Concentrated Investing. Carlisle Tobias E.

tenure) was anything but a concentrated investor, owning a large number of securities in the fund. Furthermore, concentrated investing should only be undertaken by people who are prepared to do intensive research and analysis on their investments. People outside of the investment profession usually don’t have the time to do this, and are far better off with an index fund or finding a competent investment manager – preferably one who employs a focused approach.

      The second caveat is more important, and applies to investment professionals and non-professionals alike (perhaps even more to professionals). It is summed up in an insightful and humbling quote from legendary martial artist Bruce Lee, which is as follows:

      A goal is not always meant to be reached, it often serves simply as something to aim at.

      Coming from one of the most disciplined and exacting athletes in the history of martial arts, this statement is illuminating. One can hardly imagine Bruce Lee trying to break a two-by-four with his fist and accepting, after a failed attempt, that this goal was not reachable. Evidently, beneath his hard-driving exterior, there was a more philosophical side. Similarly, in the context of this book, our intention is not to show that the great individuals profiled in the following chapters constitute the standard against which one should hold oneself, but to provide a road map with some concrete ideas on how to be a better investor. Not everyone should attempt to replicate their style or accomplishments. Rather, these profiles are a guidepost on the journey to successful investing.

      With these caveats, we do believe that the average enterprising investor with the ability to perform in-depth fundamental analysis will be better off trimming the number of investments they hold and redistributing their capital into their top 10 or 15 ideas. To quote Bruce Lee a second time:

      The successful warrior is the average man, with laser-like focus.

– Allen Carpé Benello

      Acknowledgments

      This book would not have been possible without the generous facilitation and support of Louis A. Simpson. In addition, we are the beneficiaries of a great deal of assistance in the production of the manuscript for Concentrated Investing. We’d like to thank the interviewees Lou Simpson, Charlie Munger, Kristian Siem, Glenn Greenberg, and Jim Gordon. Finally, we appreciate the assistance of the team at Wiley Finance, most especially Bill Falloon, Susan Cerra, and Meg Freeborn, who provided guidance and advice along the way.

      Introduction

      Conscientious employment, and a very good mind, will outperform a brilliant mind that doesn’t know its own limits.

– Charlie Munger1

      Concentration value investing is a little-known method of portfolio construction used by famous value investors Warren Buffett, Charlie Munger, long-time Berkshire Hathaway lieutenant Lou Simpson, and others profiled in this book to generate outsized returns. A controversial subject, the idea of portfolio concentration has been championed by Buffett and Munger for years, although it moves in and out of fashion with rising and falling markets. When times are good, portfolio concentration is popular because it magnifies gains; when times are bad, it’s often abandoned – after the fact – because it magnifies volatility. Concentration has been out of favor since 2008, when investment managers began in earnest to avoid what they perceive as a risky business practice.

      It is time to re-visit the subject of bet sizing and portfolio concentration as a means to achieve superior long-term investment results. We will start by examining some of the academic research on concentration versus diversification on long-term investment results. One central feature of the discussion surrounding concentration is the Kelly Formula, which provides a mathematical framework for maximizing returns by calculating the position size for a given investment within a portfolio using probability (i.e., the chance of winning versus losing) and risk versus reward (i.e., the potential gain versus the potential loss) as variables. The Holy Grail for any investor is a security with a high probability of winning and also a large potential gain compared to the potential loss. Given favorable inputs, the Kelly Formula can produce surprisingly large position sizes, far larger than the typical position size found in mutual funds or other actively managed investment products. In addition, some academic studies point to the diminishing advantages of portfolio diversification above a surprisingly small number of individual investments, provided each investment is adequately diversified (no overlapping industries, etc.). Also, portfolios with a relatively smaller number of securities (10 to 15) will produce results that vary greatly from the results of a given broadly diversified index. To the extent that investors seek to outperform an index, smaller portfolios can facilitate that goal, although concentration can be a double-edged sword.

      Investors can employ the traditional value investing methodology of fundamental security analysis to identify potential investments with favorable Kelly Formula inputs (a high probability of winning, and a high risk/reward relationship), in order to maximize the chances of significant outperformance, as opposed to significant underperformance, with a concentrated portfolio.

      We have unparalleled access to investors in Warren Buffett’s inner circle. Interviews with several highly successful investors who have achieved their success employing a concentrated approach to portfolio management over the long term (at least 10 to 30 years) will be incorporated throughout this book. One common feature of these investors is that they have had permanent sources of capital, which has changed their behavior by allowing them to endure greater volatility in their returns. Most people seek to avoid volatility in general because they perceive increased variance as an increase in risk. The investors we examine, however, tend to be variance seekers. At the same time, however, they are able to produce returns with low downside volatility compared to the underlying markets in which they invest.

      This book profiles eight investors with differing takes on the concentration investment style. The investors and the endowment interviewed are contemporary. One of the investors profiled, Maynard Keynes, is now a historical figure, but was the early adopter of many of the ideas that came to be held by his successors. The purpose of the book is to tease out the principles that have resulted in their remarkable returns. Though they operated through different periods of time, all have compounded their portfolios in the mid-to-high teens over very long periods – defined as more than 20 years. The investors in this book are rare in that they all have either permanent or semi-permanent sources of capital. We hypothesize that this is an important factor in allowing them to practice their focused style of investment. The book also puts forward a mathematical framework, the Kelly Criterion, for sizing investment “bets” within a portfolio. The conclusion of both the profiles of these great investors and of the Kelly Criterion is remarkably coincident.

      Modern portfolio theory would have us believe that markets are efficient and that attempts to beat market performance are both foolhardy and expensive in terms of return. Yet the fact remains that there is at least a small cadre of active managers who have beaten the market by a significant margin over prolonged periods. This book and the investors profiled in it agree with the proponents of efficient market theory on two points:

      1. Markets are mostly efficient.

      2. They should be treated as efficient if you are, as Charlie Munger puts it, a “know-nothing” investor.

      In other words, it requires a lot of hard work and a significant amount of knowledge to produce market-beating returns. If you do not have this, it is to your benefit to diversify and index. If, however, you possess knowledge and the capability for hard work as well as a few other characteristics outlined in the book, it is to your benefit to focus your energies on a small number of investments. The degree of focus is a stylistic choice and cannot be prescribed for any given individual, but the investors in this book concentrate on anywhere from 5 to 20 individual securities. The larger the number, the more the benefits of diversification, the lower the volatility of the portfolio, but also, in most cases, the lower the long-term returns. The trade-off between larger bets and more volatility is an individual choice, but both the Kelly Formula and the participants in the book point to the advantages of larger bets and more concentrated portfolios. In fact, the reader will probably be quite surprised by how large the bets can be calculated to be. Once again, placing bets of significant size

1

Charles Munger, interview, February 23, 2012.