By LAUREN R. RUBLIN
For the past 20 years, students of stock-market investing have worshipped at the twin altars of modern-portfolio theory and efficient-market theory. The first holds that the more diversified a portfolio, the less the risk from each of its components. The latter posits that active money managers have no more stockpicking prowess than a bunch of randomly tossed darts. Marry these theories, and what do you get? An index such as the S&P 500, which has vanquished all but a few extremely gifted -- or is it merely lucky? -- active managers, especially in recent years.
No surprise, you won't find too many portfolio jockeys at the wedding, throwing rice. Instead, the S&P's compelling example to the contrary, a small but growing cadre of investment pros is turning its back on both revered theories. These particular managers seek to beat the mighty index -- and some have done so resoundingly -- by concentrating their bets on no more than 25 stocks. And they're in arguably excellent company: Warren Buffett, the king of concentrators, confines his stock holdings to fewer than 10 anointed names.
Though it flies in the face of business-school doctrine, portfolio concentration has intuitive appeal. "If one manager holds 40 stocks, you might get his 10 best ideas, while the other 30 are filler," says Greg Horne, president of Ashbridge Investment Management, a Philadelphia-based investment adviser. "I would just as soon get the filet."
Others see no hope for glory without commensurate guts. "No hospital wings or college dormitories have ever been named by an indexer," declares James Oelschlager, founder of Akron, Ohio-based Oak Associates, which manages almost $5 billion in mutual funds and institutional accounts. "They've been named by people who invested in one or two stocks and rode them for a period of time."
By fund-manager standards, Oelschlager too might qualify for his own wing or dorm. Screening Morningstar's Principia Plus database turned up only three mutual funds with 25 or fewer stocks that beat the S&P 500 over three- and five-year periods: Oelschlager's White Oak Growth Stock, Oak Value and Sequoia, a 15-stock fund run by Buffett confreres William Ruane and Richard Cunniff, that long has been closed to new investors. A few other relatively concentrated funds, including Clipper, Longleaf Partners and Ken Heebner's CGM Capital Development, also have amassed outstanding long-term records, but the slim ranks of tenured superstars hasn't deterred a batch of newcomers in the past year or two.
"Although some concentrated funds have been around for quite a while, it's just in the last 18 months that we've seen funds launched specifically to play on a concentrated theme," says Ken Gregory, a San Francisco investment adviser and newsletter writer. Some upstarts, such as Yacktman Focused, CGM Focus and PBHG Large Cap 20, were spawned by successful, more diversified parents. The infant Marsico Focus (along with a more diversified offering) is manager Tom Marsico's new act; the popular fund manager departed Janus Funds last fall. Lately, $1.2 billion Oakmark Select has had industry jaws dropping: the 19-stock fund, managed by William Nygren, returned 55% in '97, its first full year, and another 13.4% in the quarter ended March 31. Nygren's top holdings include U.S. Industries, USG, Tele-Communications Liberty Media Class A and PartnerRe.
Concentration seemingly is more popular, or at least has met with more widespread success, among institutional money managers. Screening Invest-Works Pro, a database maintained by Barra RogersCasey, for similar composition and performance characteristics yielded 14 products, ranging from $25 million in institutional tax-exempt accounts run by Sorema Asset Management to $4.3 billion in accounts managed by the aforementioned Oak Associates. And that list doesn't include firms that lack five-year track records or have trailed the S&P by so much as a whisker.
Wilson/Bennett Capital Management, of McLean, Virginia, is in the latter camp. In the last 10 years value investor John W. Fisher, the firm's founder and CEO, has managed to keep pace with and frequently beat the market by holding just 12-15 stocks. "I didn't make a conscious decision in 1987 to run concentrated portfolios," he says. "The analytical process -- valuing businesses and pieces of businesses -- lends itself to a concentrated approach. We get to know the companies well, and if you're following 12 or 13 stocks, it's much easier to know what's going on in the underlying businesses."
Fisher is on intimate financial terms with, among others, Bankers Trust, Texaco, Mobil and Philip Morris. In Big Mo's case, he charges, the market currently is placing "almost $2 negative value" on the tobacco business.
In the past year, Fisher claims, he's received as many phone calls inquiring about concentration as he did in the previous nine. "The Buffett effect has had a lot to do with it," he surmises. "Also, some people finally have come to the conclusion that there is no way to follow 100 different companies, particularly large-cap multinationals. The guys buying 90-100 stocks really are closet indexers. They're simply trying to keep up with a benchmark."
Brett Robertson, president of Dallas-based Richmont Investment Management, seconds that rather inflammatory notion. Academic and industry studies, he notes, have shown that the inclusion of as few as 16 stocks in a portfolio eliminates as much as 93% of stock-specific risk, provided, that is, the stocks aren't closely correlated. "Yet in spite of the statistical facts, many managers hold more than 100 stocks," he marvels. "A lot of traditional shops don't concentrate because it means taking a lot of risk to the mother ship, and major blowups can mean the end of marketing. If they don't do anything wrong, money is going to pile into their funds, even if they're just mediocre. We think diversification is a recipe for mediocrity, especially if you measure the fees of a diversified portfolio against an S&P index fund."
Those are fighting words to proponents of diversification -- namely, the vast majority of active managers, some of whom have racked up sterling returns with 100 stocks, and more. But they get to the heart of the increasingly raucous debate about whether less is more. And they lend credence to Bill Nygren's assertion that the current interest in concentration "stems directly" from the success of indexing.
How so? Investors who allocate their assets to a variety of managers or funds, each with a diversified portfolio, in short order find, says Nygren, that they have replicated the S&P or another index, albeit at greater cost. Yet, the two investment approaches need not be opposed. "We believe concentration works hand in hand with indexing," he adds, suggesting that concentrated and diversified funds together can make better music than a collection of diversified funds alone.
It's easy to see the drawbacks to pure concentration, which Morningstar highlighted in several studies in the past two years. Sharply limiting the number of holdings in a portfolio does not, in itself, provide any performance edge. It's the manager who makes all the difference. In the hands of a great stockpicker, a tightly focused portfolio has an excellent chance of outperforming the market, as each winning issue packs much more of a wallop. But the exaggerated impact of a rotten egg or two, conversely, can spell disaster.
Some concentrated funds also are more volatile than their diversified brethren, although not necessarily more risky. Investors who take their financial temperature daily should steer clear, as White Oak Growth Stock's recent adventures illustrate. The fund "got slaughtered," in manager Oelschlager's words, in last year's tumultuous fourth quarter, only to snap back with a handsome first-quarter gain of 17%.
If concentration isn't for cardiac patients, neither is it for most short-term investors. In fact, Dennis Bertrum, founder and president of New York's Bank Street Advisors, believes that concentrated-fund holders must be willing to hang on for five years, at least, in order to reap maximum reward.
Nor should these investors confuse volatility with risk. "As soon as some people see higher volatility numbers in their portfolios, their minds shut down and they see risk," says Richmont's Robertson. "To me, if 20 years from now you haven't met your investment goal, that is the real risk."
Proponents of concentration, on the other hand, see ponderous problems with diversification. Chiefly, they cite diminished opportunities to beat the market as one's holdings collectively grow to resemble it.
To Ronald Surz, a managing director of Roxbury Capital Management, in Santa Monica, California, the effort to diversify is a "distraction." Risk, he observed in a recent paper, increases as "a manager populates a portfolio with the unfamiliar for the sake of matching index characteristics. Once committed, the manager becomes dependent on others for both buy and sell signals, thus following the herd and incurring unnecessary turnover." That's particular problematic in today's market, with the leaders of the S&P 500 achieving the status of momentum stocks.
Indeed, minimal turnover sometimes is a happy byproduct of a more focused approach, as a manager who falls deeply in love with a few good, exhaustively researched ideas presumably will be less likely to fall out of love on a regular basis. Accordingly, says Charlotte Beyer, director of the Manhattan-based Institute for Private Investors, concentration is particularly appealing to tax-sensitive investors, including the heirs to numerous family fortunes -- especially considering that most of those fortunes were built on one or two great ideas.
How can individuals best utilize concentration? The answer lies less in the concept than the recipe. Oakmark's Nygren puts most of his own eggs in the basket he manages, although the idea probably won't appeal to more timid souls. For these nail-biters, a touch of Tabasco, achieved by blending concentrated with indexed assets, might be just enough.
Yet, such an admixture would seem to subvert the whole point of concentration -- namely, the possibility of scoring a grand slam with a crackerjack stockpicker's very best ideas. Greg Horne, of Ashbridge, suggests a better way. "When you combine several concentrated portfolios using noncorrelated strategies, you have the best chance of beating a benchmark," he says.
Ken Gregory certainly hopes so; he and partner Craig Litman have designed the 15-month-old Masters Select Equity fund around the concept of an all-star team of concentrators. They've parceled out assets to six distinguished managers with distinct investment styles, and have charged each -- Shelby Davis, Spiros Segalas, O. Mason Hawkins, Richard Weiss, Foster Friess and Jean-Marie Eveillard -- with buying no fewer than five, and no more than 15, favorite stocks.
And the envelope, please? Last year, the fund returned a total 29.1% -- easily beating the Dow Industrials and the average equity fund, though not the turbocharged S&P 500.
Still, proponents of few-stock portfolios think they can best the S&P, and some boast dazzling returns to prove it. Never mind fancy theories; all it takes, they say, are a few great ideas, a bit of time -- and a lot of concentration.