I’ve just finished the rough draft of a new book about concentrated value investing and the investors who practice it. One of the side-effects of extreme concentration is idiosyncratic portfolio performance–concentrated portfolios behave differently from the market. This makes sense. To beat the market one must hold stocks in a different composition to the market, which in turn means performance that’s different, both to the upside and the downside. The investors interviewed in the book all have very long track records (more than 25 years) of massive outperformance, but all have endured regular and extended periods of underperformance. Such is the toll of concentrated investing.
The performance of the market–let’s say the S&P 500–is the market capitalization-weighted average performance of the largest 500 stocks in the US. In most years the performance of the aggregate doesn’t tell you a great deal about the performance of the underlying stocks. The extent to which the performance of the best stocks in the market outperform the worst stocks is known as dispersion.
Patrick O’Shaughnessy has a great new site called The Investor’s Field Guide where he shares the results of backtests and other research he conducts. In Is Being Different Better? Dispersion and Active Management he takes a look at dispersion. In the chart below he compares the average excess returns for the best and worst performing 10 percent of stocks in three different market capitalization ranges–large, small and micro–over the last 50 years.
These are excess total returns measured against an equal-weighted benchmark, which means, for example, the +58 percent result for the Best Performing 10% (Large) means that those stocks beat the market by 58 percent in any given year. As the chart makes clear, the smaller the stocks in the universe, the greater the magnitude of outperformance (or underperformance). Micro cap stocks offer the best opportunity for skilled stocks pickers (and the greatest opportunity to trip over). That’s dispersion.
Since our goal is earning the highest returns possible above the market, it stands to reason that we should prefer parts of the market which offer the greatest chance of earning huge returns. … [T]hese results highlight an opportunity in micro- and small-cap investing. This is especially true for smaller, individual investors who don’t have to worry about market impact when trading. Large institutions simply can’t run meaningfully large micro-cap portfolios, and so many small stocks go unnoticed.
Check his new site The Investor’s Field Guide or read more Is Being Different Better? Dispersion and Active Management.
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Here’s your book for the fall if you’re on global Wall Street. Tobias Carlisle has hit a home run deep over left field. It’s an incredibly smart, dense, 213 pages on how to not lose money in the market. It’s your Autumn smart read. –Tom Keene, Bloomberg’s Editor-At-Large, Bloomberg Surveillance, September 9, 2014.
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