Investors can be overwhelmed with decisions when constructing their investment portfolio, such as international versus domestic equity exposure, correlation with the overall market, sector risk, the underlying investments’ quality and holding size, to name a few.
There are many views on the appropriate exposure to an individual company in a share portfolio. Most commentary focuses on the maximum exposure to a company, with many institutional mandates dictating holdings equate to no more than 5-10% of the fund. Less often discussed is the ideal minimum investment size.
Diversified versus concentrated
Determining the optimal investment size is informed by the investor’s preferred investment style, especially if the portfolio is diversified or concentrated, and how risk is managed.
A diversified investment style leads to numerous, small holdings. A more diversified portfolio is favoured by investors giving a high priority to managing risk and preserving capital. As diversification within a portfolio increases, generally volatility decreases.
In contrast, a concentrated approach to portfolio construction delivers fewer stocks with larger positions as a proportion of the overall portfolio. The performance, good or bad, of an investment is amplified by price movements in one or two stocks, increasing the risk and volatility of the portfolio.
Individual investors and investment managers sit at various points along a scale between the concentrated and diversified approaches.
With holdings in 60-100 companies on average at any one time, Wilson Asset Management is at the diversified end of the spectrum with our bias towards having many, smaller holdings in our investment portfolio.
A question of risk and liquidity
Essentially, an investor’s preference for a diversified or concentrated approach hinges on the management of risk. Another way we manage risk is by maintaining above-average cash holdings. For example, our first listed investment company (LIC), WAM Capital, has held an average of 34% cash since its inception in 1999.
We apply our rigorous rating process to assess if a company represents a worthwhile investment proposition and we identify a catalyst we believe will re-rate its share price. Then, a range of factors inform our level of investment in that business. Our holdings in investee companies generally represent less than 3% of our investment portfolios (and can be as small as 0.25% of a portfolio) depending on our level of conviction and factors including liquidity and potential upside to our valuation.
The more liquid a company’s shares, the more flexibility the investor has to increase or decrease their exposure. We assess a company’s liquidity by measuring the number of days required to exit our position based on current selling volumes. More broadly, we also consider the liquidity of all our holdings, routinely analysing the likely timeframe to convert our entire investment portfolio to cash.
Often, a company’s liquidity can fluctuate and sometimes it can only truly be measured in tougher trading conditions. This is particularly the case in the micro-cap end of the share market.
Transaction, labour and opportunity costs
There are other factors for an investor to weigh up when considering holding size as a proportion of their portfolio. In particular, there are costs involved in maintaining any investment and, as the number of positions increases, these costs also rise.
Transaction fees such as brokerage are an important cost to control. Time and energy is also required to manage a portfolio, including the administration. The greater the number of holdings in a portfolio, the greater the effort required to monitor and assess those investments. As a result, highly diversified, actively-managed portfolios are very labour intensive.
Opportunity costs arise because capital deployed in one investment is made to the exclusion of an investment in another stock or stocks. We continually re-assess all investee companies to ensure they represent a worthwhile investment proposition. We assess whether they still warrant a place in our portfolio or if that capital could generate a better return invested elsewhere.
Considerations for investors
There is no universal or agreed ideal maximum or minimum level of exposure to an individual company but rather a best fit with an investment style and approach to risk.
Wilson Asset Management believes diversification provides access to liquidity ensuring we can be nimble and flexible in deploying our shareholders’ capital. However, most institutional funds have mandates that restrict how the manager invests capital in terms of sector weightings, maximum holding sizes, cash holdings and deviations above and below an index.
Chris Stott is Chief Investment Officer of Wilson Asset Management (WAM). This article is general information and does not consider the needs of any individual.