FOCUS INVESTING: THE BIG PICTURE

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FOCUS INVESTING: THE BIG PICTURE

'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 (broadly based active portfolios) makes no sense for you.'


Reduced to its essence, focus investing means this: Choose a few stocks that are likely to produce above-average returns over the long haul, concentrate the bulk of your investments in those stocks, and have the fortitude to hold steady during any short-term market gyrations. This is the strategy Mr. Buffett has used over the years, and his stock market portion of Berkshire Hathaway's portfolio continues to be highly concentrated today with over 70% of its multi-billion dollar value in just a handful of stocks...

Indeed, a whopping 50% of Mr. Buffett's US$35 billion stock portfolio is in just two companies: Coca-Cola and American Express! The top five holdings make up an amazing 73% of this huge dollar value portfolio. That is focus investing!

Over the years, Warren Buffett has developed a way of determining which companies are worthy places to put his money; it rests on a notion of great common sense: If the company is doing well and is managed by smart people, eventually its stock price will reflect its inherent value. Buffett thus devotes most of his attention not to tracking share price but to analyzing the economics of the underlying business and assessing its management.

Mr. Buffett's owner-oriented business screening process helps him methodically choose such stocks for long-term investment. In aggregate, his business screens (very similar to our WS8 Portfolio screens, as our Intellivest-members know) provide a method for isolating the companies with the best chance for high economic returns. He is looking for economic franchises, companies with a long history of superior performance and a stable management and that stability means they have a high probability of performing in the future as they have in the past. And that is the heart of focus investing: concentrating your investments in companies with the highest probability of above-average performance.


The Focus Investor's Golden Rules
(from Robert Hagstrom, The Warren Buffett Way, 2005)

Concentrate your investments in outstanding companies run by strong management.
Limit yourself to the number of companies you can truly understand. Ten to twenty is good, more than twenty is asking for trouble.
Pick the very best of your good companies, and put the bulk of your investment there.
Think long-term: five to ten years, minimum.
Volatility happens. Carry on.

What's wrong with conventional diversification? For one thing, it greatly increases the chances that you will buy something you don't know enough about. Philip Fisher, who was known for his focus portfolios, although he didn't use the term, profoundly influenced Buffett's thinking in this area. Fisher always said he preferred owning a small number of outstanding companies that he understood well to a large number of average ones, many of which he understood poorly.

'Know-something' investors, applying Buffett's tenents, would do better to focus their attention on just a few companies. How many is a few? Even the high priests of modern finance have discovered that, on average, just fifteen stocks gives you 85% of the benefits of wide diversification. For the average investor, a legimitate case can be made for ten to twenty. Focus investing is not possible with a portfolio of more than twenty stocks. Buffett, with the confidence gained over the years, has narrowed his focus primarily to just five stocks despite the enormous value of his portfolio-- some US$35 billion!


Put Big Bets on High-Probability Events

Phil Fisher's influence on Buffett can also be seen in another way, notes Robert Hagstrom--his belief that the only reasonable course when you encounter a strong opportunity is to make a large investment. Warren Buffett echoes that thinking: 'With each investment you make, you should have the courage and the conviction to place at least ten percent of your net worth in that stock.'

You can see why Buffett says the ideal portfolio should contain no more than ten stocks, if each is to receive ten percent. Yet focus investing is not a simple matter of finding ten good stocks and dividing your investment pool equally among them. Even though all the stocks in a focus portfolio are high-probability events, some will inevitably be higher than others, and they should be allocated a greater proportion of the investment. Blackjack or poker players understand this intuitively: When the occasional hand you are dealt makes your probability of winning very high you place a higher bet.

I can't be involved in 50 or 75 things. That's a Noah's Ark, way of investing-- you end up with a zoo. I like to put meaningful amounts of money in a few things.

-- Warren Buffett, 1987

Focus investing is the antithesis of a broadly diversified high-turnover approach. Although focus investing stands the best chance among all active strategies of outperforming an index return over time, it requires investors to patiently hold their portfolio even when it appears that other strategies are winning.

How long is long enough? As you might imagine, there is no hard and fast rule (although Buffett would probably say that anything less than five years is a fool's theory). The goal is not zero turnover (never selling anything); that's foolish in the opposite direction, for it would prevent you from taking advantage of something better when it comes along, or correcting an obvious mistake when it becomes apparent. As a general rule of thumb, Hagstrom advises that we should aim for a turnover rate between 5 and 10 percent, which means holding our average investment for 5 to 10 years.

Focus investing pursues above-average results, and there is strong evidence, both in academic research and actual case histories, that the pursuit is successful. There can be no doubt, however, that the ride is bumpy, for price volatility is a necessary byproduct of the focus approach. Focus investors tolerate the bumpiness because they know that in the long run the underlying economics of the companies will more than compensate for any short-term price fluctuations.

Buffett is a master bump (price) ignorer. So is his partner, Charlie Munger. Maybe you also have the psychological make up that allows you to ignore short-term price volatility-- but these traits are very rare in my experience. But if you weren't born with them there is hope to consciously acquire them. It is a matter of deciding to change how you think and behave. Acquiring new habits and thought patterns does not happen overnight, but gradually teaching yourself not to panic and act rashly in response to the vagaries of the market is doable-- and necessary.


Credits: Parts of this article are extracts from Robert Hagstrom's 2nd edition (2005, Wiley) of The Warren Buffett Way.

[CK]

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