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 today I'm going to focus on only 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. They invest infrequently, only when they're highly confident that the odds are heavily in their favor, and then they bet big. (Not surprisingly, research shows that the same approach works in other endeavors such as poker or betting on horse races. For more on focus investing, see Bob Hagstrom's excellent book, The WarrenBuffett Way.)
Berkshire Hathaway's (NYSE:BRK.A) Warren Buffett and Charlie Munger have commented on this topic in recent annual meetings (click here for links to my transcripts from the past five Berkshire and Wesco (NYSE:WSC) 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."
Position sizing
OK, let's say you're convinced that focus investing is the way to go, and you've found a stock about which you're trembling with greed. What percent of your assets should you invest in it? 2%? 20%? (Or, given the cheap, easy leverage these days, 200%?) The answer depends on a number of factors such as your tolerance for volatility, the expected upside, and the potential downside. Generally speaking, my ideal portfolio would have 12-20 well-diversified 50-cent dollars (e.g., stocks trading at half of my conservative estimate of their intrinsic value), of which roughly five were 10% positions and rest were 5-9% positions.
I did not pick this range of 12-20 stocks arbitrarily. In Joel Greenblatt's brilliant book, You Can Be a Stock Market Genius, he provides the following statistics (see pages 20-21):
- Owning two stocks eliminates 46% of nonmarket risk of just owning one stock
- Four stocks eliminates 72% of the risk
- Eight stocks eliminates 81% of the risk
- 16 stocks eliminates 93% of the risk
- 32 stocks eliminates 96% of the risk
- 500 stocks eliminates 99% of the risk
Once one has a well-diversified, balanced portfolio of a dozen or so stocks, adding additional stocks does little to reduce risk, yet there's obviously a big penalty in terms of performance if one's best ideas are 3-5% positions instead of 7-10% positions.
Keep in mind, however, that there is no right answer. I know many fantastic money managers who own a few dozen stocks and some who own only a half dozen, but 12-20 is the level at which I'm comfortable. You need to find your own comfort zone.
At one point in my investing career, I invested in a more concentrated fashion -- for example, I doubled my Berkshire Hathaway holdings to an 18% position on March 10, 2000, a day I remember well because it was the last spasm of forced selling of the stock, driven by investors piling into tech stocks (it was the very day that the Nasdaq peaked at 5,032 -- a level that, mark my words, we will not see for at least another 10 years).
While that investment worked out well (I still own some of the Berkshire stock), I'd be surprised if I ever again invested so much of my portfolio in one stock. Why? Let me show you the scars on my back and tell you some stories. Just in the past two years -- two very good years, incidentally -- I've had a 10% position decline by 30%, two 7% positions lose two-thirds of their value (all three subsequently recovered), and a 2% position go bankrupt (I bought at $6 and sold at a penny -- ouch!). As a result, I've learned that no matter how much confidence I have in an investment, the future is inherently unpredictable and all sorts of unexpected calamities can occur. I still practice focus investing, but thanks to Mr. Market teaching me some humility, I'm not quite as focused as I used to be.
Sizing common stocks
I typically will not add a common stock position to my portfolio unless I'm willing to make it a 5% position. If I don't feel confident enough to invest at least this much, that's a good signal I shouldn't own it at all. Once this initial position is established, I cross my fingers and hope that the stock goes. down. Yup, you read that right, down! Why? Because I want to buy more and make it a 10% position but need a bigger margin of safety to do so.
Let me give you an example of a dream scenario. At the end of 2002, the worst year in the fast food industry in 20 years thanks to a weak economy and a burger war between McDonald's (NYSE:MCD) and Burger King, McDonald's stock hit a multiyear low in the $16 range. I believed that, despite horrible mismanagement, McDonald's remained one of the world's great businesses and that the new CEO had a sound turnaround plan (see "CEO of the Year: McDonald'sCantalupo"). My estimate of intrinsic value was in the mid-$20 range, so at $16, I felt that I was buying with a 40% margin of safety -- enough to make the stock a 5% position.
Then I got lucky: McDonald's continued to report weak results and investors became very bearish on consumer spending as the Iraq war loomed, so the stock fell to a 10-year low of just above $12 in March 2003. At the same time, I interviewed a longtime McDonald's franchisee who gave me insights into the dramatic positive changes that were occurring within the company but whose impact was not yet visible in the numbers. Thus, while the stock I had purchased initially was down 25% in only a few months, I had even more confidence in my investment thesis and was thrilled to be able to buy the stock at an even lower price, so I backed up the truck and doubled the position (which I still own).
Sizing shorts
Though I do some shorting, it's an awful business for many reasons, one of which is that one shouldn't do it in size, as losses are potentially unlimited. If a stock is a 7% long position at $15 and drops to $5, it will cost you nearly five points of return, but it won't put you out of business, you aren't forced to sell at the bottom, and -- if you have real guts and conviction -- you can buy more.
But what about a 7% short position at $5 that jumps to $15? That costs you 14 percentage points of return and you may be forced to cover to prevent further losses, even if you have more confidence in the position. Thus, you can see why I rarely make a short position larger than 2-3% and prefer a basket of even smaller positions.
Sizing options
Given the implicit leverage of options, I tend to make them small positions -- generally 0.5%-2.5%, though it's hard to share any rules of thumb since some long-dated, deep-in-the-money options are very similar to the underlying stock, while short-dated, out-of-the-money options are highly speculative.
Speculations
One might ask why a conservative value investor like myself would ever invest in something highly speculative, but I'm willing to make such investments with a small portion of my portfolio as long as I'm confident that the expected value is much higher than the price I'm paying. Consider an investment with the following expected one-year payoffs:
- Loss of entire investment: 60% chance
- No gain or loss: 10% chance
- 2x gain: 10% chance
- 5x gain: 10% chance
- 10x gain: 10% chance
The expected value of a $1 investment given these probabilities is $1.80, a fabulous return, but let's assume you could only make this investment once. Would you do so, knowing that there's a 60% chance that you'd lose it all? Try explaining that to your investors (or worse yet, your spouse)!
If you did make the investment, how much of your portfolio would you risk? This is not a hypothetical question; in the past few weeks, I faced a very similar choice and chose to invest 2% of my portfolio.
Conclusion
While there's little doubt that focus investing is likely to yield the highest long-term returns, there are no hard and fast rules about how concentrated one's portfolio should be -- it depends on tolerance for volatility, availability of other investment options, the confidence in one's analysis, and many other factors.
Whitney Tilson is a longtime guest columnist for The Motley Fool. Under no circumstances does this information represent a recommendation to buy, sell, or hold any security. He owned shares of Berkshire Hathaway and McDonald's at press time, though positions may change at any time. Mr. Tilson appreciates your feedback. To read his previous columns for The Motley Fool and other writings, visit http://www.tilsonfunds.com. The Motley Fool is investors writing for investors.
