Thoughts on Catastrophic Losses and a Hidden Risk of Diversification

“Like Michelangelo’s paintings and sculptures, successful businesses are the by-product of inspiration, hard work, and no small amount of genius. And like the works of the Great Masters, only a small minority stand the test of time and last over the long run.”

J.P. Morgan Asset Management’s “The Agony & Ecstasy — The Risks and Rewards of a Concentrated Stock Position” is a very interesting reading piece as it discusses some key topics that an investor should think about when managing an equity portfolio. Named after Irving Stone’s famous biographical novel, JP Morgan conducted extensive analysis on S&P 500 and Russell 3000 constituents going back to 1980 and found that:

• Risk of permanent impairment. Using a universe of Russell 3000 companies since 1980, roughly 40% of all stocks have suffered a permanent 70%+ decline from their peak value. For Technology, Biotech, and Metals & Mining, the numbers were considerably higher.

• Negative lifetime returns vs. the broad market. Two-thirds of all stocks underperformed vs the Russell 3000 Index, and 40% of the stocks’ absolute returns were negative.

• Concentration vs Diversification. After incorporating the issue of single stock volatility, J.P. Morgan found that 75% of all concentrated stockholders would have benefitted from some amount of diversification.

We agree with the first two conclusions while we have a different view on the third. While diversification is an important tool to manage risks, excess diversification will also be harmful for long-term wealth creation. Our Endowment Approach suggests that we should diversify our portfolio by asset class and geography, but our managers should manage rather concentrated portfolios.

Catastrophic Loss

The study focuses on U.S. stocks that experienced “Catastrophic Loss”, which is defined as a stock that experienced a 70% or more decline from its peak and never recovered back to the 60% level from its peak. From 1980 to 2014, 40% of all stocks experienced such declines. For Information Technology companies, almost 2/3 of companies experienced Catastrophic Loss! These loss rates tend to rise during recessions and market corrections, but J.P. Morgan argues, there is a steady pace of distress even during economic expansions.

Median Excess Return is Negative

J.P. Morgan also calculated how many Russell 3000 constituent companies actually outperformed the index and concluded that 2/3 of the companies underperformed the index. Even more shockingly, 40% of the companies generated negative absolute returns. To our encouragement, there were some extreme winners which compensated losses of other companies, however, only 7% of the universe is qualified for that prestige.

Consumer Staples Shines

Among 10 sectors in the study, Consumer Staples stood out. The median excess return vs. Russell 3000 of Consumer Staples was only -3% while the average of all other sectors was -67%. The Consumer Staple companies that experienced the catastrophic loss were “often low-margin supermarket, drug store and convenience store chains that struggled to compete with the rise of Walmart. The list of the winners for the past 10 years include Colgate-Palmolive Company, Hershey Company, Keurig Green Mountain Inc, Sysco Corporation, Tyson Foods, and Walmart Stores.

Diversification or Concentration?

The study concludes that, while concentration is an effective engine of wealth creation, it is extremely difficult to keep fortunes aloft through the highly concentrated portfolio. We do not disagree with this conclusion as we believe diversification is an effective tool to control risk, but we also believe that too much diversification actually causes risks for long-term wealth creation. If you invest in an equal-weighted portfolio of Russell 3000 companies, you will most likely underperform the index. To generate good returns, you still need to invest with concentration.

Manager Selection

Generally speaking, we are sector agnostic, but we occasionally find excellent sector-focused public managers in Information Technology and Consumer Staples. Interestingly, both Information Technology and Consumer Staples managers are fundamentally-driven stock pickers with a long investment time horizon even though their portfolio management approaches are different. Information Technology managers tend to have a more balanced long and short approach with relatively low net exposure whereas Consumer Staples managers tend to be more long-bias and long-only or long-bias. We selected these managers based on our experiences and instinct, but J.P. Morgan’s study confirmed that our manager selection was supported by empirical evidence.

Hedge funds are criticized for their poor performance over the last few years partly due to the high level of concentration. In our view, those who experienced recent Catastrophic Losses of their portfolio companies (e.g. Valeant, Sun Edison) were caused by the toxic combination of concentration and herd mentality. However, we should not dismiss the importance of concentration by these bad examples. Concentration does have benefits for active portfolio management as managers can allocate their limited resources to the best ideas. By investing equal-weighted diversified portfolio, you may be able to avoid landmines, but you will most likely end up with significant underperformance to market cap-weighted indexes (i.e. larger allocation to larger companies), such as S&P 500 and Russell 3000. For our endowment approach, this is a significant risk that we cannot overlook.