The best-performing newsletter so far this year has produced a gain of over 130% through Nov. 30.
The S&P 500, in contrast, has produced a gain of “just” 14% through the end of November.
Before you rush out to follow the newsletter, however, you ought to know one thing: Its model portfolio holds just one stock.
The newsletter in question is the Wagmore Advisory Letter, edited by Nate Pile. The stock on which he is betting so heavily is MannKind Corp. (MNKD) - Get MannKind Corporation Report, the long-struggling bio-pharmaceutical company. Pile believes the company’s growth potential is huge if and when its novel diabetes treatment becomes more widely accepted in the medical community.
To say that allocating your entire portfolio to one stock is risky would be an understatement. Though the newsletter is far and away the top performer for year-to-date returns, among newsletters that my firm monitors, its longer-term return is grim.
Over the five years through Nov. 30, its return is -12.4% annualized, according to my firm’s calculations.
It would be easy to dismiss such an approach as intolerably risky, which would be unfortunate because in so doing we would miss the important investment lessons that can be learned.
There in fact is a long and illustrious history of Wall Street greats whose reputations were based on having un-diversified portfolios.
Buffett and Apple
One is none other than Warren Buffett, CEO of Berkshire Hathaway (BRK.A) - Get Berkshire Hathaway Inc. Class A Report undefined, arguably the most successful investor alive today. He argues that diversification in essence is protection against ignorance, and you wouldn’t choose a diversified portfolio if you actually know what you were doing. “To have some super-wonderful business and then put money in No. 30 or 35 on your list of attractiveness and forego putting more money into No. 1, just strikes… me as madness,” he said at his 1996 annual meeting of shareholders.
Buffett certainly practices what he preaches. Nearly half of his company’s stock portfolio is now invested in just one stock: Apple (AAPL) - Get Apple Inc. Report. Earlier this year on CNBC, he said “I don’t think of Apple as a stock… It’s probably the best business I know in the world.”
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Benjamin Graham and GEICO
A similar belief in the virtues of undiversified bets was held by Buffett’s mentor, Benjamin Graham, widely considered the father of fundamental analysis. Believe it or not, more than half of Graham’s lifetime profits came from his huge investment in just one company -- pricately held GEICO.
Graham makes an incredible admission of this in the postscript to the 4th edition of his investment classic, The Intelligent Investor. He writes that the run-up in GEICO’s stock price “far outstripped the actual growth in profits, and almost from the start the quotation appeared much too high in terms of the partners’ own investment standards.” Nevertheless, Graham’s fund continued to hold GEICO, since it was regarded “as a sort of ‘family business’.”
What morals can be drawn from this story, Graham asks? “One lucky break, or one supremely shrewd decision -- can we tell them apart? -- may count for more than a lifetime of journeyman efforts.”
Risk and Reward
You might be tempted to discount these examples by insisting that, if we focused on all advisers who took risks like Buffett and Graham, we’d undoubtedly find that they did not outperform the market on average. After all, it’s hardly surprising that the top of the performance sweepstakes will be populated by the biggest risk takers. But wouldn’t just as many, if not more, big risk takers be found at the bottom, too?
Not necessarily. Consider an academic study that was published 15 years ago in the Journal of Finance. Titled “On the Industry Concentration of Actively Managed Equity Mutual Funds,” its authors were Marcin Kacperczyk of the Imperial College of London; Clemens Sialm of the University of Texas Austin; and Lu Zheng of the University of California, Irvine. The professors found that, on average and on a risk-adjusted basis, the least diversified mutual funds outperformed the most diversified ones.
One thing that is key to the success of all the advisers mentioned here is the ability and the willingness to stick with positions through thick and thin. That means not investing in any position on margin or with amounts you might need to draw upon over the shorter term.
That’s just another way of saying that these undiversified investment bets are for the long term. Some have referred to this long-term focus as “time diversification” to distinguish it from the more traditional definition of diversification as owning lots of individual securities. Indeed, some analysts have argued that holding one stock for a long period, say ten years, is actually less risky than holding a many-stock portfolio for a short period of time.
The bottom line? Don’t be too quick to dismiss Pile’s highly concentrated portfolio. Even if it does not ultimately work out for him, his approach challenges us to re-examine portfolio construction rules that we have long taken to be sacrosanct.
Apple is a part of Jim Cramer’s Action Alerts PLUS investing club portfolio.
(Note: The Wagmore Advisory Letter is one of the newsletters that pays a flat fee to have its performance audited by my performance rating firm.)