What is High Conviction and Concentrated Investing?

High conviction and concentrated investing is a strategy that aims to identify and invest in companies that offer the highest potential for generating Alpha. This approach involves doubling down on an investor’s best ideas with the expectation of achieving above-average returns. A conviction investor holds a firmly held belief or opinion towards their target companies.

Concentration reinforces the conviction by focusing all the investor’s attention on their firmly held beliefs. Conviction and concentrated investing complement each other, as both are essential for achieving the success of the strategy.

This investment strategy is based on in-depth research, an intimate knowledge of your holdings, and a hands-on approach to managing a portfolio. Instead of spreading focus on numerous ideas, a conviction and concentrated investor narrow their attention to a select group of promising businesses that have the greatest potential for outperformance.

The archenemy of diversification.

High conviction and concentrated investing are the antithesis of diversification. Diversification is a smart way for most investors to invest. However, high conviction and concentrated investing can be beneficial for those who know what they are doing. It means focusing your wealth on a few of your best ideas, which can be great if the investment thesis materializes. But, if you get it wrong, you can lose significant amounts of your net worth.

Take the example of Michael Burry from “The Big Short”. He went all-in on one high conviction and highly concentrated idea that paid off. However, if it didn’t, he would have been ruined. High conviction and concentrated investing require deep research, analysis, and an intimate knowledge of your holdings. It also requires patience and discipline.

Investors should own a concentrated portfolio of high-quality businesses…

Michael Burry

This style of investing is also known as “Focused Investing,” and many successful investors use it. Conviction and concentrated investing contradict diversification, modern portfolio theory, and the efficient market hypothesis. This strategy involves a different approach to generating the best returns.

Why is Conviction and Concentrated Investing effective?

Concentrated investing is a strategy that involves investing all your capital in a few select investments. Although it poses a higher level of risk due to the concentration of capital, it presents an opportunity to outperform. Having a deep understanding of your holdings and backing your best ideas allows your wealth to capture all the upside potential.

The key to focused investing is to maintain focus. It’s challenging to keep up with the evolution of a large number of companies. The more you study and understand a business, its future prospects, and risks, the stronger your conviction about it becomes.

Concentrated investing can build significant wealth because there is a higher degree of capital allocated to each idea. In a diversified portfolio, there is a lot of capital spread around to various asset classes and holdings. If one position goes up significantly but is only a small percentage of the portfolio, the overall portfolio may not increase in value as much. However, if a high conviction idea takes off within a concentrated portfolio, the overall value of the portfolio can increase significantly.

However, there may be an increased level of risk. This is because a larger degree of the portfolio is weighted to a smaller number of positions. For example, if 10% is allocated to 10 ideas and one idea goes bust, that’s 10% of the portfolio gone. This is where diversification for most investors becomes a more effective way to manage risk.

Running a concentrated portfolio on your best ideas allows you to allocate your wealth to those ideas that can compound and increase your capital. By doing this, you are avoiding allocating it to other companies you have less conviction and knowledge about.

The philosophy behind focused investing.

The investment strategy philosophy is simple. If investors develop a conviction about a company and believe in its future opportunities, they should back their idea. Concentration builds wealth by allocating capital to ideas that have been thoroughly researched and believed to have the best opportunity for outperformance. Risk comes from not knowing what you’re doing.

Do not make small investments. If you are going to put money at risk, make sure the reward is high enough to justify the time and effort you put into the investment decision.

Michael Steinhardt

Building conviction is hard, but if you develop in-depth knowledge about a business or opportunity and that knowledge builds into conviction, you should back yourself. The philosophy focuses on knowing a lot about a few good ideas rather than knowing a little bit about many different ideas.

The idea of focused investment is challenging to accept and implement since we are taught to diversify, and markets are considered too efficient to create alpha. However, this philosophy works. Rather than finding supporting evidence, it’s essential to understand that all strategies work for those who stick to them long enough to see the results.

There are many success stories about highly diversified investors and highly concentrated investors. Both are right. They were doing what they believed was the best for their capital and based on their investment philosophy.

Who is a Concentrated portfolio for?

It’s important to note that running a concentrated investment portfolio is not suitable for everyone. This strategy should only be implemented by seasoned and experienced investors who possess intimate knowledge about a few select businesses. While some super investors suggest that diversification is ignorance and recommend staying concentrated, it’s not that simple for most investors.

To pursue concentrated and conviction investing, investors need to have a knowledge-based approach. They need to know how to analyse a company, conduct adequate research and develop an in-depth investment thesis for each of their holdings. Therefore, it’s generally advisable for most investors to benefit from diversification.

The concentrated and conviction investment strategy is best suited for those who want to study a handful of companies, conduct a thorough investment process and have the time and patience to see their ideas play out in the long term. It requires a lot of skill and research to be a focused investor. Without due diligence, one cannot develop a high-conviction mindset towards a business.

Even though concentration focuses on your best ideas, you can still diversify within a concentrated portfolio. This can be done by holding companies in different industries, or market cap sizes that are not correlated to one another. Therefore, while concentrated investing can be a lucrative strategy, it requires patience, discipline, and a lot of hard work. Whilst the returns may be attractive, investors need to understand the downside risk is greater should you get ideas wrong.

Do you believe in diversification and believe markets are efficient?

I think answering these simple questions early in your journey will help you understand whether this approach is for you. If you believe markets are efficient and there is little room for finding alpha, and you believe in diversification, this approach is not for you.

The fact is high conviction and concentrated investing are not for everyone. I’ve never advocated for any certain style of investing. We all are different and have different needs, risk appetites, time horizons, goals, and experience levels.

The best place to see whether this focused investing style is for you is to approach it with bite-sized chunks. Perhaps you’re running a core-satellite portfolio, maybe within the satellite portion you start to develop some conviction around ideas. Always start small. Never read a quote by one of the greats about allocating all your wealth to your best ideas and proceed to follow the advice. It’s taken them a lifetime to fine-tune and hone their investment philosophy.

The concept of concentration and conviction should be viewed as a philosophy more than a strategy. An investor with largely agree with the philosophical ideas behind the idea or not.

Some rules for conviction and concentrated investing.

Here are some rules I follow as a concentrated high-conviction investor. There is no specific number of positions that define a concentrated portfolio. I typically hold 8-10 positions while others may hold 20-25.

I didn’t plan to become a high-conviction investor. Over time, I realised that it made more sense to know a lot about each of my holdings while being realistic about my limitations on keeping track of too many positions. This is how I began to focus on a handful of my best ideas and developed my own rules for running a high conviction and concentrated portfolio.

Here are my rules:

In-depth research and analysis:

I develop conviction in my ideas by knowing everything there is to know about them. I study the industry and how the company fits within it. It’s not just about valuations and numbers, but also about having conviction that the company will still be around in 10 years in an industry that will also be around.

Be aware of the downside risks in each holding:

I’ll focus on the risks in the investment thesis and spend a lot of time after I execute a position researching potential threats. I look for breaks in the thesis so I can sell before anyone else and take a loss. I don’t let “conviction” blind me to only focus on the upside.

Concentration by default:

I focus on a handful of my best ideas by reading every announcement, report, and news update. I’m looking for evolving fundamentals in the company and within the industry. I study the competitors and understand who they are and where they are going. To do this adequately and monitor my holdings, I limit the portfolio to the amount of positions I can truly understand. If I don’t truly understand a business, no matter how good the opportunity may be, I don’t invest.

Don’t borrow your conviction:

This is a problem when investors look to others for confidence without doing research themselves. They borrow conviction without developing their own. All investors should cultivate their independent analysis of why they own a company. Never substitute your thinking and belief about a business because someone else thinks it’s great. We can generate investment ideas from others but execution and conviction come from within.

Think long-term:

Most high conviction ideas for me have a 5-10 year time horizon. I commit my capital to long-term positions that can compound my money at above-average returns. There is minimal portfolio churn, and I never commit capital unless I am prepared to hold and monitor this company for years.

My opportunity cost is what lies within my portfolio:

I rarely sell, and I weigh potential new entrants against what is already within my portfolio. If a new idea comes along, it has to be better than what I already hold; otherwise, I will allocate more capital to my best ideas.

For me, concentration and conviction are grounded in extensive in-depth research, a long-term mindset, discipline, focus, and risk management by knowing what I own.

I’ve not used other forms of probability theories like the Kelly Criterion formula that I know a lot of concentrated investors use. If the Investment thesis stacks up, the checklist is strong and the overall company passes a rigorous process with flying colours, I’ll allocate a higher weight to it. I have from time to time developed a strong conviction on ideas that warranted a large weighting. It is on a case-by-case basis.

In Summary…

Developing conviction does not just come from the initial research stages, as you hold the conviction grows. The more you learn and the more research you accumulate, the better equipped you will be to make informed decisions. It is important to check your biases when investing with conviction, and not let emotions cloud your judgement. Falling in love with an idea can blind you to warning signs, which is why it is crucial to outline bear case scenarios and weigh up the pros and cons adequately.

Concentrated and high-conviction investing is about finding those long-term compounding machines. It is not necessarily aligned with a specific investment style such as value or growth investing, as both styles adopt it. Value investors may choose a concentrated portfolio of the most compelling undervalued opportunities. They invest with the conviction that the markets will eventually recognise the opportunity, and that is when they make money.

Growth investors may also run a concentrated portfolio of the best growth opportunities they see with a very bright future. Even Quality investors adopt a concentrated and high-conviction approach to the best quality companies they want to own for the long term.

While allocating a large portion of your wealth to just a few of your best ideas carries risks, it can also lead to significant rewards if done correctly. The concept of concentration and conviction should be viewed as a philosophy more than a strategy.

An investor with largely agree with the philosophical ideas behind the idea or not.