Dilution Kills, Too
...and so does turnover
by Dale Wettlaufer (TMF Ralegh)
ALEXANDRIA, VA (Oct. 23, 1998) -- Turnover kills. That was the subject of the Boring Portfolio on Wednesday. Dilution kills is another tenet that we hold.
By dilution, we mean that we don't want to water down our best investments with average investments and we don't want the bad ideas playing as large a factor in the performance of the portfolio as our best and average ideas. Let's look at a diluted portfolio.
This is Fidelity's Magellan portfolio:
Ticker % of Portfolio GE 3.47 MSFT 2.19 MRK 1.73 CCI 1.54 CD 1.43 WMT 1.41 HD 1.38 BMY 1.33 CSCO 1.09 PMO 1.06
You could argue that a $68 billion portfolio can't get enough of a couple companies to make a difference in the top weightings. Maybe so, but if you hold a few large companies long enough, they can make a difference in a portfolio this size. Let's see the difference between this laggard and a fund that has beaten the market over the last five years:
Ticker % of Portfolio MO 8.90 AN 6.24 ARC 4.92 UST 4.43 FNM 4.31 RN 3.78 TX 3.36 FCN 3.27 FRE 2.89 PNC 2.37
This is the Kemper-Dreman High Return fund, managed by value guy David Dreman. Nearly 45% of the fund's assets are represented by its top-10 holdings. It's not a coincidence that this fund's turnover is only 10% either. That means its average holding period, based on the last year's turnover, is 10 years. Concentration of holdings means that the mutual fund manager is going about investing in a businesslike manner. There should be absolutely no distinction between what a mutual fund manager does, what we do with the Boring Port, what individual investors do, and what a CEO does. We are in the business of acquiring companies, not pieces of exchange-traded paper.
Wouldn't you be horrified if a CEO made decisions to buy a set of companies one year, sell them the next, buy another set, sell them the next, and buy another set of companies and sell them the next year after that? I would. That is exactly what happens when a fund manager or investor turns over their portfolio year after year. You can rack up pre-tax gains this way on the gains on sales of these businesses. But we're more in the business of buying sales and earnings than we are in the business of taking gains on the sale of good businesses.
Returning to a central tenet of what we do, we want to see earnings of the companies we buy dwarf our purchase price and we want to see good returns on incremental invested capital that the company brings in through financing or through the retention of earnings. We can't get into that position if we flip something out of the portfolio in six months. What if you had flipped McDonalds, Wal-Mart, Coke, Cisco, Ford, or any other successful company out of the portfolio six months after their IPO? If you could find one good flip every year, that'd be fine. Your results would be great. But we can't find just one good flip each year and invest all our capital in that flip. What if we're wrong on a short-term basis, too? We surely will be in the future. The process of running a portfolio starts to look more like a trading operation than the business that it's supposed to be.
Returning to businesslike investment managers, let's take a look at Sequoia Fund (which is closed to new investors, by the way):
Ticker % of Portfolio BRKA 34.15 PGR 12.86 FRE 12.85 FITB 8.12 US Treasury Note 5.875% 6.60 US Treasury Note 5.625% 4.60 JNJ 4.22 HDI 4.00 USB 3.85 US Treasury Note 5.625% 2.63Throwing out the Treasury notes (which are still investment ideas, by the way, since T-bills would be the lack of an idea), we see that 80% of the portfolio is represented by the fund's top equity holdings. Some would say that a 34% weighting in the top holding is a bad idea. We would argue precisely the opposite. It evidences rational decision making. Would you freak out if your company increased its outstanding shares by 30% to acquire a stellar business? Look at it in another way. What if a company increased its shares outstanding by 5% and the company that it acquired in that transaction later accounted for 40% of the total equity value of the company? That's not irrational, that's the way a successful acquisition looks down the road.
If you acknowledge that Warren Buffett is a superior businessman and investor, then you should take note of the following fact about Berkshire Hathaway (NYSE: BRK.A). At the end of fiscal 1997, 65% of $56.11 billion in total assets and 79% of $45.8 billion of invested capital, was represented by this small group of investments:
Company Market value American Express Company 4,414.0 The Coca-Cola Company 13,337.5 The Walt Disney Company 2,134.8 Freddie Mac 2,683.1 The Gillette Company 4,821.0 Travelers Group Inc 1,278.6 The Washington Post Company 840.6 Wells Fargo & Company 2,270.9 Others 4,467.2
One excellent investment decision, to acquire a sizable stake in Coca-Cola, has created value of $13 billion for Berkshire shareholders in the last decade or so. That one investment now accounts for 24% and 29% of invested capital, respectively.
This doesn't necessarily mean that we're going to go out and commit 25% of our capital to the first thing we see. It does mean that a very good investment opportunity should not carry the same weighting in your capital allocation plans that a marginal opportunity does. This happens in mutual funds and individuals' portfolios all the time. There's no reason why your best long-term investment should carry the same weight in your portfolio as the idea that you have on some company beating earnings estimates. Again, if you're a trader, that's fine for you, but we're not traders.
Now, it's not as though the market is filled with stupid-cheap things right now. We don't get to buy Coke with an earnings yield or a Boring Ratio of 8%. We wish we could. But the point is that you shouldn't even take time to deploy capital in marginal ideas. If it's not worth making a significant commitment to it, it's not worth making a marginal commitment to it, to paraphrase Buffett and Charlie Munger.
This is the real value discipline we want to follow. Value discipline to us is not filling up a portfolio with stocks selling at under 1 times sales and weighting each of those positions at 2%. The books that advocate this sort of thing drive me nuts. A dollar's worth of sales at some companies are not worth more than $0.20, while each dollar's worth of sales at other companies are fairly worth $5.
The value discipline we intend to follow makes us think as rational businesspeople think about acquisitions. If a company is stupid-cheap, we'll commit a significant amount of capital to it. Even if a company is farily valued and offers excellent growth, we'll commit significant amounts of capital to it. But we'll pass up the marginal opportunities and we won't commit small portions of capital to marginal ideas just because we can't find anything else. If we can't find the values, then we'll turn over our capital to someone else, including the S&P 500 index or a good mutual fund.
Ooh -- mutual fund investing? I'll leave that one for Monday. For discussion in the meantime, please visit the Boring message board.
Stock Change Bid ANDW + 15/16 14.75 CGO +1 1/4 34.50 BGP -1 3/16 24.13 CSL -2 1/4 38.13 CSCO + 1/4 58.69 FCH + 1/2 22.75 PNR +1 1/2 37.63 TBY + 3/16 6.88
Day Month Year History BORING -0.30% 2.94% -11.92% 10.84% S&P: -0.72% 5.28% 10.33% 72.24% NASDAQ: -0.52% 0.00% 7.86% 62.72% Rec'd # Security In At Now Change 6/26/96 225 Cisco Syst 23.96 58.69 144.99% 2/28/96 400 Borders Gr 11.26 24.13 114.33% 3/5/97 150 Atlas Air 23.06 34.50 49.62% 8/13/96 200 Carlisle C 26.32 38.13 44.82% 4/14/98 100 Pentair 43.74 37.63 -13.99% 5/20/98 400 TCBY Enter 10.05 6.88 -31.56% 11/6/97 200 FelCor Sui 37.59 22.75 -39.48% 1/21/98 200 Andrew Cor 26.09 14.75 -43.46% Rec'd # Security In At Value Change 6/26/96 225 Cisco Syst 5389.99 13204.69 $7814.70 2/28/96 400 Borders Gr 4502.49 9650.00 $5147.51 8/13/96 200 Carlisle C 5264.99 7625.00 $2360.01 3/5/97 150 Atlas Air 3458.74 5175.00 $1716.26 4/14/98 100 Pentair 4374.25 3762.50 -$611.75 5/20/98 400 TCBY Enter 4018.00 2750.00 -$1268.00 1/21/98 200 Andrew Cor 5218.00 2950.00 -$2268.00 11/6/97 200 FelCor Sui 7518.00 4550.00 -$2968.00 CASH $5750.59 TOTAL $55417.78