Research Note: The Superior Returns of Concentrated Quality Investing
An Analysis Based on Warren Buffett's 1978 Shareholder Letter
Executive Summary
Concentrated investment in a small number of thoroughly understood, high-quality businesses generates superior returns compared to diversified portfolios of mediocre holdings. This research note examines why concentration in exceptional companies outperforms conventional diversification wisdom and identifies the investor characteristics necessary for successful implementation.
The Mathematics of Concentration
The concentrated investment philosophy rests on a mathematical reality: the performance delta between exceptional and average businesses far exceeds the risk reduction benefits of broad diversification. When an investor can identify businesses with sustainable competitive advantages, honest management, and attractive valuations, diluting these rare opportunities with inferior alternatives reduces rather than enhances risk-adjusted returns. Berkshire's approach requires four simultaneous conditions: businesses they can understand, favorable long-term prospects, honest and competent management, and attractive prices - a combination so rare that only a handful of opportunities emerge annually. The scarcity of investments meeting all four criteria naturally leads to concentration, as finding 50 such opportunities is virtually impossible while finding 5-10 remains achievable with diligent effort. This selective approach transforms investing from a statistical exercise in risk reduction to a business analysis exercise in quality identification, where deep knowledge of a few exceptional companies provides more safety than superficial knowledge of many average ones.
Berkshire's Concentration in Practice
The power of concentration manifested dramatically in Berkshire's results from 1975-1978, generating $112 million in gains while the Dow Jones Industrial Average declined from 852 to 805, proving that a focused portfolio of superior businesses can prosper even during market weakness. By year-end 1978, just eight positions represented $163.9 million of their $220.9 million total equity portfolio (74% concentration), with individual positions including Washington Post at $43.4 million, GEICO at $47.4 million, and SAFECO at $26.5 million. This concentration contrasted sharply with their 1971 positioning when they held only $10.7 million in stocks because few opportunities met their stringent criteria, demonstrating discipline to wait for exceptional opportunities rather than dilute standards for diversification. The portfolio's composition revealed another crucial aspect: each holding represented a business with enduring competitive advantages in industries they understood deeply - insurance, media, and advertising. The $24.7 million in realized gains during the period came from this same concentrated approach, as they sold positions only when prices reached levels where continuing to hold no longer made sense versus available alternatives.
The Institutional Impediments to Concentration
Most institutional investors cannot implement concentrated strategies due to career risk, regulatory constraints, and misaligned incentives that prioritize job preservation over return maximization. Modern Portfolio Theory's emphasis on diversification as the only "free lunch" in investing has created an institutional orthodoxy where holding fewer than 30-50 positions is considered imprudent regardless of quality differences. Pension consultants and investment committees evaluate managers on tracking error and relative performance, punishing those who deviate significantly from benchmark weightings even when generating superior absolute returns. The business risk of concentration - where being wrong on one position can devastate performance - overwhelms the investment merit for managers who face annual or quarterly evaluation cycles. This institutional behavior creates the very opportunity that concentrated investors exploit: exceptional businesses remain undervalued because most large investors must spread capital across hundreds of holdings to satisfy diversification mandates.
The Knowledge Advantage of Focus
Concentration forces a level of business understanding that diversification prevents, as owning 5-10 companies allows deep familiarity with competitive dynamics, management quality, and industry economics impossible with 50-100 holdings. Buffett's requirement to "understand" businesses reflects this reality - true understanding requires studying annual reports, industry dynamics, competitive positioning, and management behavior over multiple years. This depth of knowledge provides early warning signals when business conditions deteriorate and confidence to increase positions when temporary problems create buying opportunities. The feedback loop becomes self-reinforcing: concentration drives deeper analysis, which improves selection quality, which justifies further concentration. Contrast this with diversified portfolios where position 75 receives minimal attention and exists primarily to reduce tracking error rather than generate returns, creating a collection of under-researched, mediocre businesses that virtually guarantee mediocre results.
Risk Redefinition Through Quality
Traditional risk measurement through price volatility and correlation matrices misses the fundamental business risk that concentration addresses: the permanent loss of capital from investing in deteriorating businesses. By concentrating in companies with sustainable competitive advantages, Berkshire redefined risk from short-term price fluctuation to long-term business deterioration, accepting higher price volatility in exchange for lower business risk. The insurance companies dominating their portfolio (SAFECO, GEICO) possessed underwriting disciplines and cost advantages that made permanent capital loss unlikely despite periodic bear markets. Similarly, Washington Post's dominant newspaper franchise and Interpublic's advertising agency network provided earnings streams resilient to economic cycles. This quality-based risk management proved superior to diversification-based approaches, as evidenced by their 70% gain during a period of market decline, demonstrating that owning pieces of wonderful businesses provides more protection than owning many pieces of mediocre ones.
Key Metrics from Berkshire's Concentrated Approach
Portfolio Concentration: 74% in top 8 positions ($163.9M of $220.9M)
Performance vs. Market: +70% gain while Dow declined 5% (1975-1978)
Total Gains: $112 million realized and unrealized on $133.8 million invested
Selectivity: Only $10.7 million invested in 1971 when opportunities were scarce
Individual Position Sizes: Up to $47.4 million in single holdings (GEICO)
Bottom Line
Concentrated quality investing should be pursued primarily by individual investors and family offices with permanent capital, business analysis skills, and psychological fortitude to withstand periodic quotational losses while maintaining conviction in thoroughly researched positions. Small fund managers with patient capital bases and 5-10 year evaluation periods can successfully implement concentration strategies, particularly those managing under $500 million where position sizes remain manageable and investment universe includes overlooked opportunities. Endowments and foundations with true long-term horizons (10+ years) and boards educated about quality-based risk management should allocate portions of their portfolios to concentrated managers who demonstrate business analysis depth rather than diversification breadth. Corporate executives investing personal wealth should embrace concentration in industries they understand deeply, leveraging their operational knowledge to identify exceptional businesses while avoiding the diversification mandates that constrain their corporate portfolios. The investors who must avoid concentration include those with short-term liquidity needs, career risk from quarterly performance evaluation, regulatory constraints mandating diversification, or lacking the analytical skills and emotional discipline to distinguish between temporary quotational losses and permanent business deterioration.