To take advantage of value investing, you need a smaller portfolio than you may think. I was curious to see what different levels of portfolio concentration would have produced in a value-only portfolio over the past 50 years, and report the results here.

I set up portfolios which bought the absolute cheapest stocks trading in the U.S. (including ADRs). Portfolios ranged from 1 stock to 100 stocks, and stocks needed to have a minimum market cap of $200MM (inflation adjusted). Cheapness is defined as an equal weighted combination of a stock’s price/earnings, price/sales, EBITDA/EV, Free Cash Flow/EV and total (shareholder) yield. Each portfolio was rebalanced on a rolling annual basis (meaning 1/12 of the portfolio is rebalanced every month. Think of it like maintaining 12 separate, annually rebalanced portfolios). This means that the “one stock portfolio” will have more than one stock, because different stocks rise to the top through the months. This process removes any seasonal biases and makes the test more robust.

Here are the results, including return and Sharpe ratio. The best returns came from a 5 stock (!) portfolio. The best Sharpe ratio came from the 15 stock version. Both return and Sharpe degrade after 15 stocks.

The same is true of glamour portfolios. The concentrated glamour portfolios have bad returns and are incredibly volatile. The 1-stock version had an annual standard deviation of 50% and the 5 stock version had a standard deviation of 40% (hint, I wouldn’t short these!).

I’ve written before about overdiversification. I’m also a huge believe in high active share, and that to beat the market you must dare to be great (that is, different). These results are further evidence support these beliefs.