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Fin 4201/8001 1
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.”
Fin 4201/8001 2
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
Fin 4201/8001 3
Find Outstanding Companies
Graham part12 tenetsConsistentFranchise or low-costRational, honest, & skilled
management
Fin 4201/8001 4
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
Fin 4201/8001 5
Big Bets on High Probability Events
Concentrate Weight best ideas most heavily Do your homework – have confidence in
your “rightness”
Fin 4201/8001 6
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)
Fin 4201/8001 7
Don’t Panic
Fortitude Random walk Price changes happen – Mr. Market Shorter periods → ups and downs LTCM was right, just not soon enough
Fin 4201/8001 8
What about diversification?
Good, if you don’t know much about the
stock market and are happy with average
returns with lower risk.
Fin 4201/8001 9
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
Fin 4201/8001 10
Star investors of focus investing
J.M. Keynes Charlie Munger Bill Ruane Lou Simpson Warren Buffett
Fin 4201/8001 11
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
Fin 4201/8001 12
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
Fin 4201/8001 13
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
Fin 4201/8001 14
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
Fin 4201/8001 15
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
Fin 4201/8001 16
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
Fin 4201/8001 17
Isn’t it possible
that the performance
of these successful focus investors
is a matter of chance?
Fin 4201/8001 18
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
Fin 4201/8001 19
Three thousand focus investors
3000 portfolios containing 250 stocks. 3000 portfolios containing 100 stocks. 3000 portfolios containing 50 stocks. 3000 portfolios containing 15 stocks
Fin 4201/8001 21
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.
Fin 4201/8001 22
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.
Fin 4201/8001 23
Business professors would claim that there is
no skill, and this can be duplicated by 225
million coin-flipping orangutans.
Fin 4201/8001 24
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?
Fin 4201/8001 25
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.
Fin 4201/8001 26
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.