Most investors focus their efforts on stock picking, but I believe that portfolio management is an equally important component of long-term investment success. By this, I mean four things:
- How many stocks to hold and how large to make each position (concentration)
- How diversified the portfolio should be (by industry, market cap, etc.)
- Knowing when to buy more
- Knowing when to sell
These are all big topics, so for now let's focus on the first one.
Focus investing
While there are a handful of exceptions such as Peter Lynch, the overwhelming majority of great investors that I'm aware of practice focus investing — see the chart below. They invest infrequently, only when they're highly confident that the odds are heavily in their favour, and then they bet big. Not surprisingly, research shows that the same approach works in other endeavours such as poker or betting on horse races. (For more on focus investing, see Bob Hagstrom's excellent book, The Warren Buffett Way.)
Chart: Number of holding and position sizing for 11 noted value fund managers.
The funds are from left to right; Sequoia, Tilson Focus, Clipper, Fairholme, Oakmark Select, Legg Mason Growth Trust, Longleaf Partner, Weitz Value, Legg Mason Value Trust, Tweedy Brown Value, John Hancock Classic and Third Avenue Value.
The number of positions is shown under the bars and ranges from 22 to 41, with an average of 28. The next two rows (% Top), highlight the concentration within the funds; the per cent of funds held in top ten positions (average 58%) and the top position (average 11%). That's focus investing at work!
Berkshire Hathaway's (NYSE: BRK.A ) Warren Buffett and Charlie Munger have commented on this topic in recent annual meetings. Munger commented, "If you took out our 15 best ideas, most of you wouldn't be here. We have this investment discipline of waiting for a fat pitch."
Buffett added:
I keep xeroxes from annual reports 50 years ago. [Some ideas were] just so obvious. I knew when I sat with the CEO of GEICO 50 years ago that it was a big idea.
If we start buying a stock, we want to go in heavy. I can't think of a stock where we wanted to quit.
We've made some big mistakes starting to buy something that was cheap and within our circle of competence, but trickled off because price went up a bit. Good ideas are too scarce to be parsimonious with.
You don't have to be right on everything or 20%, 10%, or 5% of businesses. You only have to be right one or two times a year. You can come up with a very profitable decision on a single company. If someone asked me to handicap the 500 companies in the S&P 500, I wouldn't do a very good job. You only have to be right a few times in your lifetime, as long as you don't make any big mistakes.
It seems so obvious that it makes more sense to buy more of your best idea than add a 100th position to a 99-stock portfolio, yet the average mutual fund holds more than 100 stocks. In almost all cases, this is foolish "deworsification" and reflects closet indexing rather than prudent money management.
Munger agrees, noting that "What's funny is that most big investment organizations don't [look for the fat pitch]. They hire lots of people, evaluate Merck vs. Pfizer and every stock in the S&P 500, and think they can beat the market. You can't do it. Very few people have adopted our approach." Buffett added: "Ted Williams, in his book The Science of Hitting, talked about how he carved up the strike zone into different zones and only swung at pitches that were in his sweet spot. Investing is the same way."
In the next article in this series we'll look more closely at position sizing. Focus Investing – Part 2
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More articles on portfolio management:
- Diversification without diworsification
- Two great investors sharing one winning strategy
- Focus Investing – Part 3
A version of this article was originally written by Whitney Tilson for fool.com.
