Diversification is the goal of funds with a large number of stocks in their portfolios. Yet be aware that the more diverse the portfolio, the closer to the benchmark index a fund tends to trade and the less the stock picking skills of the manager can be expressed.

Last year, research from the Association of Investment Companies (AIC), looking at investment companies in the equity sectors only, found that a third of these companies have 50 or fewer companies in their portfolios; 57 out of 174 companies.

As the AIC’s communications director Annabel Brodie-Smith remarked: ‘It’s interesting that a third of equity investment companies have a concentrated portfolio. Clearly, these managers are taking high conviction decisions on their portfolios.

‘However, the investment company sector has always offered a wide variety of choice for investors. Some investors will be looking for investment companies with a higher number of holdings, arguing that it gives them a more diversified portfolio. When it comes to performance there’s no hard and fast rules on which is better, and it very much comes down to manager style and what investors want.’

Betting big

Nick Train of Finsbury Growth & Income Trust (FGT) says: ‘Clients want professional investors to beat the index and you really can’t do that without taking risk.’

‘There are many different types of risk an investor can take. The type of risk that works best for us is to create highly concentrated portfolios, made up of big holdings in what we analyse to be very low risk/high quality companies.

‘The theory is that – if we get it right – the gains from a winning share are disproportionately great, because we have a big position size. Meanwhile – if we make a mistake with our timing and buy a share that goes nowhere for a period – at least we own a piece of something reliable that ought to come good eventually.’

Gary Channon, who manages Aurora Investment Trust (ARR), adds: ‘What we found was that lower concentration reduces the volatility of the fund but also reduces the long-term returns of our strategy. We concluded that lower returns were not a price worth paying for lower volatility.’

Other concentrated investment companies include British Empire Trust (BTEM), a focused book of investments in companies trading at a discount to underlying net asset value and the small cap focused Strategic Equity Capital (SEC) with just 17 holdings as at 31 March.

Other concentrated portfolios include Prospect Japan (PJF), Lindsell Train (LTI) and Martin Currie Asia Unconstrained Trust (MCP). The latter’s portfolio of 28 holdings makes it the most concentrated in the AIC Asia ex-Japan sector.

Phoenix from the flames

Phoenix Asset Management-run Aurora is an extremely concentrated portfolio. It seeks to achieve long-term returns by investing in a portfolio of between 12-20 equities using a value-based philosophy inspired by legendary investors Warren Buffett, Charlie Munger, Benjamin Graham and Philip Fisher, the author of Common Stocks and Uncommon Profits who popularised ‘scuttlebutt’, or primary research using a range  of sources.

Aurora invests in high quality businesses run by honest and competent management purchased at prices that, even with low expectations, ‘will deliver excellent returns.’

In short, Aurora looks for great businesses when they are cheap, usually because they are having short term issues; if its research is correct these companies should recover and deliver high returns.

Phoenix’s contrarian value approach is reflected in the fact that a stock will never be purchased at a price above the team’s estimate of the company’s ‘intrinsic value’ under the worst feasible outcome.

‘We are value investors but we’re not deep value investors,’ explains Phoenix director Tristan Chapple, an exponent of scuttlebutt. ‘We want really high quality, but cheap, so companies trading at 50% of what they are worth or less.

We are often looking in areas of distress. And we are looking at businesses that make at least a 15% return on capital,’ says Chapple. ‘That is incredibly rare.’

He adds: ‘Our secret sauce, if there is one, is the research we do.’ The trust’s managers carry out exhaustive reading on the businesses they are looking at; visiting them, their competitors and suppliers. ‘We don’t think we can know more than 12-20 businesses,’ says Chapple, whose view is that risk management is done by knowledge, not diversification.

One unloved share Aurora owns is Sports Direct International (SPD), Mike Ashley’s sporting goods retail giant. ‘We’ve got to know the business really well. It has 50% of the UK market, the best retail management team we’ve come across and it is cheaper than the competition.

We’ve visited almost every country in Europe in which they operate – it enables us to understand why Sports Direct is winning,’ says Chapple.

Innovative option

An interesting option in the open-ended funds arena is the Guinness Global Innovators Fund (IE00BQXX3K83). It has a concentrated portfolio of 30 large and medium-sized sized companies in any industry and in any region. Managed by Ian Mortimer and Matthew Page, the fund provides global exposure to companies benefiting from innovations in technology, communication, globalisation or innovative management strategies and has a strict value discipline to avoid over-hyped stocks.

‘We like asset light companies that can build and grow from their own operating cash flow,’ says Page. ‘And we want companies that generate a return on capital above their cost of capital.’ Companies that currently pass muster with the managers’ stringent criteria include Paypal, Google’s parent Alphabet and AAC Technologies, a Chinese acoustic component manufacturer for smartphones.

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