Why concentration is the new diversification

-- | 13/05/2019

Page 1 of 1

Ruth Saldanha: We've been discussing the importance of both diversification and concentration in your portfolio. Today, we have Sam Baldwin, Senior Portfolio Manager at Guardian Capital, who is here with an unusual strategy. Though he holds diversification as a part of his methodology, he has only 15 to 20 stocks which is quite concentrated for a portfolio.

Sam, thanks so much for being here today.

Sam Baldwin: Thanks for having us here, Ruth.

Saldanha: How do you define both diversification and concentration in the Canadian equity context?

Baldwin: Sure. Well, calling a concentrated portfolio diversified sure can get people's attention. And quite often concentration and diversification are thought of as trade-offs. From a portfolio construction perspective, we ask ourselves from a different perspective, can we build a concentrated portfolio that's also diversified, what would that look like. And the way we approach this is to use solid investment principles. And so, for us, this really speaks to quality, valuation, and low correlation. And so, what we found is that if we can find 15 to 20 companies that have high-quality characteristics and that are also attractively-valued and have low correlation versus one another, then we can build a deliberately diversified portfolio with only selecting from the best ideas that we can find in the market.

Saldanha: Though you have only 15 to 20 stocks in your actual portfolio, you also maintain a watchlist. Could you tell us a little more about that? What does it take to get into that watchlist and how many stocks do you hold in it?

Baldwin: Yeah. So, this really speaks to what's the ideal type of stock that we look for. And what we really look for is, as I mentioned before, we look for high-quality stocks trading at an attractive valuation that have a low correlation to one another. But what we mean by quality is really, does a company have a long-term runway for growth. Also, from the profitability perspective, are they able to navigate the cycle with adequate profitability. Thirdly, we look for manageable risk characteristics. And the fourth and last thing we would for is good stewardship. And so, when we roll these things together into a quality assessment, what we find is when you look at the collection of high-quality companies and you measure the performance, what you tend to find is an above-market performance with below-market risk over time. And that quality collection would be about a fifth of the market in our estimation, so 50 to 60 stocks or so.

Saldanha: Finally, let's take a step back and talk about the macro picture a little bit. Individual stocks will be impacted separately, but on a larger scale, what are some of the risks that Canadian investors should look for from an overall economy perspective?

Baldwin: Yeah. So, there are plenty of risks in the short-term and there always will be at any point in time that we would sit down and talk. Now, we've had a long expansion and we are getting towards the later innings of this cycle and central banks have been tightening in several global central banks. And what we tend to find is that tightening measures act with a lag. And so, while the Fed has backed off and the market recently has bounced and is excited about the Fed not tightening as strongly as they might have worried about last fall, these tightening effects we expect to assert themselves with a lag. And similarly, in the trade area, we've seen protectionist motions from Washington and elsewhere and we expect that these headwinds will assert themselves with a lag in the economy. So, there's reasons to be careful and cautious.

But on the flip side, things can also go right. And so, what we don't want to do is make a big call on the direction of the market and what we want to do is focus on the fundamentals that drive the portfolio and staying diversified. Now, at the stock level, if you are selecting from within quality stocks, then volatility can at times be your friend. And so, some of our best purchases that we've made over the history of the strategy have been in those times when there was a wave of pessimism and the stocks can subsequently do quite well from that point of low expectations.

Saldanha: Thank you so much for joining us with your perspectives, Sam.

Baldwin: Thank you for having us.

Saldanha: For Morningstar, I'm Ruth Saldanha.

This report appeared on www.morningstar.com.au 2021 Morningstar Australasia Pty Limited

© 2021 Morningstar, Inc. All rights reserved. Neither Morningstar, its affiliates, nor the content providers guarantee the data or content contained herein to be accurate, complete or timely nor will they have any liability for its use or distribution. This information is to be used for personal, non-commercial purposes only. No reproduction is permitted without the prior written content of Morningstar. Any general advice or 'class service' have been prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), or its Authorised Representatives, and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. Please refer to our Financial Services Guide (FSG) for more information at www.morningstar.com.au/s/fsg.pdf. Our publications, ratings and products should be viewed as an additional investment resource, not as your sole source of information. Past performance does not necessarily indicate a financial product's future performance. To obtain advice tailored to your situation, contact a licensed financial adviser. Some material is copyright and published under licence from ASX Operations Pty Ltd ACN 004 523 782 ("ASXO"). The article is current as at date of publication.