Investing in a concentrated portfolio of companies, which own the world’s most successful brands, generate cash, and have very little debt, delivers income and capital growth regardless of age or life stage. This article will examine a portfolio to demonstrate what this strategy has achieved.
Background
The client initiated the portfolio in late 2012. The portfolio has grown at an annualised rate of over 12,7% USD return for just over nine years, providing a total USD return of 203%. $100 000 (R860 000) invested in this portfolio just over nine years ago is worth $305 000 (R4 840 350) at the time of writing, despite the client withdrawing 7% of the funds annually over the last 4 years to pay living expenses.
Portfolio construction – concentration vs diversification
The portfolio consists of a concentrated selection of companies, which own the world’s most successful brands, generate cash, and have very little debt. The portfolio is concentrated because the share selection consists of only 14 companies. The portfolio has not contained bonds and property since inception. This would change were interest rates to rise off their historic lows significantly.
It is worth noting that a concentrated portfolio is the opposite of a diversified portfolio. Conventional dogma would describe a focused portfolio of 100% equities owned by a retiree as heresy while simultaneously failing to argue why diversification into assets offering poor return prospects is prudent. For example, conventional wisdom recommends investing a retired person’s funds in income-generating bonds, despite the lowest yields and highest bond prices in history. Diversification and rigid alignment to portfolio construction rules is an antidote to thinking, not losses.
The other argument for diversification centres on volatility, defined as the portfolio’s value fluctuation. More diversified portfolios, like “balanced portfolios”, are supposed to be less volatile. However, this is not evident at present in this low interest rate environment.
Why did the portfolio go up?
Benjamin Graham said it best. “In the short term, a market is a voting machine; in the long term, it is a weighing machine.”
The 14 companies in the portfolio generated 93% more cash in 2021 than they delivered in 2012. And 2021 was a year the world had yet to recover from the global pandemic! The market has no choice but to ‘weigh’ the cash generated over time and reward shareholders with a higher market value for the company. Companies that make no cash have nothing to weigh. They rise as stories, and predictions get speculators excited to bid their prices up. Eventually, cash generation counts.
But it’s gone up – you should sell!
Two of the holdings are up over 1 000%. Modern portfolio theory recommends selling companies that have seen their value increase because they “unbalance” the portfolio. Blind rebalancing is another example of thoughtless dogma. The whole point of our investment strategy is to purchase shares in companies that have the potential to sustain their current performance for DECADES. The reason to sell a company (and incur massive capital gains taxes) is when that company loses brand appeal, and no one wants to buy their products or services anymore. The Japanese brands of the ’80s like Sony, Panasonic and Canon, to name a few, lost brand appeal as the world moved to US technology brands. The analysis of great companies is a daily exercise requiring insight into human behaviours, psychology, company finance, history, and economics. We expect the portfolio to hold the same shares in the next nine years as we did in the last nine years.
The last factor in the portfolio’s performance is just as fundamental as the rest but difficult for most humans to internalise. The portfolio is nine years old. In hindsight, few people would decline this return. But illogically and inexplicably, few people are motivated to start an investment journey that will prosper over the next nine years. The promise of quick money prospects (a short-lived mirage) and the social cache of being with the in-crowd on the latest tech trends and thinking draws people in.
That’s why retirees are likely to continue to outperform.
The information contained in this communication is for information purposes only and does not constitute advice in any form, including but not limited to investment, accounting, tax, legal or regulatory advice. AXIAM Data provided by DMA.