By Michael Brush
True or false: To build big wealth in the stock market, it pays to be widely diversified.
If you guessed “true,” you might want to reconsider.
Successful investors from Warren Buffett to Ron Baron teach us time and again that taking concentrated positions can really pay off.
Of course, this isn’t for everyone. For it to work, you have to have the time and skills to figure out what stocks to concentrate in. Otherwise, you might choose badly and lose a lot of money. There is a high risk of this happening. If you don’t have the time, just get broad market exposure for the long term.
But if you want to tiptoe into taking larger positions, one workaround is “coat tailing.” Find an investor with a good long term track record. Then buy a larger-than-normal position in what they own a lot of, after you have studied the company enough to understand it.
With that in mind, I recently checked in with James Davolos of the Kinetics Market Opportunities /zigman2/quotes/210522217/realtime KMKNX +0.55% and Kinetics Paradigm /zigman2/quotes/209207252/realtime WWNPX +0.77% funds. Those mutual funds are a good study in concentrated position investing. They have enviable records, and a whopper of a concentrated position — more on that later.
The funds beat their Mid-Cap Growth category and Morningstar U.S. Midcap Broad Growth Index by an annualized five to 10 percentage points over the past three to five years, according to Morningstar Direct.
Having a concentrated position comes naturally to Davolos, who helps manage the two funds.
“Look at the holdings of almost every billionaire on earth,” he says, “and you’ll see their wealth is wildly concentrated, whether it is in a public stock or private business.” In the early days, the insurance company Geico produced the big gains for Berkshire Hathaway /zigman2/quotes/200060694/composite BRK.B +0.40% , he notes.
Finding mispriced stocks
The key to taking concentrated bets (and investing in general) is to find companies with great qualities that the market is not yet recognizing. Even though markets are supposed to be efficient, that’s possible. And it’s easier these days because of the rise of exchange traded funds (ETFs) and indexing, believes Davolos.
Thanks to ETFs and index funds, investment dollars often go into a small number of stocks indiscriminately, meaning the biggest positions in the most popular ETFs and indices — like the Invesco QQQ Trust (QQQ), the S&P 500 or the Dow Jones Industrial Average. These vehicles are market cap weighted. So, they are relatively overweight their stocks with the biggest market caps, like Alphabet (GOOGL), Amazon.com (AMZN), Apple (AAPL), Microsoft (MSFT) and Tesla (TSLA). This means that ETF and index investing plow more money into these names. This leaves other stocks overlooked, left behind and mispriced, says Davolos.
Another problem is that ETFs and indexing pull money out of active management, which reduces “price discovery.” When active managers have fewer analysts and investment dollars, they have less firepower to research stocks and trade them up to where stock prices reflect underling company values.
For more on this theme, see my column in which even index pioneer John Bogle of Vanguard worries about the potential downsides to indexing. ( https://www.marketwatch.com/story/your-love-of-index-funds-is-terrible-for-our-economy-2018-12-10 )
The upshot : There may more misvalued stocks around in the stock market because of indexing and ETFs. Here’s more detail on one of them.
Everything is bigger in Texas
The Kinetics Market Opportunities and Kinetics Paradigm funds have 46% and 61% of their portfolios in a single energy stock you’ve probably never heard of: Texas Pacific Land /zigman2/quotes/203839070/composite TPL +1.03% .
Those positions are big in part because the stock has done well. It has tripled since December 2020. The funds started buying them in 2012 and 2002, when the stock traded in the $40 range and under $10, respectively. But Kinetics has continued to add for years, rather than trim. Most recently they bought last week as high as $1,888 per share.
What’s so great about this company? Texas Pacific Land owns a lot of land in the energy-rich Permian Basin in western Texas, so-named because its rock dates back to the what geologists call the Permian era. The company owns all this land because it was originally a land trust in 1888 set up to take over large land holdings from the Texas and Pacific Railway Co.