Lessons From 2008: Know When to Bet Big

 | Jul 25, 2012 | 2:30 PM EDT
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In this third and final installment of the key lessons provided by the 2008 market selloff, we come to a topic that is arguably one of the most debated areas of investment management: portfolio allocation. But before diving in, read the first lesson on cash management and the second lesson on investing in pessimism, if you haven't done so already, as they provide a framework for what comes next.

Before the market selloff in 2008, I held a rather narrow view with respect to portfolio concentration: bet big on your best ideas. Truly fantastic investment ideas are hard to come by, and when you are presented with one, it makes little sense to waste it by tiptoeing in. Keep in mind that ideas that pass this test are rare -- finding just one every year would be considered a great success rate. This was the case when I stumbled on Premier Exhibitions (PRXI) nearly four years ago when the company had a market cap of less than $50 million, yet owned RMS Titanic assets that could be worth anywhere between $150 million and $300 million or more.

When presented with such an upside/downside scenario, provided you have done a rigorous analysis of the business, don't be afraid to make a big bet, perhaps as big as 10% to 15% of investment capital.

Yet we all know that concentration can kill a portfolio, especially when the market drops 40% in a single year. Even your best idea will likely experience enough volatility to affect investment performance. If you are subject to capital redemptions or forced to sell for other reasons, it doesn't matter how good your idea is if you have to sell it for other reasons. That's what happened to many investors in 2008 -- they sold only to see some of those same investments double or triple in price in 2009. Interestingly, many "diversified" portfolios were wiped out after 2008. Mutual funds and hedge funds, some that held more than 50 securities, were forced to shut down.

The lesson learned: Betting big should be done when you are absolutely certain that you can own the stock until it reaches intrinsic value. Also, portfolio concentration should be a function of your opportunity set. After the 2008 selloff, I could have easily constructed a 20-stock portfolio that would have significantly outperformed the market. I did just that, in fact; my fund held about 20 to 22 positions in 2009 and the portfolio was up more than 60% that year. Concentration is not required when hundreds of stocks were trading at a fraction of intrinsic value. Potash Corp. (POT) was trading for less than $20 a share, ATP Oil & Gas (ATPG) climbed to $17 from $4, Brietburn Energy Partners (BBEP) climbed to over $15 from $7, and so forth.

Today, the situation is vastly different; stocks are not bargains. The most fertile area appears to be in the larger-cap plays as opposed to 2009 when small-caps were dirt cheap. And because the opportunity set is much smaller today, it makes more sense own more of a cheap stock than to spread your capital across several names and call that diversification. I'd rather sit tight holding a big position in Bank of America (BAC) than own several stocks that Wall Street currently likes. Look what optimism did to shares of Chipotle (CMG) after the company grew profits by more than 30%.

What goes hand in hand with concentration, in the current environment, is having plenty of cash on hand so you can make more big bets when the price is right. Better yet, if the markets drop another 10% or more, you can start pulling the trigger on many more ideas.

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