My initial introduction to investing exposed me to different strands of thoughts and notions about investing. Only a few of these notions about investing are fundamental principles and exist as objective truths in my opinion. (yes, I see the contradiction here) One such principle includes the notion that the intrinsic value of a business is determined by the sum of all future cash flow that is generated by the business discounted at an appropriate rate. Another is the notion that shares represent partial ownership in businesses. Besides these fundamental principles, there are many tried and tested investment lessons and stylistic preferences that work for different individual investors. For example, many successful investors prefer to do highly concentrated investing. Warren Buffett famously said:
“I always tell students in business school they’d be better off when they got out of business school to have a punch card with 20 punches on it. And every time they made an investment decision, they used up one of their punches, because they aren’t going to get 20 great ideas in their lifetime. They’re going to get five or three or seven, and you can get rich off five or three or seven. But what you can’t get rich doing is trying to get one every day.”
I am intuitively attracted to the basic premises behind concentrated investing – 1) great ideas are hard to come by and when given the chance needs to bet big, and 2) high concentration forces discipline to focus on companies that are within one’s circle of competence. The mantra of concentrated investing contradicts the conventional investment wisdom which preaches diversification. In the name of diversification, most investment funds would routinely own hundreds of stocks. Investment managers who own 20+ stock would be considered concentrated by average industry standards. As a fully-signed up practitioner of concentrated investing, I generally own no more than 10 businesses and currently, my top three positions make up over 50% of my portfolio.
Lately, I am observing something strange. As I learn more about businesses in the technology and creative industries which typically exhibit extreme pay-off characteristics, I am struggling to apply the concentrated investing to investment opportunities with small chances of success but have huge pay-offs in the event of success. For example, video game companies are typically considered by the investment community as a hit-driven business and hence not investable because no one can figure out the long term earning power of a game company. However, there are compelling situations where the combinations of valuation, unique insights into the business and historical track records that can lead to profitable investment opportunities into a game company. Any cursory look at Nintendo’s historical earning profile, which is very highly cyclical, would seem to reinforce the view that video game is a hit-driven business and hence uninvestable. However, a confluence of technological trends and industry changes seem to herald a very bright future for Nintendo. Through the proliferation of cloud computing, higher Internet speed and adoption of the subscription business model, Nintendo could be building a direct and continuous relationship with its customers and transition the hit-driven revenue model into a stable and growing earnings stream. In this case, Nintendo could be worth multiples of its current market cap.
Nintendo is in a state of change – it could navigate the changes perfectly or it could fail to transform itself and relegated into the oblivion. I believe Nintendo has a non-trivial chance of wild success due to its unique culture, extraordinary game development track record and strong IP. Let’s call a non-trivial chance of success as 10%. And let’s assume that if successful, it could be worth 10x more. But it still has a 90% chance of failure and would be worth 50% of its current valuation in the event of failure. The expected return for Nintendo would be 1.5x which seems like an attractive bet to make. However, it is not reasonable to have this as a large position size, say 20% of the portfolio, because there is still a 90% chance that I will lose 50%! The logical strategy is to spread the bet over a large number of these opportunities such that we can achieve the expected return. But spreading the portfolio over a large number of bets runs counter to the mantra of concentrated investing!
Now consider another investment opportunity that has the following characteristics – 70% of a 1.7x payoff and a 30% chance of 5% loss – which has the same expected return of 1.5x as the Nintendo example. Now, this looks like a classical asymmetric bet and could be a big bet in the portfolio despite having both investment opportunities having the same expected return. The second investment opportunity is likely to be a stable business with a solid asset value to act as valuation backstop. It could be an elevator OEM going through a cyclical low point and the earnings are depressed because new elevator sales loss is masking the true profitability of the maintenance income. If both investment opportunities are available to me, I would always pick the second one over the first one! It becomes really challenging if the opportunities with the best expected return exhibit extremely pay-off structure like the Nintendo example.
While I have not done a rigorous study, it does seem like concentrated investing works better in a stable industry environment where the company’s intrinsic value is relatively stable and the difference between the best operator and the average operator is relatively small. However, companies that are currently in a rapidly-changing industry with winner-take-most characteristics can produce extreme pay-off structures because the winner is able to grow its intrinsic value dramatically. Maybe these binary investment opportunities might not be so suited to the highly-concentrated investing style. But what if the best investment opportunities lie in these rapidly-changing industry with extreme pay-off structures?
This runs into another notion of investing where Warren Buffett famously said that change is the enemy of investors. Four years ago, I would agree whole-heartedly. I am less sure now. I think change could be the friend of an investor if, and only if, the investor has unique insights into the nature of the change that allows the investor to handicap risks confidently and figure out the pay-off structure clearly. One still has to do the work to gain real insight into an industry / a company that is undergoing change.
Arguably, it requires a lot more work to gain insight into a changing industry versus a stable industry. So all else equal, I would much rather make the same amount of money with the least amount of effort possible. Alas, the investment management field has gotten more competitive and what used to work before might no longer work so well anymore. So to stay ahead of the competition, one has to do things differently. Maybe this includes being open-minded about how to conduct concentrated investing and perceive industry changes in the context of investing.