Concentration and Risk

Concentration does not increase risk. Risk comes from the purchase price and equity selection.

Indications of a quality selection at a quality price
1. It is in your circle of competence
2. Productive debt
3. Moat
4. Excellent management
5. Unreasonably low price

Assuming that all of these are met, let’s look at probabilities of a 5 stock portfolio. If you’re like Pabrai and you assess a high probability(target 90% chance of being right) of 5x for each company, it will create risk/reward asymmetry in your portfolio. Let’s assume that all of the other positions in your portfolio go to zero, you only have to be 100% right on
1 to break even
2 to 2x your portfolio
3 to 3x your portfolio
4 to 4x your portfolio

You can assess probabilities with different expectations and different number of stocks in a portfolio. The formula is
1/expected multiple of return = % correct you need to break even
2/expected multiple of return = % correct you need to 2x your portfolio
and so on….

This is not a risk free strategy
1. Your analysis could be completely wrong or kind of wrong. Ex. of kind of wrong is where your total portfolio decreases 20% at fair value. Your analysis could only be only kind of right. Ex of kind of right is where your total portfolio increases only 20% at fair value.
2. You were right about your analysis but the 10% probability that it doesn’t work out occurs.
3. The market irrationally under-prices it for longer than you expected which decrease your returns.
4. Black Swans

The reason to concentrate is because these 5x+ companies are difficult to find. If you can find 100 equities, each with the equal probability of hitting an equally high multiple, then it would be wise to diversify. In today’s somewhat efficient market it is much easier to diversify if you have a lower hurdle rate. Companies with lower expected return are much more abundant.