Learnings from the GiantsRobert Hagstrom

Focus Investing

“Diversification is protection against ignorance. It makes little sense if you know what you are doing.” – Warren Buffett

Portfolio construction is a topic which, literally speaking, is not given adequate ‘weight’ as compared to its relation with overall portfolio returns alongwith the effort which an investor needs to put in to generate those returns.

If one were to invest in 50 or so stocks, we can be sure that quality of ideas – and hence overall portfolio quality – may not be as strong as one that is built on 7 or 12 stocks. Why? For the simple fact that the quality of ideas tapers down as one moves down through the list. If it is so obvious then why do highly paid ‘professionals’ would do something this dumb too frequently? Well, in a world which measures risk by volatility, it shouldn’t be a surprising outcome.

A portfolio with say 7 stocks would generally be more volatile than one with 50 stocks. But so be it! By selecting 50 stock portfolio over 7 one does an irrational trade-off – he gives away an opportunity to profit from 7 conservatively chosen ideas and instead gets into one with large number of stocks and hence lowers the overall portfolio quality while also reducing its chances to generate excess returns.

You might argue how can one be sure that a concentrated portfolio is bound to perform better than others? To this an answer would be: It may not outperform every time (i.e. every given year) but over a longer period (at least >3yrs) if the manager has done his job right in terms of selecting conservatively assessed businesses and acquiring them at substantial discount to their intrinsic values, sooner or later he should be able to earn his deserved reward. In this sense, markets test more of our patience and our ability to keep emotions under check than our IQ or intelligence.

Robert Hagstrom has beautifully explained all of the above by way of a case study on this topic in his book The Warren Buffett Way –

Using the Compustat database of common stock returns, we isolated 1,200 companies that displayed measurable data – including revenues, earnings, and return on equity. We then asked the computer to randomly assemble, from these 1,200 companies, 12,000 portfolios of various sizes, forming four portfolio groups:

  1. 3000 portfolios containing 250 stocks
  2. 3000 portfolios containing 100 stocks
  3. 3000 portfolios containing 50 stocks
  4. 3000 portfolios containing 15 stocks – the focus portfolio group.

Next, we calculated the average annual return of each portfolio in each group over a 10-year period (1987-1996). Then we compared the returns of the four portfolio groups to the overall stock market (defined as the S&P’s 500 index) for the same period.

  • Among the portfolios containing 250 stocks, the standard deviation was 0.65 percent; the best portfolio returned 16% annually, and the worst was 11.4%
  • Among the 100 stock portfolios, the standard deviation was 1.11 percent – 18.3% best, 10% worst
  • Among the 50 stock portfolios, the standard deviation was 1.54 percent – 19.1% best, 8.6% worst
  • Among the 15 stock portfolios, the standard deviation was 2.78 percent – 26.6% best, 6.7% worst

Notice that higher the number of stocks, lower is the standard deviation from mean returns. So a manager working for an institution happens to love his job, it is obvious that his interest would lie in creating a portfolio which is fairly diversified and which mimics the index against which his performance is assessed.

And if another manager happens to outperform index and his fund by a significant margin, he can always show up Sharpe ratio, beta, standard deviation, etc. of that manager’s portfolio, compare it to that of his fund – which would obviously be on lower side – and announce to his clients that he took much less risk than the manager in question and hence on risk adjusted basis, his performance and that of any other outperformer is not much different. Clients are happy that the manager took much less risk (risk in terms of volatility) and manager has retained his job. What a win-win combination – but only for the manager!

Clients with decades in hand for investing were short changed for manager’s need to maintain his job. He chose to lower the probability of generating excess returns and traded off higher returns for lower volatility. Knowing the power of compounding where every percentage point counts over one’s investing life time, it looks like a terrible idea. And yet in economics they still preach the concept of ‘rational economic man’.

He further concludes by saying –

From all this, one key finding emerged: When we reduced the number of stocks in a portfolio, we began to increase the probability of generating returns that were higher than the market’s rate of return. But, not surprisingly, at the same time we also increased the probability of generating lower returns.

To reinforce the first conclusion, we found some remarkable statistics when we sorted the data:

  • Out of 3000 250-stock portfolios, 63 beat the market.
  • Out of 3000 100-stock portfolios, 337 beat the market.
  • Out of 3000 50-stock portfolios, 549 beat the market.
  • Out of 3000 15-stock portfolios, 808 beat the market.

With a 250-stock portfolio, you have a one-in-50 chance of beating the market. With a 15-stock portfolio your chances increase dramatically, to one in four.

So we now know that less is better when it comes to investing. But what are challenges one needs to consider while adopting this strategy? These are the ones I think is necessary for any focus investor:

  • Understand how institution imperative works: As outlined above, markets can remain irrational for period longer than the investor-manager can hold on to his job. Similarly, one can say that for someone who manages third party money – he needs to be sure that his clients are compatible with how he thinks about portfolio construction.
  • Temperament: One needs to have correct mindset in order to reap the rewards from concentrated investing. Markets are volatile. In fact, on average, a listed company has 80-100% price movement from yearly low to yearly high. But as Buffett says, volatility is a friend of an investor enemy of a speculator. With right temperament one can harness the fleeting power of volatility into compounding wealth & generating excess returns. Focus on the value part of the equation rather the more easily available counterpart – price.
  • Own the right businesses: Another unsaid part of the above exercise is time horizon and business quality. In my mind both are inter-linked i.e. with stronger businesses, which are also compounding their intrinsic values at good enough rates, it is easier to hold on to them for years versus a weaker or below average quality business. Focus investing requires an investor to take very long horizon for the business in question. Higher the competitive advantages which a company enjoys, easier it becomes to hold on to them as market takes its own sweet time to reevaluate company’s prospects.
  • Stock Selection: This is possibly the most important thing for a focus investor. Which fewer stocks in place, one needs to be sure of the business, understand it deeper, value it conservatively and acquire it at a substantial discount to its value five – seven years down the line. This is something which one learns by experience over time.

 

Finally, is 7 is the right number or should one go with 20? I believe there are no right or wrong answer for this. One needs to understand & introspect and come up with deems fit for him. As they say to each, his own! But what we need to ensure is to not spread ourselves unreasonably thing than what the situation would warrant.

 


Niraj Bardia

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