The Shrinking Investable Universe

Reflections #5

Welcome to this week's edition of Reflections. Before we dive into it, we want to take a moment to express our thanks for all the support on our recent posts. In just over a month we have reached 200 subscribers! This growth has been amazing, and we really appreciate it!

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Today, we're exploring an interesting paradox in investing, inspired by Chris Mayer: as our knowledge and experience in the markets grow, the number of investments we consider often becomes smaller.

"Diversification is a protection against ignorance. It makes little sense if you know what you are doing."

—Warren Buffett

The Counterintuitive Journey of an Investor

Many investors begin their journey believing that more options lead to better outcomes. They eagerly explore a vast array of stocks and sectors. However, an interesting phenomenon occurs as one's investing understanding develops: the pool of attractive investments seems to shrink. This isn't because opportunities are disappearing. Rather, it's a result of developing a more selective eye and higher standards for what constitutes a truly great investment.

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The Evolution of Investment Criteria

As investors gain experience and refine their strategies, several factors contribute to this narrowing of focus:

Quality Over Quantity

At the outset of their investing journey, most investors are willing to take positions in a broad array of companies. But as experience grows, they begin to understand that focusing on businesses that meet specific, stringent criteria can yield better long-term results. It becomes clear that holding only a handful of well-understood and high-quality businesses is preferable to spreading capital too thinly across many mediocre ones.

Understanding of Intrinsic Value

As the understanding of intrinsic value deepens, investors learn to be more selective about valuations. Just because a stock appears undervalued doesn’t mean it is a great investment. More seasoned investors learn to sift through the noise, zeroing in on companies that are not only undervalued but also possess strong fundamentals. This reduces the number of appealing candidates.

Emphasis on Competitive Advantage

Experienced investors increasingly appreciate the importance of competitive advantages, or "moats." These barriers to competition ensure that a company can maintain profitability over the long term. Recognising the value of strong moats naturally narrows the investable universe, as only a select few companies possess truly sustainable advantages.

Management Quality

As investors become more skilled at evaluating the quality of leadership, they find that fewer management teams meet their criteria. Great management can be a key driver of long-term success. For many seasoned investors, it’s not just about buying into a good business but also about buying into the right management team, which often excludes many companies from consideration.

Long-Term Perspective

When investors begin to think in terms of decades rather than quarters, the list of investable companies also shrinks even further. Businesses that can compound value over 10, 20, or 30 years are rare, and finding such long-term compounders becomes a key goal. As Warren Buffett famously put it:

"If you are a long-run investor and have no leverage, then you can be very selective in what you can buy. Wait for a good opportunity if you're in it for the long run."

—Warren Buffett

The Benefits of a Refined Focus

While it may feel counterintuitive at first, this shrinking investable universe often leads to better outcomes. By narrowing your focus to a smaller pool of higher-conviction investments, you can reap several benefits:

• Higher Conviction: With fewer options, investors can dedicate more time and energy to understanding each business deeply. This deeper understanding leads to higher conviction in each investment. High conviction, in turn, helps investors hold through periods of market turbulence.

• Improved Decision-Making: A clearer set of criteria makes the decision-making process simpler and more disciplined. Instead of getting overwhelmed by an endless sea of potential investments, a more refined approach allows for sharper focus and reduces the likelihood of errors. When you know exactly what you’re looking for, it's easier to avoid being swayed by market noise.

• Enhanced Patience and Discipline: By focusing on a smaller number of high-quality stocks, you're naturally inclined to practice patience, both in waiting for the best opportunities and holding firm through market volatility. This refined approach helps you avoid impulsive decisions and promotes disciplined investing. As Buffett famously said, "The stock market is a device for transferring money from the impatient to the patient.”

• Reduced Noise: With a more focused portfolio, investors can tune out the daily noise of the market and concentrate on what really matters: the business fundamentals and long-term prospects of the companies they own. This quiet focus can help investors avoid the distractions that often lead to poor decision-making in overly diversified portfolios.

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Navigating a Smaller Universe

Embracing a smaller investable universe doesn’t mean closing yourself off to new opportunities. Narrowing your focus can provide clarity, but it’s crucial to continue learning about new industries, technologies, and market trends. This keeps you flexible and better equipped to recognise opportunities that align with your evolving criteria. While it’s important to uphold high standards, being overly rigid can cause you to miss out on great opportunities. Staying adaptable as the world changes, while remaining disciplined to avoid compromising your standards for short-term gains, ensures you don’t box yourself in.

Additionally, as you focus on a more concentrated portfolio, regularly reviewing your holdings is essential to ensure they continue meeting your evolving standards. Businesses evolve, and what once seemed like a fantastic investment may no longer fit your criteria. Regular reassessment allows you to keep your portfolio aligned with your goals, staying proactive and adaptable as market conditions shift.

"The big money is not in the buying and the selling, but in the waiting."

—Charlie Munger

The Role of Expertise

As your investable universe shrinks, developing deep expertise in specific areas becomes increasingly important. Specialising in certain sectors or industries allows for a better understanding of the companies within those spaces, providing a potential edge over other investors.

Better Assessment:

In-depth knowledge of a specific industry allows for more accurate assessments of potential investments. Understanding the competitive landscape, growth drivers, and risks unique to an industry can give you an edge in identifying businesses with the potential to outperform.

Competitive Advantage:

This expertise also serves as a competitive advantage. By becoming an expert in a select area, you can identify opportunities that others might overlook or misinterpret. You’ll be able to see the potential in businesses that are operating within your area of expertise, even when the broader market doesn't fully appreciate them.

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Conclusion

The shrinking of your investable universe should not be seen as a limitation but a sign of growth as an investor. It reflects a shift from a broad, unfocused approach to a refined strategy built on knowledge and experience. By narrowing your focus to a select few high-conviction ideas, you can develop a deeper understanding of each company and make more informed investment decisions. To read more about concentrated portfolios, check out this post:

The Case for a Concentrated Portfolio

Also, if you're interested in seeing how we invest and the stocks we hold, be sure to explore our investing philosophy and the latest portfolio reveal.

Our Investing Philosophy [Free Checklist]

Portfolio Reveal and a Change Going Forward

Thanks for reading this far! We hope you found this post helpful—if you did, feel free to like and share it with others.

Have a great rest of your week,
The S.C. Team

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Disclaimer: The content provided in this newsletter is for informational purposes only and does not constitute financial, investment, or other professional advice. The opinions expressed here are those of the author and do not necessarily reflect the views of Schwar Capital. Investing involves risk, including the possible loss of principal. Past performance is not indicative of future results. The author may or may not hold positions in the stocks or other financial instruments mentioned. Always do your own research or consult with a qualified financial advisor before making any investment decisions.