How many stocks should a portfolio contain?
The story of 20-year-old student Jake Freeman, who made $110m (£93.7m) trading shares in Bed Bath & Beyond, seems to have angered a surprising number of people.
He invested every dollar he and his friends could muster in a single stock — $27 million of them, it turns out. People seem to be undecided between being more irritated by his wealth or his luck. The result could have been very different.
The story raises the question of how many stocks an investor should own. Academic research generally suggests that 20 to 30 provides enough diversification to limit the impact of a single imploding stock while offering the potential for reasonable returns.
It is also common to say that investors only have a limited number of good ideas. For strong performance, they must support these ideas with strong conviction. Therefore, portfolios should only contain a short list of securities. This argument is so pervasive that it may seem puzzling that I will now argue the opposite.
Early in my fund management career, I was reprimanded at an annual review for my lack of wrong performance.
It was a solid year for the portfolio. When my senior colleague asked which companies had been disasters, I was quick to reply, rather smugly, “None!” His answer took me by surprise. “You can’t take enough risks, then. It’s like tennis – if you’re not serving a few double faults, you’re not trying to hit the second serve hard enough.
Although it is frustrating when an asset disappoints, an investment that goes wrong can only cost your portfolio the amount invested. Successes, on the other hand, can generate many multiples of the initial price.
Over the years, I have experienced failures and successes on several occasions. I’m still smart on construction company Carillion, whose true debt position was understated in its accounts.
But I can come back to a few big winners. Perhaps one of the best was Croda, a Yorkshire company that extracted lanolin – the fat found in sheep’s wool – for cosmetics, leather dressing and as a waterproofing agent. It has become a multinational specialty chemical company. I bought the shares at £1.70 in the early 1990s. It’s around £67 today.
Small cap investing, which I specialize in, often produces a binary outcome – a big success or a dismal failure. By holding 100-120 stocks, I mitigate the potential damage of failures and increase my chances of finding winners. It’s the opposite of focused investing, but it’s not unfocused investing.
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 businesses early on their path to growth – opening the door to some of the best potential returns from managing your winners.
You can patiently wait for the slow burners to ignite – I’m thinking of Serica Energy, whose stock price swerved for several years but rose 120% last year. You can slowly add holdings as confidence builds and support trusted managers trying to change the fortunes of a declining or stagnating business. In every market cycle, many of the best returns come from turnaround companies.
A good example is Johnsons Service Group, a provider of hotel laundry services and workwear, which, awash in debt, faced a near-death experience during the 2008-09 financial crisis. We had a small stake and participated in a salvage rights issue, taking additional shares. The activity focused on the rental of textiles – table linen, towels and bedding, as well as work clothes for various industries.
It’s a good recovery story. Covid and recession fears mean it has fallen sharply from its peak of £2.15 in February 2020, but at 91p it is still much higher than the bailout issue price of 2008 of 20p. 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, allowing them to check off all the boxes in the process. They will prefer companies and management to have a long-term track record, which will make it more difficult to support start-ups.
They will want substantial evidence that reversals are turning. This is probably wise if you are managing a small number of stocks. But the problem with this approach is that once all the boxes are checked, the company valuation tends to be high. Stock prices are climbing a wall of worry in investor perception. To get a good deal, it is usually necessary to buy before all the problems are solved.
The impact of failures is less detrimental if holdings are small, but that doesn’t mean you can become lax about the right investment disciplines. Every business you own will face challenges and risks. It is important to ensure that these are not the same risks — that your portfolio is diversified. When participation becomes expensive – or when trust in management is lost – a long list should not be an excuse to hang on and hope. Every farm must count and be closely monitored.
This brings me to one of the perceived problems with long lists – how to properly track many companies. I could flip that concern the other way. How does a high-conviction manager—or a do-it-yourself investor—with a short list of holdings know that stocks are relatively good value if the manager doesn’t review and understand the alternatives in the market?
Managing long lists can be difficult for a do-it-yourself investor. It takes time. The costs of trading stocks in lower proportions also hurt profitability.
I think 10 good large-cap stocks is enough to build a basic stock portfolio for most retail investors who have the time and expertise to do their research and monitor their portfolio. I guess they hold other assets – some bond funds, cash, property – so they have portfolio diversification beyond those stocks. They could then have “longlist” funds managed by managers specializing in small and mid caps.
My main point here is not to say how a portfolio should be managed, but to try to rebalance much of the modern commentary that I think overemphasizes the benefits of “shortlisting” and high conviction investments. There is no one correct method for building a portfolio.
Each investor must find an approach suited to his temperament, time and talent. Unless, of course, it means throwing every penny you have at a stock. Despite Freeman’s experience, this is an all too likely strategy to leave you without a bed or a bath but with hot water.
James Henderson is co-manager of the Henderson Opportunities Trust and the Lowland Investment Company