Sunday, May 22, 2016

Warren Buffett and Charlie Munger on portfolio concentration, and having the right temperament for it

A short quote from Warren Buffett in 2008 (similar to his 1998 comments):
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. . . . [Berkshire vice-chairman] Charlie [Munger] and I operated mostly with five positions. If I were running $50, $100, $200 million, I would have 80 percent in five positions, with 25 percent for the largest.
And then a longer excerpt from the book about Charlie Munger's style:
In the book Damn Right!, Buffett told Munger’s biographer Janet Lowe that Munger initially followed the fundamentals of value investment established by Graham, but was always far more concentrated than other traditional value investors like Walter Schloss: 
Charlie’s portfolio was concentrated in very few securities and therefore his record was much more volatile but it was based on the same discount-from-value approach. He was willing to accept greater peaks and valleys of performance, and he happens to be a fellow whose whole psyche goes toward concentration, with results shown.  
Munger defines “very few securities” as “no more than three:”  
My own inquiries on that subject were just to assume that I could find a few things, say three, each which had a substantial statistical expectancy of outperforming averages without creating catastrophe. If I could find three of those, what were the chances my pending record wouldn’t be pretty damn good. I just sort of worked that out by iteration. That was my academic study—high school algebra and common sense. 
Munger’s rationale for holding so few stocks was based on practical considerations—“How could one man know enough [to] own a flowing portfolio of 150 securities and always outperform the averages? That would be a considerable stump.” He believes that securities are mostly appropriately valued: 
[T]he people that came up with the efficient market theory weren’t totally crazy, but they pushed their idea too far. The idea is roughly right with exceptions. 
That observation, and his own research, pressed him to seek only the handful of situations where he might have an edge: 
It would not be too much to say it was obvious to me that I could not have a big edge over everybody else and all securities. In other words, it was also obvious to me that if I worked at it, I would find a few things in which I had an unusual degree of competence. It was natural for me to think in terms of opportunity costs. So once I owned three securities—A, B, and C—I wasn’t going to buy any other security. I had actually studied them. I don’t know how much diversification would be necessary over a long period of time. I worked it out with pencil and paper as a matter of probabilities. If you are going to operate for 30 years and only own 3 securities but you had an expectancy of outperforming averages of say 4 points a year or something like that on each of those 3 securities, how much of a chance are you taking when you get a wildly worse result on the average. I’d work that out mathematically and assuming you’d stay for 30 years you’d have a more volatile record but the long-term expectancy was—in terms of disaster prevention—plenty good enough for 3 securities. I had worked that out in my own head using just high school algebra. 
In seeking his edge, Munger pursued small, unknown stocks that wouldn’t be of interest to the bigger investors: 
I tended to operate, as so many successful value investors do, not looking at Exxon and Royal Dutch and Procter & Gamble and Coca-Cola. Most of the value investors, if you analyze who’ve been successful over a long time, have operated in less followed stocks. 
Like Simpson, Munger likes “financial cannibals,” companies that buy back a lot of stock: 
[W]hat those [successful] companies had in common was they bought huge amounts of their own stock and that contributed enormously to the ending record. Lou, Warren, and I would always think the average manager diversifying his company with surplus cash that’s been earned more than half the time they’ll screw it up. They’ll pay too high a price and so on. In many cases they’ll buy things where an idiot could see they would have been better to buy their own stock than buy this diversifying investment. And so somebody with that mind-set would be naturally drawn to what Jim Gibson used to call “financial cannibals,” people that were eating themselves. 
Munger often refers to the value “mind-set.” He considers temperament a crucial element to holding a concentrated portfolio. When Buffett installed Lou Simpson as GEICO’s chief investment officer, Munger recognized in him the right temperament, and a kindred spirit: 
Warren has this theory that if you’ve got a lot of extra IQ points in managing money you can throw them away. He’s being extreme of course; the IQ points are helpful. He’s right in the sense that you can’t [teach] temperament. Conscientious employment, and a very good mind will outperform a brilliant mind that doesn’t know its own limits and so on and so on. Now Lou happens to be very smart but I would say his basic temperament was a big factor. He has the temperament of the kind of investor we like and we are.

For those curious about what kind of upside vs. downside one would need to justify Munger's 3-stock portfolio according to the Kelly Formula, I touched on this in a post last year
If you're assuming 50/50 odds of being right (which is hopefully conservative), then you'd need a 3x upside vs. downside ratio over your investing timeframe before investing. 
As an example, if you are following Kelly and assuming 50/50 odds of being right, you'd need a 150% (2.5x) expected return if your worst-case downside is a 50% loss. And to repeat some of my thoughts on Kelly, I don't think one should try and use it precisely because you can't know the exact odds or payoffs when making an investment. But I think it's a useful tool to use when thinking about position sizing and the attractiveness of a given investment. And its usefulness reminds me of one of my favorite quotes from Munger:
"I could see that I was not going to cope as well as I wished with life unless I could acquire a better theory-structure on which to hang my observations and experiences. By then, my craving for more theory had a long history. Partly, I had always loved theory as an aid in puzzle solving and as a means of satisfying my monkey-like-curiosity. And, partly, I had found that theory-structure was a superpower in helping one get what one wanted. As I had early discovered in school wherein I had excelled without labor, guided by theory, while many others, without mastery of theory failed despite monstrous effort. Better theory I thought had always worked for me and, if now available could make me acquire capital and independence faster and better assist everything I loved."
As I wrote previously, a high level of concentration is only good "if you are willing to put in the significant effort required to deeply understand each investment." There is a big difference in the amount of work necessary to run a 5-10 stock portfolio (or less in Munger's case), and the amount of work needed to run a 20-30 stock portfolio. And as Buffett recommends, if you aren't willing to put in the work necessary in either of those cases or don't have the skill to find capable managers that do, then indexing is probably the way to go.