The Road to Being a Crorepati Could be Through One Stock

Do you have any favourites investing gurus that you like to follow?

I have a few.

These include the likes of Warren Buffett, Munger, Peter Lynch, Walter Schloss...

These are all legends and have in common the commitment to the process they followed and the splendid returns they generated with their disciplined approach.

Over the years, I have learnt more from reading their works and from books about them, than from specialising in financial management, where the subject was mainly approached from an academic perspective, and with little practical insights.

But interestingly, below the successful track records, there is not too much in common.

In fact, there is huge contrast in some of their investment approaches.

Selective and Focused Versus Broad

When Buffett was working with less capital, his top five holdings comprised over 90% of his portfolio. He was a typical concentrated investor. And that's true even now.

Over his decades long career, he has proved that being selective works if you have the long term horizon and strong stock selection skills.

On the other hand, investors like Peter Lynch and Schloss never believed in concentration. At the peak of his career, Peter Lynch's portfolio had over thousand stocks.

So, investors and analysts have a serious dilemma.

A concentrated investment in winning stocks can make your portfolio outperform by a wide margin. But what if one of your bets fails? Would not that be a fatal mistake? Is it worth the risk?

The Sweet Point

In the famous book Concentrated Investing, the authors share an interesting analysis by Elton and Gruber. It quantifies the effect of diversification on risk.

Risk here measures the deviation of the portfolio return from market return. This means that a portfolio with just one security will have highest risk. Further, a portfolio with all the securities trading in the market will have zero risk.

As per their analysis, most of the gains from diversification (reduction in risk) are enjoyed by holding between 20 to 30 securities.

And with the experience I have, I agree.

You see, there are two key elements in the making of multibagger stocks

The first is the stock selection. The second is the size of the investment.

Let me take a specific example in Hidden Treasure to highlight this.

As I shared in one of the recent issues, since inception in February 2008 until September 2022, as per externally audited track record, Hidden Treasure has delivered an internal rate of return (IRR) of 26.9%.

The comparative IRR for Sensex and Smallcap Index stand at 8.2% and 7.7% respectively.

This included all recommendations made during the period, considering equal allocation to all stocks.

The biggest winner for us has been Page Industries, with a gain of 16,477% since recommendation in January 2009 (a CAGR of 45.2% in 13.7 years).

Not surprisingly, a few of my subscribers were curious what would be the IRR excluding this outlier.

For the record, without Page Industries, the IRR is 22.8%. Please note this specific result is not audited as it's based on a custom request.

A single stock, out of 155 stocks, made so much difference. And that too on equal allocation.

With hindsight wisdom, if exposure to Page Industries would have been higher, our track record would have been much better. After all we did have the high conviction in the stock. It's the reason we have held it for than a decade.

Anyway, we are learners. So, when I next saw a similar crorepati stock opportunity, I asked my subscribers to double down the exposure than I typically recommend in smallcaps.

This was a stock with unlimited market potential - a long runway, as the management expanded business from conventional businesses to new sectors like FMCG, food, and pharma. These sectors have a huge opportunity size and higher margins.

To capture the huge opportunities and demand, the company has planned a capex that is likely to expand the capacities by up to 56% over next two years. The growth guidance remains in healthy double digits.

The stock has delivered 677% in a little less than seven years as I write this, a CAGR of 35.1%, excluding dividend yield. In fact, it's just 29% away from being a ten bagger.

So far, the going is good. And we are in no hurry to take the profits off the table, as we believe this could just be a prelude to a great run ahead.

Hidden Treasure subscribers can read the stock report here.

Coming back to the debate of concentrated versus diversified, I believe it all depends on one's stock selection skills and conviction levels.

The more you diversify, your returns are likely to follow the market averages. On the other hand, higher concentration could mean a higher deviation from market returns.

If you get the selection right, you could beat markets significantly. A wrong selection, however, will be a death knell for your portfolio returns.

I think the famous economist John Maynard Keynes has to say in the matter:

• As time goes on, I get more and more convinced that the right method in investment is to put large sums into enterprises which one thinks one knows something about and in the management of which one thoroughly believes.
  
  It is a mistake to think that one limits one's risk by spreading too much between enterprises about which one knows little and has no reason for special confidence.
  
  One's knowledge and experience are definitely limited and there are seldom more than two or three enterprises at any given time in which I personally feel myself entitled to put full confidence.

From a practical and execution perspective, here's what I would suggest...

1. Invest only in the stocks where you have some insight. Avoid complex business models and cases where most of the growth expectation is an outcome of compelling story telling and hype - The likes of Paytm, Zomato and Nykaa, and now, Mamaearth's IPO.
2. While taking exposure for the first time, it makes sense to put limits. Overtime, some businesses will perform better than expectations and a few will underperform. Allocation, and investment decision then, will be a function of the conviction and confidence in the management and its execution abilities overtime.

And here's the final word on the topic from Buffett himself, that I believe will be perfect way to conclude.

• I have 2 views on diversification. If you are a professional and have confidence, then I would advocate lots of concentration. For everyone else, if it's not your game, participate in total diversification.
  
  If it's your game, diversification doesn't make sense. It's crazy to put money into your 20th choice rather than your 1st choice.
  
  Charlie and I operated mostly with 5 positions. If I were running 50, 100, 200 million, I would have 80% in 5 positions, with 25% for the largest.

Warm regards,


Richa Agarwal
Editor and Research Analyst, Hidden Treasure