ved=2ahUKEwjWsfGhjpT6AhWXiVwKHQelCO4Q3ecFegQIGxAY as at 6 September 2022
Please read the following important information regarding funds related to this article.
- If a Company's portfolio is concentrated towards a particular country or geographical region, the investment carries greater risk than a portfolio diversified across more countries.
- Some of the investments in this portfolio are in smaller companies shares. They may be more difficult to buy and sell and their share price may fluctuate more than that of larger companies.
- This Company is suitable to be used as one component in several in a diversified investment portfolio. Investors should consider carefully the proportion of their portfolio invested into this Company.
- Active management techniques that have worked well in normal market conditions could prove ineffective or detrimental at other times.
- The Company could lose money if a counterparty with which it trades becomes unwilling or unable to meet its obligations to the Company.
- Shares can lose value rapidly, and typically involve higher risks than bonds or money market instruments. The value of your investment may fall as a result.
- The return on your investment is directly related to the prevailing market price of the Company's shares, which will trade at a varying discount (or premium) relative to the value of the underlying assets of the Company. As a result losses (or gains) may be higher or lower than those of the Company's assets.
- The Company may use gearing as part of its investment strategy. If the Company utilises its ability to gear, the profits and losses incured by the Company can be greater than those of a Company that does not use gearing.