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Warren Buffett And The Art Of Focus Investing

Summary Buffett (BRK.B) stated he would have a portfolio of 4-5 securities if he were managing smaller sums of money ($50 million, $100 million, or $200 million). Most value investors who use a focused approach significantly outperform the market. The secret to this approach is the Kelly Growth Formula for portfolio allocation. “If I were running $50, $100, $200 million, I would have 80 percent in five positions, with 25 percent for the largest. In 1964 I found a position I was willing to go heavier into, up to 40 percent. I told investors they could pull their money out. None did. The position was American Express after the salad oil scandal. ” -Warren Buffett; 2008 Berkshire Hathaway (NYSE: BRK.A ) Annual Meeting Source: Dang Le, “Notes from Buffett meeting 2/15/2008,” Underground value blog , February 23, 2008; also cited in The Kelly Capital Growth Investment Criterion by Edward Thorpe, William Ziemba, Leonard Maclean ” Back in the 1960s I actually took a compound interest rate table and I made various assumptions about what kind of edge I might have in reference to the behavior of common stocks generally. I knew from being a poker player that you have to be heavily when you’ve got huge odds in your favor (he concluded as long as he could handle price volatility, owning as few as three stocks would be plenty). I knew I could handle the bumps psychologically because I was raised by people who believed in handling bumps. So I was an ideal person to adopt my own methodology.” –Charlie Munger; D*mn Right! By Janet Lowe Introduction Today I briefly wanted to illustrate the concept of a focused investing approach. I remember when I started investing nobody ever seemed to have a methodology as to how many stocks to have in their portfolio or how to decide which amount/percentage to place of each stock in a given portfolio. Obviously there was the academic theory of diversification taught in most finance classes that advocated 50-100 stocks, but it continued to puzzle me that it was so difficult to find information on a more focused approach. In this article I’ll attempt to outline the parameters of a focused strategy that I use, and also list several resources on focus investing to hopefully save everyone time as finding all of this research was quite time consuming for me. Academic Theory, Diversification, and Value Investing Focus “The Berkshire-style investors tend to be less diversified than other people. The academics have done a terrible disservice to intelligent investors by glorifying the idea of diversification. Because I just think the whole concept is literally almost insane. It emphasizes feeling good about not having your investment results depart very much from average investment results. But why would you get on the bandwagon like that if somebody didn’t make you with a whip and a gun?” — Charlie Munger, 2005 There are no winners in the short-term, relative performance derby. Attempting to outperform the market in the short term is futile…The effort only distracts a money manager from finding and acting on sound long-term opportunities…As a result the clients experience mediocre performance…Only brokers benefit from the high level of activity. – Seth Klarman; quote taken from James Montier’s Value Investing Most universities and institutions teach that a diversified approach to investing is the best way to minimize risk and still obtain good results in the market. The majority of the investment community believes this, and most mutual funds own anywhere from 50-100 stocks with few exceptions. This approach typically leads to a return that is equal to or less than the S&P 500 and also causes most mutual fund performance to fall in a very narrow range. There is no incentive for the average fund manager to deviate from the norm as even one year of performance that is significantly less than his or her peers would probably result in the mutual fund manager being fired or severely reprimanded. Investment management companies reinforce this behavior as investment companies performing in-line with their peers don’t suffer significant losses of assets under management even if their long run performance is abysmal. A study by Randy Cohen et al. (2009; quoted in Montier’s Value Investing) the obsession with relative performance is one of the key sources of underperformance among active fund managers. Although 80-90% of fund managers underperform the S&P 500 averages in a given year, it is interesting to note how much the performance of fund managers top picks deviate from the average. Cohen’s study focused on the top 25% of “best ideas” among active managers and noted active fund managers “best ideas have a long-term average return of 19% per year vs. a market return of 12% over the same period. Best ideas were determined by portfolio allocation and looking at manager’s most significant holdings in size, especially those differing from weights in a typical index fund. If active managers followed a more focused approach and invested a larger percentage of their investable funds in their “best ideas,” both the managers and their clients would be a lot wealthier. In contrast to the diversified approach I described above that is praised by most academics and mutual fund managers there is a school of thought in the value investing community labeled “Focus Investing” by Robert Hagstrom of Legg Mason . This approach advocates putting your investable funds into a few securities and is based on a formula known as the Kelly Growth Criterion. As noted above, Warren Buffett advocates holding four to five securities using this approach and his partner Charlie Munger advocated an even more extreme approach, holding just three securities. This approach is often misunderstood, and there were a few questions on this topic at the Berkshire annual meeting this year. The main question was generally why Berkshire held so many securities and wasn’t “more focused.” Although at first glance this may appear to be true, let’s dig a little deeper to see just how focused the portfolios are. Despite holding roughly 50 stocks, Berkshire’s portfolio is still very focused with 63% of the portfolio invested in four securities (AXP, KO, IBM, WFC), and 82.10% invested in the top ten holdings (in addition to the four previously mentioned, positions five through ten are: WMT, PG, USB, DVA, MCO, GS) as of 3/31/2015. Although at first glance this focused investing approach may seem very risky, Joel Greenblatt tells a different story in his book You Too Can Be a Stock Market Genius noting that, “owning just two stocks eliminates 46 percent of the nonmarket risk of owning just one stock. This type of risk is supposedly reduced to 72 percent with a four stock portfolio, by 81 percent with eight stocks, 93 percent with 16 stocks, 96 percent with just 32 stocks, and 99 percent with 500 stocks.” Greenblatt seemed perplexed at why an investor would add hundreds of stocks to his portfolio to reduce risk by 3 percent. ROBERT HAGSTROM’S STUDY: DOES THE TYPICAL FOCUSED PORTFOLIO OUTPERFORM? ” The deleterious effects of such improbable events can best be mitigated through prudent diversification. The number of securities that should be owned to reduce portfolio risk to an acceptable level is not great, as few as ten to fifteen different holdings usually suffices.” — Seth Klarman, Margin of Safety In their study “Focus Investing: An Optimal Portfolio Strategy Alternative to Active versus Passive Management, ” Joan Lamm-Tennant, Phd., and Robert Hagstrom concluded that while a portfolio consisting of 15 stocks gives an investor a 1-in-4 chance of beating the market (S&P 500 index); a 250 stock portfolio reduces those odds to 1-in-50. Their study was based on 12,000 randomly assembled portfolios constructed with the following parameters: 3,000 portfolios with 250 stocks 3,000 portfolios with 100 stocks 3,000 portfolios with 50 stocks 3,000 portfolios with 15 stocks When sorting the ten year data, they found that 63 portfolios from group #1 (250 stocks) beat the market returns, 337 from group 2 (100 stocks) beat the market, 549 from group #3 (50 stocks) beat the market returns, and 808 from group #4 (15 stocks) beat the market’s return over the time period studied (1987-1996). Although the data below will show that the average portfolio returned less than the S&P 500 over that period (a particularly well performing period for large cap stocks), it also shows that as you reduce the number of stocks in a given portfolio, the probability of beating the returns of the S&P 500 increases. KELLY GROWTH CRITERION AND PORTFOLIO ALLOCATION “It is known that the great investor Warren Buffett’s Berkshire Hathaway actually has had a growth path similar to full Kelly betting.” – Scenarios for Risk Management and Global Investment Strategies; Rachel and William Ziemba “Discussion of Buffett’s concentrated bets gives considerable evidence that Buffett thinks like a Kelly Investor, citing Buffett bets of 25% to 40% of his net worth on single situations. — The Kelly Capital Growth Investment Growth Criterion: Theory and Practice, ” World Scientific Publishing Company, 2011; written by Thorpe, Maclean, and Ziemba. When I first started investing the most difficult topic for me was deciding how much of my portfolio to invest in a given position. This changed when I stumbled upon the Kelly Growth Criterion while reading through Ed Thorpe’s classic book on blackjack Beat the Dealer , after it was mentioned in Ben Mezrich’s book Bringing Down the House , which was later turned into a movie called “21.” The Kelly Growth Criterion is a probability based model that teaches one how much of his bankroll he should wager in a given situation, whether it’s gambling at a casino or investing in the stock market. Ed Thorpe mentions the Kelly Growth Formula in his classic book on Blackjack, “Beat the Dealer,” which became the foundation for the MIT Blackjack team as shown in the book Bringing Down the House: The Inside Story of Six MIT Students Who Took Vegas for Millions by Ben Mezrich. Interestingly enough the Kelly formula was not developed by J.L. Kelly (who it is named after) but rather by the incredible genius Claude Shannon as detailed in the excellent , Fortune’s Formula: The Untold Story of the Scientific Betting System that Beat the Casinos and Wall Street , by William Poundstone. After the formula was developed and published by Shannon another Mathematician, J.L. Kelly realized the formula could be applied to gambling, and the Kelly Growth Formula for gambling/investing was born. The formula is simply expressed as: 2p – 1 = X, where 2 times the probability of winning minus 1 equals the percentage of one’s bankroll that should be bet. For example, if the probability of beating the house is 55 percent, you should bet 10 percent of your bankroll to maximize profit. If the probability of beating the house is 70 percent you should bet 40 percent, etc. Kelly Growth: Application “We might invest up to 40% of our net worth in a single security under conditions coupling an extremely high probability that our facts and reasoning are correct with a very low probability that anything could change the underlying value of the investment.” – Warren Buffett; Letters to Investment Partners In his excellent book The Dhando Investor, Mohnish Pabrai outlines the application of the Kelly Growth Formula to Buffett’s 1964-67 investment in American Express (40% of partnership assets). Pabrai estimates the odds of this bet in a conservative case would be: Odds of 200% or greater return in three years – 90 percent. Odds of breakeven return in three years – 5 percent. Odds of a loss of up to 10 percent in three years – 4 percent. Odds of a total loss on the investment – 1 percent. Using the above odds, the Kelly formula would advocate betting 98.3 percent of assets on American Express according to Pabrai. Buffett invested an amount (40%) under the maximum suggested and placed a few other bets with the remaining 60% of assets. Pabrai gives several examples of ideal portfolio allocation in Dhando Investor, and also notes that several other famous value investors (Joel Greenblatt and Eddie Lampert) seem to be using a Kelly Approach. As noted above, Buffett’s ideal portfolio allocation places 25 percent of assets into the best idea, with the remainder allocated to four investments. Although Buffett has never advocated the Kelly formula, it seems that he uses it or some variation in his portfolio allocation. Kelly Growth: Target Investments “Good jockeys will do well on good horses, but not on broken down nags.” — Warren Buffett In a recent presentation for the website Singular Diligence , Tobias Carlisle did an excellent job describing and summarizing the ideal investment targets under a Kelly approach. On a side note, if you haven’t read Tobias Carlisle’s books Deep Value , and Quantitative Value , you are missing out — they are two of my all-time favorites. Carlisle suggested that the Kelly approach favors investments with the following characteristics: Stable, low risk targets. Reasonable valuation (free cash flow yield 8-10%) Growing bigger in the next 3-5 years. High Quality businesses High Quality Management. To summarize, one should focus on buying companies with wide economic moats at affordable prices. In addition placing large bets when pessimism is at a maximum (See Buffett’s 1964 AXP Investment) is also advantageous. Conclusion “If you are a professional and have confidence, then I would advocate lots of concentration. For everyone else, if it’s not your game, participate in total diversification. If it’s your game, diversification doesn’t make sense. It’s crazy to put money in your twentieth choice rather than your first choice.” — Warren Buffett (NYSE: BRK.B ); The Kelly Capital Growth Investment Criterion by Edward Thorpe, William Ziemba, Leonard Maclean “Of course, Charlie and I can identify only a few Inevitables, even after a lifetime of looking for them… Considering what it takes to be an Inevitable, Charlie and I recognize that we will never be able to come up with a Nifty Fifty or even a Twinkling Twenty. To the Inevitables in our portfolio, therefore, we add a few “Highly Probables.” – Warren Buffett; 1996 Berkshire Hathaway Letter to Shareholders In conclusion, if one has the time and resources a focused approach to portfolio management is ideal. Since I started my investment partnership I’ve consistently had 40-50% of AUM in 4 companies: Directv (NASDAQ: DTV ), Markel (NYSE: MKL ), Express Scripts (NASDAQ: ESRX ), and Davita (NYSE: DVA ); the only time the top 4 changed (added MasterCard (NYSE: MA ) to replace DTV) was when DTV was acquired by ATT. This approach can be frightening at times as your portfolio is exposed to any volatility driven by the largest positions, but in the long run the results are incredible. Appendix Examples of Modern Day Focus Investing in Practice Allan Mecham; Arlington Value Management Nelson Peltz; Trian Capital Chuck Akre; Akre Focus Fund (MUTF: AKREX ) Hennessy Focus Fund (MUTF: HFCSX ) Lou Simpson; SQ Advisors, LLC Tom Bancroft; Makaira Partners Resources: Recommended Reading Fortune’s Formula: The Untold Story of the Scientific Betting System that Beat the Casinos and Wall Street , by William Poundstone Probabilistic Reasoning by Amos Tversky and Daniel Kahneman Skin in the Game Heuristic as Protection Against Tail Events by Nassim Taleb and Constantantine Sandis Understanding Uncertainty by Dennis V. Lindley Scenarios for Risk Management and Global Investment Strategies by Rachel and Bill Ziemba The Kelly Capital Growth Investment Criterion by Edward Thorpe, William Ziemba, Leonard Maclean An Introduction to Probability Theory and Its Applications, Volumes 1-2 , by William Feller The Mathematics of Gambling by Edward O. Thorpe The Unfinished Game: Pascal, Fermat, and the Seventeenth-Century Letter that Made the World Modern by Keith Devlin The Dhando Investor by Mohnish Pabrai The Warren Buffett Portfolio by Robert Hagstrom More Than You Know: Finding Financial Wisdom in Unconventional Places by Michael Maubossin In an Uncertain World: Tough Choices from the Brink by Robert Rubin Judgment Under Uncertainty: Heuristics and Biases (Edited by Daniel Kahnemann, Paul) Value Investing by James Montier Margin of Safety by Seth Klarman Quantitative Value by Wesley Gray and Tobias Carlisle Deep Value by Tobias Carlisle Theory of Gambling by Richard Epstein Theory of Poker by David Sklansky Singular Diligence website ( singulardiligence.com ); Tobias Carlisle Kelly Criterion in Blackjack, Sports Betting, and the Stock Market by Edward Thorpe (available at edwardothorpe.com ) Beat the Dealer : A Winning Strategy for the Game of Twenty-One Bringing Down the House: The Inside Story of Six MIT Students Who Took Vegas for Millions by Ben Mezrich. Against the Gods The Remarkable Story of Risk by Peter L. Bernstein Winning Decision: Getting it Right the First Time by Paul Shoemaker and Edward Russo Disclosure: I am/we are long MKL, BRK.B, DVA, MA, ESRX. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Buy On Euphoria, Sell On Panic – A Contrarian Strategy That Works For China

A newly-published risk model shows that buying on euphoria and selling on panic has been a successful strategy for Chinese equity markets. Rational investment Chinese style is to watch for shifts in government policy rather than changes in spreadsheet data. Liquidity is seen as the proxy signal for when Beijing turns positive/negative on equities and roll out measures to support or suppress higher prices. It shouldn’t work – but it does. Winners in China’s A-share markets buy when market sentiment is high and sell when market sentiment is low. Or, as I recommended to investors in a previous post, toss out the spreadsheet and other textbook fundamentals and go with herd psychology. It works. And now there is a study to prove it. Credit Suisse has just published a risk model for investing in Chinese stocks. And it has found that the signals for buying and selling in Chinese markets are “the opposite” of what’s expected everywhere else in the world. Chinese investors buy on euphoria and sell on panic – and the strategy has been successful on the whole, according to the Swiss banking group which has now included China in its proprietary Global Risk Appetite Index. The index, which has been around for some 20 years, measures the performance of stock markets against government bond markets based on rolling six and 12 month returns and correlates risk appetite with investment signals. The global version shows that risk is cyclical and confirms accepted market wisdom that the best time to buy is when risk appetite is low (such as during a panic) and to sell when risk appetite is high (as when the market is in euphoria). The cycles in risk appetite in most markets correlate closely with what is happening in the global economy. Extremes in risk appetite thus provide reliable countercyclical trading signals. So if you buy when the market panics and wait for the eventual rebound, you make a tidy profit. China, as always, is different. Prices don’t follow fundamentals in the way they do elsewhere in the world but are more closely linked to investor psychology, according to the report. Among the findings , as reported by the media, are: “… in China, buying the market when risk appetite was high and selling when risk appetite was low has been a successful strategy in general. This is the opposite of how our Global Risk Appetite Index has behaved.” The report gave two reasons for why the China market is different. One, the free float is much smaller than in other markets because state firms account for 45% of market valuations. Small moves in a stock can thus have a huge impact on the price. Second, the level of government intervention is high. Further distorting traditional signals is the extreme swings in risk appetite that characterize the Chinese market. Prices tend to overshoot and go off the charts before reverting to the norm – challenging standard concepts of “cheap” valuations. Nor are conventional performance metrics of much help. The fortunes of individual companies can – and have been – scuppured by government campaigns, such as Beijing’s anti-corruption drive. The Chinese corporate world is unusual in that the sins of executives are often visited on the companies they run. When a top executive falls, he typically brings down all around him, sometimes even the company itself, as I explained in a previous article, ” The Midnight Knock. ” The strategy that has produced results in China’s contrarian equity markets is to follow the herd. This means jumping in when the market is high (as the chances are that you can sell even higher) and dumping stocks when the market is low (as it is likely to go even lower). But this does not mean the Chinese stock market “behaves weirdly”. Investors in China simply follow a different set of rules, as I have argued in many previous posts. They track fundamentals but of a different sort. Chinese fundamentals have little to do with western textbook metrics and everything to do with government policy – unlike in Western markets where the term “fundamentals” has been hijacked by the financial industry to mean only spreadsheet data. In China, the very visible hand of government is always hovering – skewing market direction and distorting what would be classic signals in the free and open markets of advanced economies. The valuation that matters in China is the price-to-fear/greed ratio. And the signal for the switch from greed to fear and back is liquidity. Driving stock prices in China is liquidity . Not the economy. Not corporate earnings. Not abstract theories of reform or quality growth that is supposedly superior and sustainable for years to come. Liquidity is seen by Chinese investors as the proxy signal for when the government turns positive/negative on equity markets and will roll out measures to support/suppress higher prices. The biggest losses since the rally took off in earnest last September have all been triggered by market fears that the regulator was about to put an end to the party by pulling liquidity. Investors started turning skittish in January when the regulator tightened rules for entrusted loans which had been providing funds for stock purchases. The move was perceived as signaling a coming government squeeze on liquidity to cool the bull run in equities. The market has since been swinging between greed and fear amid conflicting interpretations of Beijing’s policy moves. Every investor in Shanghai and the rest of the country has been watching every other investor to see who might be pulling out and who might be doubling down on their bets. Confidence is a fragile commodity in a market where policy U-turns can happen overnight and with little warning. Hence, the inherent volatility in A-share prices. China’s domestic investors did not put money into the market because the textbook fundamentals looked right. On the contrary, price-to-earnings ratios were soaring, the yield advantage that stocks offer over bonds rapidly shrinking, and economic growth was at a 24-year low with corporates sagging under heavy debt burdens. What domestic punters had been betting on for the past year was a liquidity story backed by policy – the only fundamental that matters in China. The A-share markets are likely to remain range-bound in the coming weeks as investors digest the implications of Beijing’s stock rescue and decide if there is time for one more roll of the dice. This is rational investment, Chinese style. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

HHYX: International Junk Bond Exposure With Protection From A Strong USD

Summary IShares recently listed a new USD hedged high yield bond ETF. This fund is composed of Canadian dollar, British pound sterling, and Euro denominated corporate junk bonds. This fund may be useful to an investor looking for international fixed income exposure without the foreign exchange risk. The Fund On July 28th, iShares from Blackrock (NYSE: BLK ) listed a new ETF, the iShares Currency Hedged Global ex USD High Yield Bond ETF (NYSEARCA: HHYX ). As stated in the fund’s prospectus, this fund seeks to invest in corporate junk bonds …while mitigating exposure to fluctuations between the value of the component currencies and the U.S. dollar. HHYX seeks to track the Markit iBoxx Global Developed Markets ex-US High Yield (USD Hedged) Index . HHYX principally invests in another iShares fund, and/or the components of that fund, the iShares Global ex USD High Yield Corporate Bond ETF (BATS: HYXU ). The difference between the two is that, while both achieve exposure to non-USD denominated high yield bonds, only HHYX actually protects and hedges against the foreign exchange risk associated with international investing. In this article, I will briefly go over the components of the new fund and the structure of the currency hedging strategy used by this fund. Components Geography: The top five geographic areas of exposure in HHYX are: Italy (22.23%) United Kingdom (15.22%) Germany (14.87%) France (12.36%) Spain (5.97%) Investors may also note that 1.36% of the exposure comes from Greece. Remember that HHYX is strictly exposed to corporate junk bonds, and not municipal or government debt. That being said, I think most investors are aware that there is some concern in the market about the status of Italy’s debt levels. Sovereign debt is at an all time high in Italy, and there are some analysts saying that Italy will be the “next Greece.” For these reasons, I see the large exposure to Italy as one of the principle risks. Sectors: The most represented sectors in the fund are: Financials (18.85%) Telecommunication (17.10%) Capital Goods (16.91%) Consumer Cyclical (16.75%) Consumer Non-cyclical (9.40%) Grades: The primary credit ratings of the underlying investments are BB (63.67%) and B (30.71%). As far as where these credit ratings are derived from, iShares states that: Credit quality ratings on underlying securities of the fund are received from S&P, Moody’s and Fitch and converted to the equivalent S&P major rating category. From the S&P’s Credit Ratings website, here is how the various ratings are described: Of course, there are many risks associated with speculative grade junk bonds, but I will assume that if you are seeking exposure to them, then you have some understanding of these risks. How the Currency Hedge Works: In order to hedge against fluctuations of exchange rates between the USD and other currencies, HHYX shorts forward contracts for each of the non-dollar currencies in the portfolio. What this means is that if one of the underlying currencies in the portfolio loses value compared to the USD, the losses will be offset by the gains from the forward contracts. It is important to realize that the forward contracts will offset and limit, but not necessarily eliminate, losses from foreign exchange risk. It should be also noted that the inverse of this is also true. If the underlying currency of one of the portfolio’s investments gains value compared to the U.S. dollar, the gains would be offset by a loss from the forward contract. In other words, the investor would not benefit from the foreign exchange, whereas he or she would if they had purchased the asset using converted U.S. dollars. Conclusion: This article is not necessarily intended to encourage or discourage investors from investing in international high yield bonds. However, if one is inclined to do so, I believe that this new ETF is a reasonable way to gain exposure. I do have concerns about the large allocation towards Italian debt, but the underlying index could possibly rebalance if the situation deteriorated further. Arguably, it is a benefit that the fund is geared towards the higher-end of speculative grade debt. In short, if an investor is seeking to diversify his or her portfolio with exposure to international speculative grade corporate debt, this new ETF may be a worth further investigation. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. Additional disclosure: This article is not intended to be a buy/sell recommendation, it is simply offered as an analysis of a new exchange traded product that some investors may find useful for their portfolios.