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Three stocks I’m betting on that will prove my case against index investors

One of the 10 commandments of investing, is surely, “Thou shalt diversify.” This mantra is taught in finance departments in the country’s finest universities and has become an unquestioned principle in the world of financial planning where it has been widely practised.

Yet, successful private-business owners thrive because of a very important practice: They own and operate one business, or very few of them. They concentrate. And they are successful because of this attention on the details and superior characteristics of their enterprise.

There is, of course, a huge downside risk – if you concentrate poorly. Prime recent example? Valeant Pharmaceuticals International Inc. is at the top of the list, where some of the best, brightest and most successful investors following the concentrated approach dove headlong in front of an oncoming freight train that resulted in a disastrous destruction of capital for all. Consequently, concentration can be a double-edged sword. A large, bad investment can destroy capital while the well-thought-through, well-researched equity purchased at a reasonable or cheap price has a higher probability of producing outsized rates of return over the long term.

Does a concentrated portfolio produce superior results? In their 2016 book, Concentrated Investing, authors Allen Benello, Michael van Biema and Tobias Carlisle talk about the select few in the investment industry that have employed this strategy to their benefit over the long haul. Some of those mentioned and reviewed include: Warren Buffett, Lou Simpson (who managed the Geico portfolio under the Berkshire Hathaway Inc. banner for years), Charlie Munger and John Maynard Keynes. This single idea of owning just a few “wonderful” companies is the key idea that runs through all their thinking.

I have witnessed that there are just a handful of investment professionals who have, and continue to produce, outsized rates of return over the long term. The problem faced by investors is that the number of these winners is really so few.

Investors often must be able to endure potentially long periods of underperformance in a concentrated portfolio before the rewards appear.

We at Sarbit follow the “concentrated” approach. In our largest fund, the IA Clarington Sarbit US Equity Trust, we hold only nine equities with three of these composing huge weightings. In our IA Clarington Sarbit Activist Opportunity Fund, we have only five holdings.

In the U.S. equity fund, Berkshire Hathaway class-B shares (which make up almost 9 per cent of the fund’s assets) have been held for a number of years to the fund’s benefit. Despite the appreciation of the stock over that period of time, we still consider the stock’s price reasonable.

Sirius XM Holdings Inc. (more than 10 per cent of assets under management in the US Equity fund) is an extraordinary cash machine with a huge sustainable barrier to entry and continued growth in revenue and free cash flow likely in the future.

Lions Gate Entertainment Corp. is a major investment (more than 10 per cent in the US Equity fund and almost 20 per cent in the Activist fund). It’s a media leader in the fields of the production of movies and TV series. We purchased the stock after it fell approximately 50 per cent, and now trades at only 12.5 times free cash flow. The company benefits from the enormous potential growth in worldwide demand for entertainment and streaming. We think the company has a long runway to grow.

The investor has a choice: the now popular indexation approach or the more difficult approach of seeking out professional investment managers that can add value. I have chosen the concentrated style, the far more demanding approach because I would argue the results are worth the huge effort and sacrifice. No doubt, owning a small number of stocks means there is little room for error. So, the professional investor must make as sure as possible that a stock meets the qualifications that reduce the possibility of loss – absolutely the most important requirement.

When Mr. Buffett says: “Rule No. 1: Don’t lose money,” it’s no joke.

Larry Sarbit is the chief executive and chief investment officer at Winnipeg-based Sarbit Advisory Services. Mr. Sarbit is a sub-adviser on three funds for IA Clarington.