<THE BORING PORTFOLIO>
Boring Tenets, Part 4
Dilution Kills
By Dale Wettlaufer (TMF Ralegh)
ALEXANDRIA, VA (July 16, 1999) -- Dilution kills. By dilution, I mean that I don't want to water down my best investments with average ideas. Over the course of a year, I will be able to come up with a number of ideas. Not each will be a good one. The normal distribution of those ideas will be that there are one or two that I couldn't live without, six to seven that are OK but that I'm not crazy about, and one or two that I could probably forget about if I did more work on them. The idea here is to chuck anything that doesn't fall into the first category and concentrate the portfolio in the companies that best meet my tests of value, which is a prospective five-year return of 15% per year and a margin of safety should things not progress in the business as planned.
Concentration of holdings means the portfolio 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 has a 60 stock portfolio and turns it over at 70% per year. I just don't think an investor can come up with 42 great ideas per year, year after year. If you were the CEO of Coca-Cola Companies, would you want to go out and trade a significant portion of your equity for a steel or oil company to "re-balance" your portfolio? That would be insane. I find nothing wrong with having a lopsided exposure to very well-run companies and zero exposure to marginal enterprises.
Returning to a central tenet of what I do, I want to see earnings of the companies I buy dwarf my purchase price over time and I want to see good returns on incremental invested capital that the company brings in through financing or through the retention of earnings. I can't get into that position if I flip something out of the portfolio in six months. What if you had flipped McDonald's, 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):
BRKA.....34.15
PGR.....12.86
FRE.....12.85
FITB.....8.12
Sixty-eight percent of the portfolio is represented by the fund's four top ideas, which are listed above. Some would say that a 34% weighting in the top holding is a bad idea. I would argue precisely the opposite. It evidences rational decision making. Most businesses have one good idea representing the majority of their cash flow-generating capabilities. And the rest usually have two to five representing the majority of cash flow.
Restating the above, what we're doing is no different than what a CEO does -- we're trying to maximize value by allocating capital. Except we don't have the extra duties of managing people. So we actually have it easier. And perhaps the CEO has it easier than the average mutual fund manager, since he or she doesn't have to worry further about diversification, "alpha," and other things. That's another level of responsibilities that we don't have to worry about.
All of this springs from my personal exposure to business before I ever had any idea what the stock market was. I never saw someone sell their private business because they were having a super year and wanted to lock in a profit and I never saw anyone sell a quarter of their business because they wanted to diversify their holdings. Most small businesses represent the bulk of the proprietor's wealth and cash flow, which seems to make them concentrate more on their work and work harder. It's also probably the result of their concentrating their life's efforts in an area where they believe they are most competent and enjoy the most. Just because I'm investing in publicly traded companies doesn't mean I should deviate from these ideas.
In sum, I've read the literature on efficient markets and diversification and it really doesn't ring a bell with me. I've never heard people who run businesses talk about any of that stuff. I leave off with a discussion on diversification given by Wesco Financial Chairman Charlie Munger. This talk was given to a group of foundation executives last year in the wake of the Long-Term Capital Management debacle and says what may be controversial to some but makes a lot of sense to me on this subject.
Have a good Friday night. Questions, comments, and lower-intensity flames are welcome on the Boring Port message board.
