Portfolio Management - Focus Investing, Two
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In Berkshire Hathaway's 1991 Annual Report Warren Buffet explained how he approaches portfolio management: "If my universe of business possibilities was limited, say to private companies in Omaha, I would, first, try to assess the long-term economic characteristics of each business; second, access the quality of the people in charge of running it; and third, try to buy into a few of the best operations at a sensible price. I certainly would not wish to own an equal part of every business in town. Why, then should Berkshire take a different tack when dealing with the larger universe of public companies?"
The portfolio management approach at Berkshire Hathaway is called focus investing, and its essence can be stated simply: Choose a few outstanding businesses that are likely to produce above-average returns over the long haul, concentrate the bulk of your portfolio in the common shares of these businesses, and have the fortitude to hold steady during periods of short-term market volatility...
"Charlie and I are not stock pickers," said Buffet. "We are business pickers. We own publicly traded stocks based on our expectations about their long-term business performance, not because we view them as vehicles for adroit purchases and sales." That crisp description of the key difference between a "business picker" and a "stock picker" is critical to understanding why someone would choose to manage a focus portfolio versus a broadly diversified portfolio.
Thirty years ago, Warren Buffet wrote, "We continually search for large businesses with understandable, enduring and mouth-watering economics that are run by able and shareholder-orientated managements. This focus doesn't guarantee results: We both have to buy at a sensible price and get business performance from our companies that validates our assessment. But this investment approach - searching for superstars - offers us our only chance for real success."
Buffet then confessed, "Charlie and I are simply not smart enough, considering the large sums we work with, to get real results by adroitly buying and selling portions of far-from-great businesses. Nor do we think many others can achieve long-term investment success by flitting from flower to flower. Indeed, we believe that according the name :investors" to institutions that trade actively is like calling someone who repeatedly engages in one-night stands a romantic."
Remember Buffet's advice to a "know-nothing" investor: to stay with index funds? What is more interesting is what he said next: "If you are a know-something investor, able to understand business economics and to find five to ten sensibly priced companies that possess important long-term competitive advantages, conventional diversification makes no sense for you. It is apt simply to hurt your results and increase your risk. I cannot understand why an investor of that sort elects to put money into a business that is his 20th favorite rather than simply adding that money to his top choices - the businesses he understands the best and that present the least risk, along with the greatest profit potential."
In Buffet's opinion, investors are better served if they concentrate on a few spectacular investments rather than jumping from one mediocre idea to another. He believes that his success can be traced to a few outstanding investments. Of, over his career, you eliminate one dozen of Buffet's best decisions, his investment performance would be no better than average. To avoid becoming average while increasing the odds of generating above-average investment results, Buffet recommends that "an investor should act as though he had a lifetime decision card with just twenty punches on it. With every investment decision his card is punched, and he has one fewer available for the rest of his life." If investors were restrained in this way, Buffet figures they would wait patiently until a great opportunity surfaced.
There is another demerit associated with conventional diversification. It greatly increases the chance you will have purchased a company without knowing much about the business. Buffet references John Maynard Keynes, economist and one of the first focus investors, on this point. Buffet wrote, "John Maynard Keynes, whose brilliance as a practicing investor matched his brilliance in thought, wrote a letter to a business associate, F.C. Scott, on August 15, 1934, that says it all." Buffet quoted from Keynes letter.
As time goes on, I get more and more convinced that the right method in investment is to put fairly large sums into an enterprise which one thinks one knows something about and in the management of which one thoroughly believes. It is a mistake to think that one limits one's risk by spreading too much between enterprises about which one knows little and has no reason for special confidence....One's knowledge and experience are definitely limited and there is seldom more than two or three enterprises at any given time in which I personally feel myself entitled to put full confidence.
Philip Fisher, whose impact on Buffet's thinking has been noted, was also well known for his focus portfolios. He always preferred owning a small number of outstanding companies that he understood well rather than owning a large number of them, many of which he understood poorly. Fisher began his investment counseling business shortly after the 1929 stock market crash, and he remembers how important it was to produce good results. "Back then, there was no room for mistakes. I knew the more I understood about the company the better off I would be." As a general rule, Fisher limited his portfolio to fewer than 10 companies, of which three to four often represented 75 percent of the total investment.
"It never seems to occur to (investors), much less their advisors," Fisher wrote in Common Stocks and Uncommon Profits, "that buying a company without having sufficient knowledge of it may be even more dangerous than having inadequate diversification." At age 91, Fisher had not changed his mind. "Great stocks are extremely hard to find," he said. "If they weren't, then everyone would own them. I knew I wanted to own the best of them or none at all." You could summarize Fisher's portfolio management approach as "based on an unusual but insightful notion that less was more."
Fisher's influence on Buffet cab be seen in his belief that when you encounter a handsome, profitable investment, the only reasonable course is to make a large investment. Buffet echoed this thinking, writing in 1978, "Our policy is to concentrate our holdings. We try to avoid buying a little of this or that when we are only lukewarm about the business or its price." Instead, he explained, "When we are convinced as to the attractiveness, we believe in buying worthwhile amounts." He later said, "With each investment you make, you should have the courage and conviction to place at least 10 percent of your net worth in the stock."...
"The strategy we've adopted precludes our following standard diversification dogma. Many pundits would therefore say the strategy must be risker than that employed by conventional investors. We disagree. We believe that a policy of concentration may well decrease risk. if it raises, as it should, both the intensity with which an investor thinks about a business and the comfort level he must feel with its economic characteristics before buying into it."
In addition to managing a concentrated portfolio, much of Warren Buffet's success is attributed to his portfolio inactivity. He is content not purchasing or selling a single share of Berkshire's major holdings throughout the year. "Lethargy bordering on sloth," he once quipped, "remains the cornerstone of our investment style." He thus nimbly reminds us that hyperactive investing is the pickpocket that reduces an investor's return. High portfolio turnover ratios increase transaction costs and increase taxes paid which, in turn, works to reduce the compounding effect of buying and holding great companies. As we will learn, a carefully concentrated portfolio, in combination with a low-turnover discipline, works best for building long-term wealth.
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Source
The Warren Buffet Way, 30th Anniversary Edition
Robert G. Hagstrom
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