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Grow Into Concentration

Concentration is a double-edged sword. When you’re right, you achieve incredible results. When you’re wrong, you blow up.

Many concentrated growth funds holding only a handful of highly correlated stocks suffered the latter fate in the past six months as high growth tech imploded. As Q2 letters circulate around the internet, I’ve seen funds down 60-80% YTD. It’s hard to recover from that. If you’re down 80%, you have to 5x just to get back to even.

There are many mistakes we might learn from such challenged performances — risk management, ignoring fundamentals, “quality” at any cost — but my biggest question is whether concentration is appropriate for growth strategies.

Value, Growth, and Concentration

Concentration is dogmatically promoted in investing. Many believe it’s a requirement for beating the market. Buffett concentrates on his best ideas by asking, “Why would you want to own your 20th best idea?”

It’s a valid question but more meaningful when considered in the context of value vs growth.

Whether you invest in “value” or “growth,” you always have to buy something that will be more valuable tomorrow than it is today. It doesn’t matter if you’re buying an asset that appears cheap today with a high probability of accruing meaningful value to the shareholder in the medium term or an asset that will appear cheap tomorrow if it hits on less certain odds of accruing significant value to the shareholder in the longer term.

That’s the difference in philosophies between value and growth. Value pursues apparent value today whereas growth chases more subjective value in the future. Another way to think of it is that the value philosophy strives you minimize downside via a margin of safety whereas the growth philosophy strives to maximize upside given future potential.

Now back to Buffett’s concentration question about owning your 20th best idea.

In the context of value investing, it’s not worth owning ideas far down your list if you’re confident in your assessment of value with a strong margin of safety. You should concentrate in the assets where you see limited downside with the most upside.

Growth is different. Investing in growth often means investing in younger companies without track records of consistent earnings or maybe even revenue. When you invest in growth, you’re investing in a grand but uncertain future. Since you’re investing in an inherently less certain future, your margin of safety will be more limited, and your downside risk will be much larger than the value investor.

Consider an example.

If you’re Buffett buying OXY at a 20% FCF yield, you’re making a bet based on apparent value available to shareholders today. You have to believe that the oil and gas business will be relevant enough in the future to continue to generate strong value for shareholders and that OXY will continue to return capital to shareholders.

It’s unlikely that OXY ends up being a 10-20x over the next decade. It’s also unlikely that an investor loses his entire investment.

If you’re a growth investor buying a green energy company with no earnings or capital return program but strong prospects for future value based on the adoption of EVs, then you’re making a very different bet.

The green energy company could be a 10-20x returner or even more over the next decade. But it’s also very possible the trend fails, a competitive solution emerges, or some other negative event happens that invalidates a fragile claim on the future. Growth names often end up zeroes.

Given the potential for 10x, 20x, and even greater returns given an uncertain future, the nature of growth investing is better suited for exposure to your 20th best idea because that idea might be the one that ends up a 100x.

Grow Into Concentration

A better approach for growth investors is to allow your portfolio to grow into concentration.

If you were to invest in 20 companies and not rebalance for 10 years, two to four of the companies would end up comprising most of the value of the portfolio. The active growth investor can grow into concentration by holding on to winners and cutting losers, and you’re bound to have losers if you invest in growth. As I write often here, most companies aren’t great, which means they won’t be great investments over long periods of time.

If you structure a portfolio that grows into a concentrated representation of big winners over time, rather than concentrate in your highest conviction winners all at once, you achieve a few important things:

You decrease your chances of an unrecoverable blow up. An investor’s goal should be to maximize his long-term rate of compounding. It’s hard to do that with a down 60-80% year.
You create a margin of safety at the portfolio level vs the investment level. Since it’s hard to create meaningful safety in individual growth investments, you can create that safety through management of the position size. You can still weight your most favored ideas higher than your less favored ideas, even drastically so, but avoiding extreme concentration decreases the chances of existential threats if one or two ideas go against you.
I find having few more ideas in the portfolio, even if small in scale, reduces commitment bias to large, concentrated positions. If you demand concentration to the point of no exposure to other ideas, it becomes harder to move on from those ideas long after you should because you don’t know where else to go.

There’s no single answer to the concentration question. Peter Lynch often owned more than 1,000 stocks in the Magellan Fund. That’s the opposite of concentration. Stage of investment also matters — you should take more swings at earlier stage companies, while you can get away with taking fewer swings at more mature growers.

Concentration is great, but it must be considered as part of the broader strategy of a portfolio. Concentration at all costs shouldn’t be the beginning demand of a growth fund while ignoring all else. Dogmatic embrace of concentration in growth invites high highs accompanied by painful blow ups.

Bear markets teach us lessons if we’re willing to listen. Concentration is a better destination for growth investors than a starting point.

Notes and Quotes

Nuclear Energy and Painful Stupidity

Speaking of growth investments, one of the most obvious and exciting areas for innovation is in nuclear energy. The energy crisis in Germany, and the painfully stupid current plan to shut down the country’s remaining nuclear plants while Russia toys with the Nord Stream pipeline, has brought nuclear power to the forefront.

Doomberg highlighted the progress of NuScale Power, a recent SPAC. The company makes small modular reactors (SMRs, also the company’s ticker). It appears that NuScales reactor will become just the seventh reactor design to be approved for use in the US.

From Doomberg’s piece:

The simultaneous recognition that NuScale isn’t perfect but that perfection need not be the enemy of the more-than-good-enough is the type of pragmatic response one would expect from industry veterans who have long-suffered like beaten puppies at the hands of anti-scientific decision-makers. The benefits of the underlying technology of uranium fission are so overwhelmingly positive for humanity that getting any new design over the line is a victory worth savoring.
Of course, the one thing radical environmentalists can’t stand for is the development of technologies that allow humans to flourish while minimizing our impact on the planet. They are in the suffering business, after all, and business is booming. Many professors at elite universities long ago debased their institution’s reputation for scientific rigor in the name of political self-enrichment, and a recent “study” attacking SMR technology – one which rolled out the same old and tired attack on the nuclear waste issue – is another in a long line of political gibberish masquerading as research:
“Mini nuclear reactors that are supposed to usher in an era of cheaper and safer nuclear power may generate up to 35 times more waste to produce the same amount of power as a regular plant, according to a study.
A team of researchers at Stanford University and the University of British Columbia came to this conclusion after studying a design from each of three small modular reactor (SMR) manufacturers: NuScale Power, Toshiba, and Terrestrial Energy.”
This is the type of headline that announces a report which can – and should – be immediately dismissed as captured propaganda. If you are prone to believe that the best the nuclear industry can offer after eight decades of development is a design exacerbating nuclear waste by a factor of 35, then, as the saying goes, we have a bridge to sell you.

Painfully stupid things are always obvious, and I won’t hide my ideological biases here.

It’s becoming more and more apparent that the objections to nuclear are painfully stupid when set against vocal demands to move away from fossil fuel sources from the very same people who object to nuclear.

Nuclear is ready for broader adoption. We need to embrace it, acknowledging the inherent risks and ignoring objections from the non-objective.

Disclaimer: My views here do not constitute investment advice. They are for educational purposes only. My firm, Loup Funds, may hold positions in securities I write about. We do not own SMR at this time. See our fuller disclaimer.

The Deload

Concentration as a Destination