The decision to sell or hold a concentrated position may sound simple, but these situations are often more complex than they appear. They require the investor to reconcile investment dynamics, tax considerations and a variety of subjective, emotional factors. Taxes are not the only reason that a client may want to hold onto a concentrated position—a holding may have understandable sentimental value based on family history, or it may have proven its worth in the past with exceptional performance. We have found that focusing on each client one at a time is the only way to help them make the right choices.
Concentration—A Double-Edged Sword
Our firm has always believed in the value of concentrated investment—in other words, in the merits of putting our clients’ capital behind a select set of high-conviction ideas. Our partner Ben Griswold continuously reminds us that one of the best ways to build wealth over time is to put your capital behind great companies and let the power of compounding work for you.
However, it’s equally important to remember that holding a concentrated position carries risk. A bank with one borrower is in trouble if that borrower doesn’t pay them back; a company with one customer is in trouble if that customer goes elsewhere. Similarly, investors should be cautious about a heavy weighting in a single investment. One also needs to consider that time is not always your friend if you hold a single, concentrated investment. Very few companies have generated above-average returns for shareholders over extended periods of time, and even great companies are eventually susceptible to strategic failures, management mistakes or disruptive innovation.
Given all of this, we believe in addressing concentration explicitly with our clients—either with a plan to diversify over time or at least with an examination of trade-offs associated with maintaining the concentrated position.
Here are some of the considerations we often discuss with clients:
- Liquidity: How easily can we sell or trim the position? Does it have limited daily trading volume? Does the client hold restricted stock or need to consider time windows during which selling is authorized?
- Taxes: What are the tax consequences if the position is sold? This is a central question driving this publication and a critical factor for many of our clients who hold concentrated positions.
- Fundamental Risk: What is the strategic and operating backdrop for the company or asset, and what can we expect in terms of return and volatility going forward? What would a worst-case scenario look like, and how likely is that scenario?
- Role in Portfolio: Is this a growth or income asset? Does the client rely on the income stream produced by the holding? Can the asset’s attributes be replicated by other investments?
- Client Perspective: Is there a meaningful emotional attachment to the company that should be considered (family legacy, for example)? Is there a benefit that wouldn’t be apparent from financial analysis (for example, does the client’s familiarity with a company provide confidence about its returns)?
In many of these situations, some amount of diversification from a concentrated holding is warranted, but there are often reasons why a client many want to hold onto some or even all of a concentrated position. These decisions are never easy for anyone involved. It is not uncommon, for example, to see a stock that we are selling do well enough to make us second-guess our thinking. But, if we are selling to reduce risk, everyone involved—our team as well as the client—should feel confident that the decision was warranted regardless of the near-term performance of the asset. This is why a comprehensive review of all relevant factors is so important—once a decision is made, everyone should feel comfortable that the decision was made for the right reasons and that it addresses the right priorities.
Many Options for Reducing Exposure
When it comes to concentrated, low-basis holdings, we rarely recommend an immediate sale of a client’s entire position. Generally, we seek to implement a gradual strategy that uses a combination of actions to mitigate risk, and we regularly re-examine our ongoing approach to ensure that we remain in sync with the client’s circumstances and market conditions.
There are a variety of tools we can use to mitigate the exposure risk of a concentrated equity position.
Outright Sale of Stock: We can choose to lay out a sale plan that gradually reduces the holding to a targeted size (or eliminates it entirely). Assuming that gains are taxable, we would generally seek to sell shares with higher cost basis first, as well as shares held for longer than one year (to ensure that the proceeds are taxed as long-term capital gains rather than ordinary income). We may also choose to coordinate sales to assist with other portfolio objectives; for example, we might look to use sales proceeds to fund regular portfolio disbursements for spending purposes.
Staged Sale of Stock: We can also develop a sale plan based on agreed-upon price targets—in other words, we will sell the stock over time but only at certain prices. These plans may include provisions for a variety of scenarios (e.g., if a stock’s price rises more than expected, or if it falls to a level that threatens other investment goals).
Exercise Options / Sell Restricted Stock: If a client is actively employed by a company in which they own a large amount of stock, we can deploy 10b5-1 selling plans or help them exercise vested options and sell shares in a cashless transaction. This may help reduce the client’s exposure to risk associated with their company or at minimum prevent that risk from growing larger.
Hedging and Other Strategies: Without actually selling a position, we can still reduce exposure to it. We can sell options to provide income that may offset some downside risk; buy options that provide a more “pure” form of downside protection; use shorting strategies to counterbalance exposure to a specific name or industry sector; or choose from a host of other, more complex option strategies. Exchange funds are an additional option. These allow a client to swap shares of a single holding for units in a broader portfolio. Because this swap is not an actual sale, the client is able to defer capital gains taxes while diversifying their holdings, All of these techniques can help mitigate the risks of a concentrated position; the client’s specific situation dictates which technique is likely to be most helpful.
We have a variety of ways to help clients plan around large positions, from wealth transfer strategies to philanthropic actions, and even ways that we can offset the risks embedded in a large holding with other investments. My colleagues cover these concepts in their contributions to this paper. However, there is no single correct answer for how to manage these positions—it all depends on the client’s situation and goals. 
Any accounting, business or tax advice contained in this communication, including attachments and enclosures, is not intended as a thorough, in-depth analysis of specific issues, nor a substitute for a formal opinion, nor is it sufficient to avoid tax-related penalties.
The views expressed are those of the author and Brown Advisory as of the date referenced and are subject to change at any time based on market or other conditions. These views are not intended to be and should not be relied upon as investment advice and are not intended to be a forecast of future events or a guarantee of future results. Past performance is not a guarantee of future performance and you may not get back the amount invested. The information provided in this material is not intended to be and should not be considered to be a recommendation or suggestion to engage in or refrain from a particular course of action or to make or hold a particular investment or pursue a particular investment strategy, including whether or not to buy, sell, or hold any of the securities mentioned. It should not be assumed that investments in such securities have been or will be profitable. To the extent specific securities are mentioned, they have been selected by the author on an objective basis to illustrate views expressed in the commentary and do not represent all of the securities purchased, sold or recommended for advisory clients. The information contained herein has been prepared from sources believed reliable but is not guaranteed by us as to its timeliness or accuracy, and is not a complete summary or statement of all available data. This piece is intended solely for our clients and prospective clients, is for informational purposes only, and is not individually tailored for or directed to any particular client or prospective client.