Thoughts on Portfolio Concentration and Merits of the #NeverSell Approach

I already know this is going to be controversial

Hey Substack readers, hope you all are well. You’ll have to excuse my extended absence from publishing, though I hope you enjoy the below thoughts, stream-of-consciousness style. I have been active on Twitter but I’d like to establish a more regular cadence of articles moving forward, ranging from general investing thoughts to one-pager type shortform individual stock notes to longform deep dives. If you like what you read, please consider subscribing to the newsletter if you haven’t already. Be healthy, be happy, and be well. —Rahul

“If you don’t know who you are, [the stock market] is an expensive place to find out.” —Adam Smith, The Money Game

As I continue to progress and grow as an investor, I find myself thinking about this quote a lot. For the vast majority of people, this means heeding Warren Buffett’s advice: averaging into broad-based index funds over their working years, a well served “protection against ignorance.” Most people lack the necessary time, enthusiasm, or capability to analyze businesses or stocks, and that’s perfectly okay. Consistent index fund investing, combined with an aversion to thrill-seeking behavior in markets, will inevitably lead to a fruitful outcome in the long run.

For a stockpicker like myself, this quote reflects a willingness to put in the work. To analyze a business’s strengths, weaknesses, and positioning. To think about the perhaps-evolving product suite and customer needs. To evaluate financial characteristics of a company and industry. I could go on, but you get the point. Ultimately, it is the stockpicker’s job to identify quality businesses they understand and reap the rewards for doing so, even going against the crowd at times to generate alpha.

For this reason, much ado is placed on individual stock selection in the investment community, but portfolio construction and management plays an equal importance. How do you size your bets in a method that produces an optimal investment outcome for you?

Ask most of the investing legends and they’ll each provide 20 corollaries to Buffett’s quote. A few below, for context:

“Very few people have gotten rich on their seventh best idea. But a lot of people have gotten rich with their best idea.” —Buffett

"The idea that it is hard to find good investments, so concentrate in a few, seems to me to be an obviously good idea. But ninety-eight percent of the investment world doesn't think this way. " —Charlie Munger

“For individuals, any holding of over twenty different stocks is a sign of financial incompetence.” —Phil Fisher

"There's no use diversifying into unknown companies just for the sake of diversity" —Peter Lynch

“Charlie Munger considers that a portfolio of four stocks is a well diversified portfolio. He says, you don’t even need a 5th stock. He goes on to say that if you lived in a small town, and if you owned the best apartment building in town, if you owned the highest quality office building in town, if you owned the McDonalds franchise in town, if you owned the Ford dealership. if you owned this collection of assets, even though they're all geographically concentrated, his perspective is that you will do very well. You will not need to do much else beyond that to have an interesting investing career.” —Mohnish Pabrai

Concentration builds wealth, but can also destroy it. Diversification preserves it. While Buffett, Munger, Fisher, Lynch, and Pabrai are all correct, and it takes fewer than the 40 stocks conventional wisdom suggests to eliminate stock-specific risks, it’s important to keep in mind the survivorship bias at play here. For those who buy their advice (of which I am one), it is of crucial importance to concentrate in durable, growing businesses with improving fundamentals at a reasonable price. Of course, this is easy to preach and difficult in practice.

To my own detriment, I have previously overconcentrated in businesses (in hindsight) of questionable quality, resulting in two mistakes: being wrong on the company analysis and position sizing too large. Focus on getting the analysis right first, then the risk/reward and sizing. One can’t afford to be wrong in a concentrated position and should sell ruthlessly if the investment thesis breaks. Conviction cuts both ways. It isn’t an excuse to be reckless.

“So much of what people call “conviction” is actually a willful disregard of facts that might change their mind.” —Morgan Housel

While I continue to run a highly concentrated portfolio today (my top 5 ideas constitute 61%), I am more diversified than ever across various industries, geographies, and end markets in higher quality, more durable companies with competitive or developing advantages. This should allow them to compound at elevated rates for many years to come.

Which brings me to my next point…

Should I Just Never Sell?

This is a question I’ve been asking myself more lately. When coffee canning good, growing durable businesses that execute for a long time, good things tend to happen. Quality with long reinvestment runways tend to age better and better over time. Cheap re-rates don’t. Business progress happens not over days, weeks, months, or quarters, but over 3-5 year increments and decades.

I remind myself of Ronald Read, a lifelong janitor who had amassed $8 million upon his death in 2014 by buying 95+ stocks with his discretionary income; of David Gardner who has captured life-changing returns on Netflix, Amazon, Tesla, Nvidia, Shopify, MercadoLibre, among others; of a famous Fidelity study that showed the best performing investment accounts were those of deceased or inactive account holders. In my own truncated investment experience, I have sold AMD, Nvidia, Apple, and Facebook (now Meta), all of which went on to multibag from those levels. The worst part is, the thesis never broke for any of those companies. I simply got bored or thought they were overvalued, and proceeded to purchase lower quality businesses largely because they were cheaper. If I never sold, my portfolio might be as much as 1.5-2x what it is today. The best sell discipline in the world can’t make up for that, and especially not across an investment career.

As my portfolio grows over time, I become increasingly drawn to the coffee can approach. I like to think my holding period is hopefully forever. But maybe it should be forever.

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The contents of this newsletter do not constitute a recommendation for trading or investment advice. Any estimates or forward looking statements made are inherently unreliable. Readers should do their own due diligence and consult their registered investment advisor or financial advisor before making any investment decision.