In their latest episode of the VALUE: After Hours Podcast, Brewster, Taylor, and Carlisle discuss The Argument Against Concentration. Here’s an excerpt from the episode:
Jake: It might actually be– Let’s talk about portfolio construction a second when we look at that result that came from there. If you took out the top five names out of that, I think you did pretty bad, actually. There’s this return profile that’s generated that comes asymmetrically from the top performers. And so, this is a recommendation against concentration in this type of strategy, because you’re almost guaranteeing that you’re flipping a coin at zero or hero at that point. If you’re going to have these very asymmetric outcomes, you almost have to position size smaller and try to own a bunch of them so that you catch it. Otherwise, it’s game over. So, you’re taking tons of risk if you’re concentrating in that.
Jake: Talking David Gardner. Guy after my heart.
Tobias: Because the right tail is so pronounced in these ones that win, that says to me that you’re better off having lots of small positions.
Tobias: You could get lucky and pick the one that wins and look like a genius. But your best-case scenario is just having a little bit of it in your portfolio, if it goes up a hundred times, then it doesn’t matter that it was only a few percent.
Jake: Doesn’t it seem difficult, though, that from that starting point, if you catch all the winners, you end up with market perform? But if you don’t, you’re smoked?
Tobias: Yeah, you are under.
Jake: That seems like a scary game to play to me.
Bill: They’re all scary games in the market. That’s what I have learned.
Tobias: Yeah. What’s your other alternative? S&P 500?
Bill: Then you– [crosstalk]
Jake: Basket of dog crap. [laughs]
Tobias: There’s some good names. If you’re going to pick the next Nifty Fifty to do that, it’s already in the S&P 500. I don’t know which ones that is though. It’s probably– [crosstalk]
Bill: It might be software. What I thought was interesting is, my man, Exit Multiple on the Twitter machine, he posted an interview. It was a podcast of a company that was undergoing a SaaS transition.
Tobias: Did they put you under for that?
Tobias: Did they put you under for that?
Bill: No, no. He’s actually a value guy at heart, I believe.
Jake: Have to get [crosstalk] valuation.
Bill: I don’t want to curse him.
Tobias: No, when they’re giving you the SaaS transition, did they give you a general anesthetic? That’s what I was asking.
Bill: No, I don’t think so. I think you have to take it fully alive.
Tobias: You have to be awake.
Bill: But what he was saying is, he said like you got to convince these customers that you have– I’m pretty sure these were his exact words that, what they’re paying $1 for today, they’re going to want to pay $4 in the future for. So, you’ve got to figure out how to deliver that value. And he was talking about how capital intensive the working capital transition is, because you go from selling something for $90 to selling something for, I don’t know, six bucks a month or whatever, $10 a month, whatever it is, and how much R&D goes into getting your product ready. And then– [crosstalk]
Jake: This is Adobe buying Figma.
Bill: Well, and then he made the comment where he said something to the extent. My takeaway was switching costs are much lower in that model. And that was what got me perked up. So, it’s like, okay, at least in that one company– I don’t know. I know that people say it’s a much more superior business model and I understand why they say it. At least according to him and his particular company, it’s a more competitive product that requires a higher sales process for something that’s easy to switch on. That’s not the greatest pitch.
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