The Warren Buffett Way
Portfolio management is the process of buying, selling or holding a security in the portfolio. The three important lessons to learn in portfolio management constructs from Buffett are:
- His way of building a portfolio for long-term growth
- His measuring stick for judging the growth in the portfolio
- His techniques to tackle the emotional rollercoaster due to the fluctuations in the stock prices.
Buffett calls himself a focus investor, i.e., who focuses on just a few outstanding companies. This chapter deals with the concepts of focus investing.
Conventionally, there are two types of portfolio management strategies namely –
- Active portfolio management
- Index investing.
Active portfolio managers are consistently in search of outperforming the benchmark (Sensex, Nifty, etc.) and take risky bets in order to generate alpha.
Index investing replicates the return of an index like Sensex or Nifty. Counterintuitively, it is index investing that works better than active investing and figures indicate that more than 50% of large cap funds (active) underperform index funds. Index investing gives the benefit of diversification to investors, i.e., save them from risks of individual stocks.
Buffett is a supporter of index investing; however, he does not support diversification much, at least seen from his portfolio management style. He has numerous times bet in large quantities in individual stocks where he believed, the potential to beat the market was pre-set. This is in accordance with the investing style of Philip Fisher who also did not support the idea of investing in a large number of companies just to avoid risk.
According to the author, when an investor studies a company as per Buffett’s tenets he gets a company which has a long operating history, is profitable and is run by efficient and honest management. Hence the risk is automatically covered and no need to follow the textual diversification methods. This is called Focus Investing.
Putting Probability Theory to Investing
- Calculate probabilities: In the stock market investors should take out the probabilities of various outcomes like sales growth, merger, bankruptcy, etc. before taking a financial bet.
- Wait for the best odds: In the world of probability, odds mean chances that are in your favor. In the world of investing, one should look out for chances or odds when they turn in your favor. Whether you’re buying a stock or selling, patience is the key. Buy when the stock falls below its intrinsic value, sell when it exceeds the intrinsic value.
- Adjust new information: Also, be vigilant about what is happening with your investment. Never sleep over it. There will always be new information about the company that is going to affect its story and valuation.
- Decide how much to invest: Position sizing is as important as selecting the right stock. Author has advised using the Kelly formula which is 2p-1 = x, where, p is the probability of winning and x is the percentage of total portfolio that you should bet on a stock. For example, the probability of winning is 55%, then 2p-1 = 2 * 55% -1 = 1.1-1 = 0.1 or 10%. Therefore, bet 10% of your portfolio on the stock.
The author now discusses traits of some of the well known Focus Investors.
John Maynard Keynes
Keynes was a well known economist, however, he was also a legendary investor. He managed the investments for King’s College. Keynes theory published:
- An investor can outperform markets if he concentrates on selecting a few companies which are cheaper than other stocks and its potential intrinsic value.
- These investments should be held for very long periods of time.
- A balanced investment position. Here he did not specifically mean holding a large number of stocks for diversification but holding large investments in a few securities in different sectors or regions can also cover the risk.
Charlie Munger Partnership
The success of Berkshire Hathaway can be attributed to both Warren Buffett and Charlie Munger. Charlie, a lawyer by profession, was also interested in investing and had an investment partnership to his name before joining hands with Warren Buffett. Since his earlier days, Charlie has been focused on investing in great quality companies that are available at a significant discount to their intrinsic value.
Bill was a batchmate of Buffett at Columbia University and was a student of Graham as well. He is the founder of Sequoia Capital. Buffett was a keen follower of Bill’s track record of managing investments. He was so impressed by him that when he closed down the Buffett Partnership, he advised the partners to return to Bill for their investment. He was a risk taker and has grown Sequoia’s assets from 1971 to 2013 at an average annual return of 14.46% as compared to 10.65% for S&P 500.
Lau headed the GIECO (insurance division) of Berkshire Hathaway. He was regarded by Buffett as a Focused Investor. Surprisingly, GEICO's billion-dollar investment portfolio had just 10 stocks. Simson, like Buffett, invested in companies that were generating high returns on capital and were run by able managers. He believed that the right temperament to invest in is not to be happy or sad being against or with the crowd. He pondered over annual reports rather than research reports to select his stocks.
It's common between all these five investors (Buffett and the four mentioned above) to buy stocks with a significant margin of safety and concentrating the portfolio among a few high-quality names helps to generate the best returns.
Let’s summarize the focused investing approach:
- Think of investing in stocks as buying part ownership in a business.
- Study the business that you own along with the peers of the company.
- The minimum investment period should be 5 years.
- Never buy investment stocks on leverage.
- Attain the right temperament and personality to invest.