So says Terry Smith, CEO at Fundsmith.
As a manager running a genuinely high conviction fund, holding between 20 and 30 stocks at any one time, you might expect him to have this point of view.
But Smith cited research which showed the benefits of diversification in reducing risk within a portfolio peak at 23 stocks.
On top of this, from a manager’s point of view, he thinks it is easier to know a lot about 20 to 30 companies than to know about 100 companies in-depth. Likewise, his list of 60 to 70 companies ‘to keep an eye on’ is easier to track than a bigger universe of potential investment targets.
Bearing in mind his fund has a global remit his concentration shows even more conviction.
He is not alone in this approach either. Nick Train, portfolio manager of Finsbury Growth and Income Trust and founder of Lindsell Train is another advocate of the concentrated approach.
He holds 24 “great companies” and has an average turnover of zero to 10% per annum, which means stocks are held for an average period of seven years. Train only sells stocks if he no longer considers them quality companies or when their rise in value causes them to become too large a proportion of the portfolio.
This is similar to Smith, who says in ten years of managing the Tullett Prebon Pension Fund half of his sells were made out of necessity because of takeovers.
The other half were sold because he saw better value in other stocks on his “good quality” radar, or because management in these companies ‘did something silly’. He is reported as saying his turnover rate per annum at that time was only about 4% of the pension funds holdings and yet it “comfortably beat any equities index you care to name”.
Such a track record has not been left behind since launching his fund management firm in 2010. The Fundsmith Equity Fund has returned 41.5% since inception in November of that year compared with 23.5% from the MSCI World Index and in 2012 it returned 12.5% compared with 11.4% from the MSCI World Index.
At the helm of Finsbury Growth and Income Trust Train also has impressive numbers to cite. Over five years he has posted returns of 65.4% versus 13.2% from the FTSE All Share Index and last year returned 25.4% compared with 12.3% from the index.
Both of these managers invest in mainly household names, with an emphasis on the role of the consumer and what Smith describes as “small ticket goods” – meaning you get change from a tenner when purchasing them.
Buffett in the background
They both also cite Warren Buffett as an influence in their approach to portfolio management of building a concentrated portfolio of ‘quality companies’ with strong brands and/or powerful market franchises.
Buffett is known for his view “wide diversification is only required when investors do not understand what they are doing”, but there is no escaping that blue-chip, high-quality companies can at times seem overvalued for exactly those attributes.
Smith disagrees. Firstly from a valuation perspective, he says many great companies are still trading in the mid-range by historical standards.
Secondly, investors are constantly expecting quality stocks to mean revert and their advantage be “competed away”. Smith says they think the capital coming into such companies as a result of their good returns will mean those returns come down to a lower average.
“This is a good economic theory, but I think these companies we seek to own perform a miracle of capitalism and do not mean revert. The market continues to value them as if they will but they do not and they have managed not to for decades. Mostly they are undervalued and we do not need to sell them”.
His “upshot to all of this” is that rather than seeking superior performance by buying high risk stocks, investors should seek out ‘boring’ quality companies with predictable returns and superior fundamental financial performance, thereby taking advantage of their persistent undervaluation.
The trouble is now the secret is out won’t everybody do the same and thus push prices higher? Let us know what you think below…