Friday, November 7, 2014

The Seventh Best Idea

From this Warren Buffett speech at the University of Florida:

"If you can identify six wonderful businesses, that is all the diversification you need. And you will make a lot of money. And I can guarantee that going into a seventh one instead of putting more money into your first one is gotta be terrible mistake. Very few people have gotten rich on their seventh best idea. But a lot of people have gotten rich with their best idea. So I would say for anyone working with normal capital who really knows the businesses they have gone into, six is plenty, and I probably have half of what I like best. I don't diversify personally."

Clearly, this view on diversification is far from conventional. Charlie Munger -- and this is not exactly a surprise -- once said something rather similar in a speech to the Foundation Financial Officers Group:*

"I have more than skepticism regarding the orthodox view that huge diversification is a must for those wise enough so that indexation is not the logical mode for equity investment. I think the orthodox view is grossly mistaken."

Identifying what, over the long run, will end up being six wonderful businesses to own then waiting patiently until the shares can be bought at attractive prices may not be impossible to do, but it is easier said than done. Unwarranted confidence in a concentrated portfolio is, at the very least, simply a recipe for big and expensive mistakes.

Many will find they do need to have broader diversification or that they are better off in an index fund. That's, of course, necessarily unique for each investor. Some of this will come down to one's own realistically assessed capabilities, but much else comes down to temperament and other psychological factors.

Beyond the requisite skills and background, patience followed by decisiveness when the opportunity presents itself is needed. Here's Munger's take from the 2004 Wesco shareholder meeting:

"It wasn't hyperactivity, but a hell of a lot of patience. You stuck to your principles and when opportunities came along, you pounced on them with vigor."

and

"Success means being very patient, but aggressive when it's time."

Now, the fact is that Buffett's current equity portfolio has far more than six stocks in it. This would appear at odds with Buffett says above, but the top 5 or 6 stocks continue to make up a substantial proportion of the portfolio.

Among the reasons for the large number of stocks in the current portfolio, is that many of the smaller positions are the work of his two investment managers, Todd Combs and Ted Weschler.

Then there's just the sheer scale of what Buffett has to manage these days compared to earlier times.**

Some commentators, when asked, seem willing to opine on just about any equity investment alternative. Well, maybe someone can actually understand such a wide variety of businesses and industries with sufficient depth, just consider me just a little bit skeptical of this. I mean, who can properly understand nearly everything in the equity investment universe? Focus is needed. Otherwise, brilliant outcomes in terms of risk and reward just don't seem likely.

Lots of breadth might mean too little depth. In other words, knowing just enough to be dangerous about many different stocks. Eventually, this way of operating seems almost certain to take an investor far outside their own necessarily unique circle of competence. That's a great way to get spread too thin and make unnecessary mistakes.

"To kill an error is as good a service as, and sometimes even better than, the establishing of a new truth or fact." - Charles Darwin

"...Warren and I are better at tuning out the standard stupidities. We've left a lot of more talented and diligent people in the dust, just by working hard at eliminating standard error." - Charlie Munger in Stanford Lawyer

My own favorite stocks may or may not prove to be great long-term investments but, to me, essentially none of them are selling at attractive enough prices to buy these days. As usual, the buying needed to happen in a decisive manner when it felt most uncomfortable. That, of course, was during the financial crisis and, well, even as recently as a few years ago. Some very good assets were properly cheap three to five years ago even if wild near-term price action -- especially during the height of the crisis -- had to be tolerated.***
(What appeared rather cheap often temporarily became cheaper. This was the case even among the very highest quality businesses.)

Will stocks rise or fall from here? No idea. I never try to figure out such things. The focus, instead, is on how price compares to estimated intrinsic value. It's never about trying to guess how stock prices might fluctuate. That sort of thing is a total waste of energy.

In any case, at least for now, the balance of risk and reward has changed dramatically for the worse. Prices would need to meaningfully fall -- or, alternatively, per share intrinsic values would need to increase over time without much change in price -- for the balance of risk and reward to improve.

When stocks do not sell at a plain discount to a conservative estimate of value, it's time to be patient. It's time to keep chipping away at the ongoing process of understanding what I own -- and what I might someday like to own -- in a better way. It's time to make sure I'm prepared to act decisively if/when they become cheap again.

This doesn't necessarily mean all my favorite investments are overvalued.

This doesn't necessarily mean I'll be selling; attempting to frequently buy and sell is a recipe for unnecessary mistakes and frictional costs.

This does mean, at the very least, that the margin of safety is currently insufficient for me to be willing to make incremental purchases.

Adam

Related posts:
Portfolio Theory & Diversification
Buffett on Diversification
Munger & Buffett on Diversification - Part II
Munger & Buffett on Diversification

* Here are some additional examples of Munger's view of diversification: 

"We believe almost all good investments will involve relatively low diversification." - From the 2004 Wesco meeting

"The academics have done a terrible disservice to intelligent investors by glorifying the idea of diversification." - From an interview in Kiplinger's

** Some other reasons it can be challenging to have a concentrated portfolio include the fact that a best idea may not be available at a attractive enough market price, insufficient funds are available when the market price is right, and, well, pure indecision (i.e. an error of omission).
*** The key thing was recognizing when the drop in price was far greater than the reduction in per share intrinsic value. Well, at least what intrinsic value would look like in a more normalized environment. It's worth noting that the very good businesses can actually increase their per share intrinsic value during a crisis (even if near-term market price action would temporarily seem to indicate otherwise).
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