Concentration or Diversification

Over the last couple of days, we’ve argued that it is a mistake for Mohnish Pabrai, or other successful investors, to expand the number of positions in their portfolio in order to lessen volatility. Yet, you’ve heard enough from me; what do the professionals have to say?

In You Can Be a Stock Market Genius (Simon & Schuster, 1997), Joel Greenblatt, whose annualized returns at Gotham Capital from 1985-1995 were 50%, states that a concentrated portfolio of five securities will only carry 3% more downside potential (within one standard deviation of the mean) than a portfolio of fifty securities. Said differently, a portfolio of fifty securities stands a two out of three chance of returning between -8% and 28%; a portfolio of five securities stands a two out of three chance of returning between -11% and 31%. The returns on ten securities should fall between -10% and 30%. In short, there isn’t a significant difference in variability if one owns five, ten, twenty, or five hundred securities.

Warren Buffett’s compounded annual partnership returns from 1957-1969 were 31.6%. Though it is not easy to determine the relative size of the partnership’s positions, it is well known that Buffett put 40% of the partnership’s assets into American Express during the Salad Oil Scandal of 1964. Martin and Puthenpurackal found that “Berkshire Hathaway’s portfolio is concentrated in relatively few stocks with the top five holdings averaging 73% of the portfolio value.” As Buffett himself has said, “if you really know businesses, you probably shouldn’t own more than six of them. If you can identify six wonderful businesses that is all the diversification you need… going into a seventh one, rather than putting money into your first one, has got to be a terrible mistake.” Buffett has even gone so far as to say that he would have been willing to allocate up to 75% of his portfolio in the distressed assets of Long Term Capital Management in 1998.

Charlie Munger, Buffett’s partner at Berkshire, has quipped that you could be adequately diversified if you owned the best office building in town, the best apartments in town, the dominant car dealership, and the highest grossing McDonald’s.

Now, to be clear, these three are speaking primarily to dedicated investors willing to devote time and intensity to studying businesses. Broad diversification achieved through index funds is likely the best strategy for the majority of market participants. But for those who make it their profession to beat the market’s returns, concentration is an important component of success.

All told, this series gives voice to my growing conviction that the majority of one’s investing returns will come from a few great ideas. Looking at Buffett’s returns, substantial gains came from relatively few holdings—National Indemnity, American Express (the first time), Geico, See’s Candies, Capital Cities, the Washington Post, and Coca Cola. Though countless reasons can be offered for diversifying, it is hard to argue against the success that has followed his concentration.

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Morningstar’s Wide Moat Focus Index

As some may know, Morningstar currently has a Wide Moat Focus Index that “consists of the 20 securities in the Morningstar US Market Index with the highest ratios of fair value… to their stock price, and which have a sustainable competitive advantage…”

For those persuaded by the idea that some businesses have wider economic moats, but without the time or desire to go looking for them, the Index provides the investor with twenty places to start. As of 2/27/2009, the Index included Monsanto Company, Waters Corporation, Starbucks Corporation, Maxim Integrated Products, Fastenal Company, Zimmer Holdings, Applied Materials, Paychex, IMS Health, Forward Air Corporation, The Western Union Company, KLA-Tencor Corporation, Avon Products, eBay, International Speedway, St. Joe Corporation, Autodesk, American Express, Legg Mason, and Bank of America.

Even more useful is Morningstar’s description of their methodology for selecting the favored twenty. First, a business must pass the “show me the money” test, which demands that its return on invested capital (ROIC) has consistently exceeded its cost of capital. Having satisfied this initial screen, Morningstar analysts then assess whether the margin can be attributed to a clear competitive advantage. Morningstar classifies four major types of competitive advantage: high switching costs (e.g., Stryker), lower general costs (e.g., Wal-mart), valuable intangible assets (e.g., Harley-Davidson), or a sufficiently large network of users (e.g., eBay, NYSE).

Stryker benefits from high switching costs because surgeons that use their products would have a difficult time retraining their habits and skills to efficiently use a competitor’s. Wal-mart sells a wide array of basic consumer goods that could be purchased in numerous locations; that is, its products are practically indistinguishable—essentially commodities. In a commodity business, the only lasting advantage is being the perennial lowest cost producer, and in retailing that’s Wal-mart; in car insurance, Geico. Harley Davidson offers a product that its customers will pay a premium for (and then profess their undying love through abundant bodily art). eBay’s network of buyers and sellers offers each an optimal market experience; buyers find a rich selection, and sellers can solicit the largest number of buyers and presumably the highest prices.

Looking over Morningstar’s favored twenty, a couple businesses stand out. First, and perhaps with the benefit of hindsight, it is hard to imagine a retail bank like Bank of America with a sustainable economic moat. The little brick retail banks reign in ubiquity in our town, all seemingly offering similar rates and services. Though it may have been inconvenient to set up banking accounts in the past, online platforms have surely simplified the process.

American Express is also an interesting case. While swiping an AMEX used to carry some cache, today it is mere French vanilla. While American Express does have its credit card network, by sheer numbers, Visa’s and Mastercard’s stand superior.

All told, Morningstar’s Index highlights some interesting businesses for the wide moat investor. We’ll take a deeper look at some in the weeks ahead.

Disclosure: I, or persons whose accounts I manage, own shares of eBay at the time of this writing.

On Buying Castles with Moats

Please permit me to state the obvious. In the last five months, the U.S. stock market averages have sustained a nearly unprecedented decline. Stocks are the cheapest—relative to GDP and trailing earnings—that they have been in more than a decade. And at least some stocks represent ownership shares in highly profitable, wide moat businesses that cater to basic, enduring customer preferences. Yet, as we’ve seen, Warren Buffett has been writing derivative contracts and cutting deals in bonds and preferred stock, rather than adding to his share of Coca Cola. But why?

The simplest and most plausible explanation is that Coca Cola is not yet cheap. Berkshire Hathaway has found Burlington Northern attractive at these prices, and Mid American did make a stab at Constellation Energy, but for the most part, the castles with the widest moats still seem too expensive, despite the market’s current 30-50% off sale.

If we read between the lines correctly, then I think that we see an important facet of buying castles. The most highly desired castles with the widest moats rarely go on sale. In fact, even if the general market declines, they are not necessarily cheap. To get a bargain on the best castles, one needs more than market pessimism–one needs insane, crazy, irrational behavior.

For example, in 1963, when Buffett took his stake in American Express, the business had been swindled out of $50 million in Tino De Angelis’ salad oil scandal. In 1976, Geico announced a loss of $126 million. As the expectations of bankruptcy grew, Buffett was buying.

The most desirable castles with the widest moats receive many covetous glances from an abundance of suitors every day. In today’s market, such castles are rarely cheap, even in a market of overwhelming pessimism. To get a bargain on a castle is no small feat.

Disclosure: I, or persons whose accounts I manage, own shares of Berkshire Hathaway at the time of this writing.