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Focus Investing

“Choose a few stocks that are likely to produce above-

average returns over the long haul, concentrate the bulk

of your investments in these stocks, and have the

fortitude to hold steady during any short-term market

gyrations.”

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Focus Investing - Five rules

• CHOOSE = Find outstanding companies

• FEW = Less is More

• CONCENTRATE = Put Big Bets on High-Probability Events

• HOLD STEADY = Be Patient

• FORTITUDE = Don’t Panic over price changes

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Find Outstanding Companies

Graham part12 tenetsConsistentFranchise or low-costRational, honest, & skilled

management

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Less is More

Fisher part Concentrate in outstanding firms Limit portfolio to firms you can comprehend

• Size - 10 is good number

• Scope - Circle of competence

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Big Bets on High Probability Events

Concentrate Weight best ideas most heavily Do your homework – have confidence in

your “rightness”

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Be Patient

Hold Steady Think long term (10 years) Longer periods → economics of underlying

business will dominate share price. Low turnover – (10 years → 10% turn)

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Don’t Panic

Fortitude Random walk Price changes happen – Mr. Market Shorter periods → ups and downs LTCM was right, just not soon enough

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What about diversification?

Good, if you don’t know much about the

stock market and are happy with average

returns with lower risk.

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If not?

Then focus, and you will have extreme

returns: very high returns or very low

returns. If you do it well, you have very

high returns with higher volatility

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Star investors of focus investing

J.M. Keynes Charlie Munger Bill Ruane Lou Simpson Warren Buffett

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John Maynard Keynes1928-1945

 Chest Fund

(%)U.K. Market

(%)

Average Return 13.2 -0.5

Standard Deviation 29.2 12.4

Minimum -40.1 -25

Maximum 56 21.5

Range (Max – Min) 96.1 46.5

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Charlie Munger Partnership Ltd.1962-1975

 Partnership

(%)Dow Jones

Industrial (%)

Average Return 24.3 6.4

Standard Deviation 33 18.5

Minimum -31.9 -23.1

Maximum 73.2 44.4

Range (Max – Min) 105.1 67.5

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Sequoia Fund Managed by Bill Ruane1971-1997

  Fund (%) S&P 500 (%)

Average Return 19.6 14.5

Standard Deviation 20.6 16.4

Minimum -24 -26.4

Maximum 72.3 37.5

Range (Max – Min) 96.3 63.9

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GEICOLou Simpson1980-1996

  GEICO (%) S&P 500 (%)

Average Return 24.7 17.8

Standard Deviation 19.5 14.3

Minimum -10 -5

Maximum 57.1 37.6

Range (Max – Min) 67.1 42.6

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Buffett Partnership Ltd.1957-1969

  Partnership (%)

Dow Jones Industrial

(%)

Average Return 30.4 8.6

Standard Deviation 15.7 16.7

Minimum 6.8 -15.6

Maximum 58.8 38.5

Range (Max – Min) 52 54.1

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Berkshire Hathaway Inc.1965-1997

 Partnership

(%)S&P 500

(%)

Average Return 24.9 12.9

Standard Deviation 13.0 16.4

Minimum 4.7 -26.4

Maximum 59.3 37.6

Range (Max – Min) 64.0 64.0

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Isn’t it possible

that the performance

of these successful focus investors

is a matter of chance?

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W.D.’s Stock Pick Newsletter(or could be Sports Betting Tips)

Ignore transactions costsSplit population in half Send each half a different pickSend winners next pickRepeat until hookedCharge through the nose

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Three thousand focus investors

3000 portfolios containing 250 stocks. 3000 portfolios containing 100 stocks. 3000 portfolios containing 50 stocks. 3000 portfolios containing 15 stocks

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Performance

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Buffett’s answer (1984)

Imagine a national coin-flipping contest in which

225 million Americans bet $1 on their guess. After

each flip, the losers dropped out and the winners

kept the pot and advanced to the next round.

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After ten events, there would be 220,000 winners

left who, by letting their winnings ride, would have

gained $1024. After another ten tosses, there

would be 215 winners, each with $1 million.

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Business professors would claim that there is

no skill, and this can be duplicated by 225

million coin-flipping orangutans.

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However, if 40 of those winning animals

came from the same zoo, wouldn’t we want

to ask the zookeeper what he feeds his now

very rich orangutans?

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What are the odds? For buffet is weighted average. P(loss)*size of loss + P(gain)*amount

of gain Set up

• Stock currently is $18• Announce possible takeover at $30• Stock price immediately goes to $27

Now what do you do:• If you buy and deal goes through you make $3• If you buy and deal doesn’t price reverts to fair value ($18) or a loss of $9

Do your analysis and conclude a 90% chance of going through• (.1)*(-9) + (.9)*(3) = $1.80 positive expected value. • What is the return = 1.8/27 = 6.6%• If deal takes 6 months ≈ 13.2% return

How does this compare to alternatives.

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Wells Fargo

Bought @ $58 in 1990 – real estate loans (specialty of Wells) most vulnerable (earthquake, overbuilding, economic collapse)

He figured probability of total collapse at 10% and that 10% of wells loans might go bad to the tune of 30% of principal = .1*.1*.3*$48 billion of loans = 144 million loss but before collapse wells was EBT = $1B ≈ pretty large margin of safety.