Why We Don’t Own Concentrated Positions

investing-concepts-300x279There is no denying that substantial amounts of wealth have at times been created by company founders owning concentrated positions in their company’s stock; Warren Buffett with Berkshire Hathaway, Bill Gates with Microsoft, Jeff Bezos with Amazon and Mark Zuckerberg with Facebook are just a few examples.

What is less often discussed, but of significant importance, is how quickly substantial amounts of wealth can be lost when a concentrated position unexpectedly suffers a painful decline in value. In just the past few months the dangers of owning concentrated positions in individual stocks has gained attention.

Perhaps the most glaring example is with the greater than 70% drop in the stock price of hedge fund favorite Valeant Pharmaceutical. While the company struggles to defend itself against various accusations of wrongdoing, at least two very prominent investors and their clients have suffered significantly due to the size of their holdings in Valeant. Five-star rated Sequoia mutual fund at the end of the second quarter held a greater than 30% weight in Valeant. Not surprisingly the substantial loss of their client assets due to this concentration has caused much turmoil, including fund directors resigning. Meanwhile, famed hedge fund manager Bill Ackman of Pershing Square recently held approximately 30% of his client’s assets in Valeant and has found himself having to repeatedly publicly defend his controversial position after his fund suffered notable declines.

SunEdison is a solar business that has not garnered as much media attention as the Valeant debacle, but is a large position recently held by the famous hedge fund manager David Einhorn of Greenlight Capital. The 88% decline in the stock over just 4 months has contributed to a very challenging performance period for his fund.

Our final example of recent stock declines is not of a specific money manager, but of a noteworthy company. As recently as July of this year the very highly regarded German company Volkswagen became the largest automobile company in the world by sales. Just two months later the shocking news of an emissions scandal punished the stock to the tune of a nearly 40% loss in just 2 weeks.

No investor is immune from the occasional stock holdings that suffer painful price declines. However, we believe that by keeping our individual stock holdings to less than 5% each and more commonly about 3%, our best investment selections will grow over time with less risk than concentrated positions can create.

Source: Brian Boughner, CFA, CMT