Portfolio Construction

The following is an excerpt from Eagle Point Capital’s most recent letter to clients. Every six months, EPC writes to clients to explain what they own and why they own it. The portfolio-specific portion of each letter is for clients and prospective clients only. If you’d like to read EPC’s entire letter, please contact us.

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The whole secret of investment is to find places where it’s safe and wise to non-diversify. It’s just that simple. Diversification is for the know-nothing investor; it’s not for the professional.

— Charlie Munger

10x10

The 10x10 framework is the cornerstone of our portfolio construction philosophy. 10x10 means ten stocks, each purchased with 10% of our capital.

Why ten stocks?

A ten stock portfolio balances our stomach for volatility with our desire for above-market returns and our ability to intimately know and understand our businesses.

Conventional wisdom holds that diversification is a “free lunch” and that more is always better. We disagree. We do not diversify excessively. Good investments are hard to come by and we would rather concentrate our capital into our best ideas than spread it over many mediocre ones.

We view our stocks as businesses and our portfolio as a conglomerate. If we owned ten private businesses in different industries, conventional wisdom would say that we are diversified. We see no reason why owning businesses privately or publicly should change that assessment.

Diversification, like anything, has diminishing marginal returns and becomes detrimental when taken too far. Studies show that a ten-stock portfolio experiences less than half of the volatility of a single stock. Increasing the portfolio size from 10 to 1,000 only reduces volatility an additional 25%.

While we disagree that volatility measures risk, we still think investors should consider a portfolio’s volatility. If a portfolio is too volatile, investors won’t have the stomach to stick with it. Further, unusual and unprecedented events happen all the time. That’s why we are reluctant to concentrate our portfolio into fewer than ten investments. We want to live to invest another day.

The best strategy is worthless if investors can’t stick with it. Joel Greenblatt ran outside capital at Gotham Partners for ten years and averaged 50.0% annual returns (before fees). He owned just six stocks at a time and they were often in precarious financial or competitive positions. Despite his high returns, Greenblatt closed Gotham in 1994. The portfolio’s extreme volatility was too stressful and not worth the money. Greenblatt was tired of watching his net worth plunge 20%+ multiple times per year.

We intend to run EPC for much longer than ten years, and are willing to trade potentially slightly higher performance for a strategy we and our clients can stick with for decades.

Why 10% each?

We commit 10% of our capital to each new position in order to create a high barrier to entry into the portfolio. If we are not comfortable committing 10% of our personal net worth to the investment, we shouldn’t commit 1%. 

A 10% commitment forces us to look down (at risks) before we look up (at rewards). We do not want to buy lottery tickets. We want to buy businesses that are like cockroaches — very hardy and almost impossible to kill.

One of EPC’s core principles is to make fewer, better decisions. More decisions mean more opportunities to be wrong. We are confident we can add value via security selection. We are not confident we can add value by overweighting our favorite stock and underweighting our least favorite. If we had a least favorite, we’d sell it. 10% allocations ensure each decision we make has a meaningful impact on performance.

Compounding

The first rule of compounding: never interrupt it unnecessarily.

— Charlie Munger

Once we make an investment, we let it run. We don’t trim or double down. Our winners will naturally compound into larger positions. Our losers likewise take care of themselves by becoming smaller portions of the portfolio.

We want to avoid cutting the flowers and watering the weeds. Imagine if Warren Buffett or Jeff Bezos had trimmed Berkshire or Amazon in order to maintain an arbitrary portfolio allocation.

Removing position-sizing decisions allows us to focus on the key question at hand: is the business an attractive long term investment? So long as the answer is “yes” we continue to own it and do nothing. If the answer becomes“no” we sell it and move on to our next idea.

Terry Smith of Fundsmith sums up our philosophy when he says: “Buy good companies. Don't overpay. Do nothing.”

Cash

Investing is all about opportunity costs. Cash earns almost nothing — far less than we expect our businesses to earn. Therefore, we prefer to be virtually 100% invested at all times. We don’t know how to time the market and don’t attempt to tactically raise and lower cash. Cash rises and falls organically as a result of our security selection decisions.

Guidelines, Not Rules

The 10x10 framework is a guideline, not a rule, and we occasionally diverge from it. We don’t always own exactly ten stocks (we own 11 at the moment) or invest precisely 10% into each. We have, occasionally, added slightly to a position when we felt the price was particularly attractive. The 10x10 framework is a guideline that orients us toward success. It is a default setting we only override in exceptional circumstances.

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If you would like to invest with Eagle Point Capital or connect with us, please email info@eaglepointcap.com. Thank you for reading!

Disclosure: The author, Eagle Point Capital, or their affiliates may own the securities discussed. This blog is for informational purposes only. Nothing should be construed as investment advice. Please read our Terms and Conditions for further details.