Photo Credit: John.U || Look at all those eggs in one basket! The owner *is* watching it carefully, right?
Jason Zweig recent wrote an article on owning stock in the company that you work for. Then today in his WSJ newsletter he asked the following question:
What’s the most concentrated investment position you’ve ever had? (In other words, what single investment made up the greatest proportion of your portfolio?) Did it work out well or poorly? What did you learn from it?
I have one article to answer both questions called Life with Wife. It’s a cute article which runs through two times in my life where I had an overly concentrated investment position. The first one was regarding The St. Paul (acquired by The Travelers), where I took my first big bonus, and put it all into shares of The St. Paul. I got derided for doing that by my colleagues in the investment department, but with a AA balance sheet, trading at 55% of tangible book value, and 8x forward earnings, I felt I had a reasonable provision against adverse deviation — a margin of safety. If you read the article, you will see that I almost doubled my money in six months, then sold. At the peak it was half of my net worth, and I had a mortgage then.
So should you invest in your own company? Well, are you working for Tesla or Enron? I am being facetious here, as the guys at Enron thought they were working for a cutting-edge company like Tesla. But any analyst worth his salt would have seen that free cash flow at Enron was deeply negative.
I have a neighbor who is a Tesla mechanic. As I was mowing my lawn one day, he waved me over. He wanted advice. He hinted to me how much his Tesla shares were worth. He had consulted an investment advisor who had told him to sell the wad, and the advisor would create a growth and income portfolio allowing him to retire (he is in his 60s). But he was conflicted, because Tesla was doing so well. He asked me what I would do if I was in his shoes. (Note: the TSLA shares were likely 95% of his net worth.)
I said, “Do half, or sell 10-20% per year over time, until you do sell half.” Doing that frees you from the binary decision that you might regret. After selling half, if the price goes up, you still have more capital gains. If the price goes down, you sold some at a good time. You can be happy with yourself no matter what. I have no idea what my neighbor did. Hopefully he sold some.
The second situation in Life with Wife regarded my only significant private equity position, Wright Manufacturing, which makes the best commercial lawn mowers in the world. At that point, my holdings were 15% of my net worth, with no mortgage. The founder was throwing everything into growth, and sacrificing safety. If he hadn’t been my friend, I probably would not have invested with him. As it was, when I sold half, I had recouped my investment. After the Life with Wife article, I bought out several of the founder’s relatives, ending up with 2.2% of the company. I’ve made 5x on my money here, with distributions, and using the very thin “market” for shares. One of the founder’s sons leads the company now, and he is a far better manager than his father. I like this company, and am more likely to buy more than to sell at this point.
But at this point, it is only 10% of my net worth. I may offer to buy more, but I am thinking about it. It trades at 6x earnings, with a stronger balance sheet than the founder worked with, and a stronger competitive position. The most recent price is still below where I sold it to the second largest shareholder. Price discovery is tough when there are only 20 shareholders, and new shareholders may only enter at the pleasure of the board of directors.
Closing
So, over my life, I have reduced the relative amount at risk on my biggest positions. Does that make sense? Of course — I have less time to make up for mistakes as I grow older. The only people who should be taking high risks when they are old are who are ultra-rich. If they fail, they will still have enough for a moderate existence.
Be careful with concentrated positions. You need certainty about safety most, earnings second, and growth third. Otherwise you are a gambler, and most gamblers lose.
Hi David, thanks for sharing this valuable information. The eggs reminds me of Warren Buffet’s quotes ; )
You and Jason Zweig are covering an under-covered and under-appreciated topic. There is another category of shareholder that you did not mention and that is ESOP shareholders. I have worked for many years for a company that was an early ESOP firm to buy out the original founder group. It was private for many years and then went public a few years ago but most of the shares are still held within the ESOP. It is a fairly conservatively run company without a lot of debt and a broadly diversified client base in multiple countries. Usually these firms are relatively boring but there have been a couple of examples of these types of companies making significant boo-boos that resulted in a precipitous fall in the share value (either “fair value” if not public or daily stock exchange pricing).
My current ESOP holding is about 40% of our personal financial assets while our house is less than 20% of financial assets with very low interest rate mortage about 10% (declining annually). At the time of the GFC, the ESOP was over 50%. The rest of our portfolio is broadly diversified index funds with about 55% worldwide equities. However, there is no further diversification possible with this ESOP other than reitring and taking the money out distributing in several chunks over two years. Se we largely just ignore its volatility as there is nothing we can do about it other than leave the company now that I am age-eligible to retire. Now that I am close to retirement, I watch management quite closely to see if they start doing wildly optimistic things that could end badly because that could hasten my retirement in order to start pulling money out of this highly illiquid investment.
I half-jokingly refer to the ESOP as our “European Vacation Money”. If the stock does well, we will have a lot of freedom in retirement to do lots of things. If it does poorly moving forward, there will be less freedom. However, we have enough other savings and income sources in retirement that we would not be remotely close to being poor if the ESOP value went to zero. I counsel our young staff that it is a great benefit the company provides by putting in a certain percentage of annual income into the ESOP every year. However, they still need to save 10%+ every year into well-diversified 401k or IRAs to make sure they have enough money to retire securely on even if the company stock folds entirely in bankruptcy. The company has an excellent low-cost 401k but only a small 401k match because it puts a significant percentage of its contribution into the ESOP.
There is the opportunity to buy additional shares of the company at a small discount for a brokerage account, but I can’t conceive of doing that given how high a percentage of most employee’s financial assets are in the ESOP if they have worked for the company for a decade or more. There are so many black-out windows it would be difficult to do anything but long-term investing in the stock, which we are already doing in the ESOP. I view buying the stock in brokerage accounts as offering no addiitonal investing benefit but significant risk of SEC investigations if there was any active trading.
Thanks for the comment. This really adds to the discussion, though admittedly in a niche area of illiquid investments.
ESOPs are a niche area but there are over 600,000 people who own ESOP shares in the top 100 ESOP owned companies (at least 50% of company owned through an ESOP) in that niche. There will be quite a few more people in companies with smaller ESOP percentages. https://www.nceo.org/articles/employee-ownership-100
This would put them into about 1% of households but most of those people would not be in the multi-millionaire status which makes it quite different from the 1% wealth category which is heavily targeted by wealth managers. This is why it is an under-covered area. Thank you for your discussion on concentrated positions.
“Price discovery is tough when there are only 20 shareholders, and new shareholders may only enter at the pleasure of the board of directors.”
Hi David, I think you put yourself in the ideal investment, risk management-wise. Though price is not available like with listed companies, having only 20 shareholders, all of whom likely know each other, and newcomers can enter only if approved by directors, means price is always stable, no shareholder is likely to suddenly sell on a whim to others who can put a monkey wrench on this stability, and anytime you need to sell, the directors are likely the ones who’ll buy at a price that’s reflective of the company’s real value. They just need to keep managing the business well.
I personally think one should distinguish between concentrated positions arrived at by accident and those arrived at by deliberation. ESOPs are arrived at by accident, unless one chose to work for the company whose stock one wanted to own. Historically, deliberated concentration narrowly selected isn’t as risky as financial advisors like to pretend. Many families have kept such positions over several generations. This is well known and written about. And is it a strategy to be non-concentrated? Not really. But the fallacy that it is probably explains why attempts at diversified portfolios so often deliver poor returns except for those constructing them for their clients. I’m with Buffett, most people should be invested in indexes. But it still amazes me how sloppy, generalized, and panic porny are the statements made about concentration.