Building a Quality Growth Portfolio

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Most financial/wealth advisors preach diversification above all else. Spread your bets, the thinking goes, and you protect yourself from downside risk in any single position.

Peter Seilern argues the opposite in his 2024 book "Only the Best Will Do." Seilern makes the case that concentrated portfolios of 20-30 stocks, along with low turnover and strict sector avoidance, produce superior long-term results with less actual risk.

The reasoning is simple. If you truly understand the businesses you own, concentration becomes a strength rather than a weakness. And if certain sectors cannot meet quality growth criteria, no amount of analysis will make them investable.

Below, we'll expand on Seilern's case against diversification, why low turnover matters, and the specific sectors he avoids entirely.

Seilern addresses the popular belief that owning many stocks protects investors from undue losses. He acknowledges the logic but calls it superficial.

The better question, he argues, is whether an investor could instead be confident, after thorough investigation, that the companies held will not only avoid collapse but will survive, thrive, and grow for an undetermined period.

And once this is established, would it not be more profitable to hold a few large positions rather than many small ones?

Warren Buffett points out that the real value of diversification is as protection against an investor's ignorance. The less an investor knows, the more diversified they should aim to be. An index fund, being by definition as broadly diversified as the stock market itself, is ideal for the know-nothing first-time investor.

The quality growth investor operates from the opposite starting point. The entire purpose is to know as much as possible about every holding!

By excluding businesses incapable of delivering high returns on capital and sustained profitability over many years, Seilern believes the investor has reduced portfolio risk far more effectively than through fixating on diversification.

The logic of concentration extends naturally to holding period. If an investor has done the work to identify quality growth businesses, constant trading becomes counterproductive.

Seilern's firm targets main portfolio turnover of around 8% per annum. This implies an average holding period of 10-12 years per investment, enabling the compounding effect of sustained earnings growth over the long term.

Seilern also distinguishes between turnover driven by fundamental decisions vs. turnover created by investor flows.

Put simply, when a fund experiences significant new investment or redemptions, buying and selling to meet these flows can push reported turnover higher, understating the actual commitment to underlying holdings.

Overall, the point is that quality growth investors resist the harmful influences of emotion and market noise. Rather than reacting to quarterly earnings or macroeconomic headlines, you should form individual views of each investment, judge them on their merits in isolation, and hold them with a long time horizon.

Seilern produces a list of sectors where the quality growth investor will never find suitable investments because they fail at least one of his criteria:

The list of companies to avoid, he notes, is always longer than the list under consideration.

Seilern emphasizes that investors must maintain discipline when prices in these sectors appear cheap. He admits that most of his biggest mistakes over the years came from straying outside his quality growth criteria, tempted by apparently attractive valuations.

Seilern shares an anecdote about telling the chief executive of a leading bank that he never buys bank shares because he cannot understand their balance sheets. The CEO replied that he couldn't either. Perhaps it was a joke, Seilern notes, but he suspects not.

Bank balance sheets remain notoriously opaque, and the business model relies heavily on leverage. For Seilern, high leverage is an automatic disqualifier.

Beyond balance sheet complexity, the entire traditional banking model faces threats from technological change that will take years to overcome. Shareholders have endured massive permanent losses of capital as a result.

Telecommunications companies appear at first glance to pass quality growth tests.

The surge of data worldwide suggests sound volume expansion ahead. Overall margins are high, with oligopolies in most countries limiting competition to three or four players.

Yet as these businesses grow, newcomers enter the field and government intervention eventually erodes profitability. Regulators treat telecommunications as a public service that should be cheap and available to all, constraining pricing power over time.

Quality growth businesses have pricing power. They are not at the mercy of events but can set their own prices for their own reasons. This definition automatically excludes commodity businesses.

Mining and oil companies can make high returns on capital when commodity prices rise, but they remain vulnerable to the inevitable downturn as supply and demand rebalance. These cycles are often worsened by high leverage taken on during good times.

The shift toward clean energy adds to these challenges. Where OPEC once wielded pricing power, member states now find themselves on the back foot. Moreover, new discoveries keep adding supply while demand from traditional petroleum sources keeps falling, leaving producers with little control over price.

Airlines suffer from low-cost providers challenging market dominance, and any disaster or terrorist incident can devastate profitability. Fluctuating fuel prices also make earnings unpredictable. The industry is inherently cyclical.

Airlines have spent years on the defensive, seeking to improve market position through mergers and commercial agreements. Government efforts to address climate change will likely result in restrictions on air travel sooner or later. This is hardly conducive to secular earnings growth.

Quality growth businesses enjoy low capital intensity. Vehicle manufacturers represent the opposite, requiring significant capital on a regular basis to maintain growth. Most have low margins, little pricing power, and remain at the mercy of cyclical downturns.

Refraining from buying a new car is one of the first consumer responses in an economic downturn. Car production shrank nearly 50% during the depths of the 2008 financial crisis.

Existing car manufacturers also face threats from electric and driverless vehicles, which may render their current business models obsolete.

Startup businesses, especially in technology and the new economy, fail to meet quality growth standards.

The most important turn-off is the absence of a track record. The majority of startup businesses in the UK, for instance, fail before their first anniversary, causing permanent loss of capital for investors. Where there’s no tangible success record, there can be no basis on which to forecast future profitability.

Initial public offerings (IPOs) present similar problems. Most businesses are not mature enough to meet quality growth criteria when they reach the market. Some are not yet making profits at all, while others issue shares simply to raise more capital.

Seilern points to the 2019 wave of unicorn IPOs as examples of the risk. Lyft and Uber, both heavily loss-making, found eager investors despite requiring regular infusions of fresh capital with no guarantee they would ever reach profitability.

While identifying sectors to avoid comes easily, Seilern acknowledges that pinpointing where quality growth will be found proves more difficult. The sectors appearing most often on his fund factsheets include:

Yet even these classifications can mislead, as index providers often attach simplistic labels that obscure a company's true nature (e.g., Alphabet gets classified as IT when it's really an advertising business). This is why investors should look through labels and focus on real fundamentals.

The takeaway is that quality growth stocks are, in Seilern's words, "reassuringly expensive." They rarely look cheap at the moment of purchase. This is why "value investors" often end up never owning the best-performing shares in their market.

The quality growth investor accepts the apparent premium, trusting that fortress-like balance sheets and compounding earnings growth will deliver superior returns over time.