Why I’m a Focus Investor

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In his book The Warren Buffett Portfolio, Robert Hagstrom defines focus investing as the following:

“Choose a few stocks that are likely to produce above-average returns over the long haul, concentrate the bulk of your investments in those stocks, and have the fortitude to hold steady during any short-term market gyrations.”

To be a focus investor means that you’re going against the grain of modern finance. I was taught modern portfolio theory and the benefits of diversification in both college and business school. Modern Portfolio Theory preaches that an individual investor can’t beat the market because any new information about a stock is immediately incorporated into its price. Thus, the goal of investing is to reduce unsystematic risk or “company specific risk” by holding a diversified basket of stocks. The problem is that if your portfolio is highly diversified it’s going to be extremely difficult to obtain market-beating returns. Essentially your portfolio mirrors the market in both its composition and ultimately total returns. A focus investor consciously decides to ignore this view of portfolio management in favor of less diversification to enhance returns.

In many ways focus investing is the complete antithesis of how most mutual funds manage their portfolios. The typical mutual fund owns 50-100 positions. The end result is that their performance broadly matches the market. Even if they own a few stocks that are stellar performers they account for such a small portion of the overall portfolio that it doesn’t drastically improve performance. Most mutual funds achieve average performance because it’s difficult to outperform the market unless you make a few concentrated bets. Additionally, most fund managers are comfortable with average performance because it means stability in assets under management (AUM). The vast majority of investors are not going to pull out their money from a fund if the manager matches or slightly underperforms the market. Conversely, investors will pull their money if their fund manager dramatically underperforms his benchmark. Managing a concentrated portfolio increases risk on both the downside and upside. Although most managers would love to outperform the market by a wide margin in any given year, they are more concerned with not underperforming because of the career risk it entails. When following a focused investment strategy, the downside is more severe than the upside for traditional fund managers. Thus, the natural inclination for most fund managers is to pursue average performance.

Randy Cohen, who was my investment management professor at Harvard Business School, found in a 2009 study that the top 25% of “best ideas” among active managers actually outperformed the market by a wide margin. He found that the best ideas had a long-term return of 19% in comparison to a market return of 12% over the same period. If most active managers had increased the position sizes of their top ideas they could have drastically improved their performance. By not following a focused investment strategy, most fund managers are doing a disservice to their investors.

Why I converted to focus investing

If you analyze Warren Buffett’s stock portfolio, you’ll come to the realization that he’s always concentrated his money in a few top positions. He is obviously a focus investor. But the bigger point that I want to bring up is that he actively sought out unsystematic risk. He was looking for individual companies that would produce solid returns over long periods of time. Additionally, he wasn’t measuring risk as it’s commonly defined in modern finance: the standard deviation of price returns. He took the view that “real” risk is the actual loss of capital.

I became a focus investor because I realized that it’s better to invest more money in my top ideas rather than my 31st idea. Great investment ideas are rare. Buffett himself has said he’s happy if he identifies even two investment ideas per year. Based on my own experience, I can say that I’ve achieved the biggest gains with stock ideas in which I had a high level of conviction and the reward/risk ratio was hugely skewed in my favor. By following a focused investment strategy you allow your winners to control the outcome of your portfolio. This concept was eloquently explained by Frederick K. Martin, in his book Benjamin Graham and the Power of Growth Stocks, where he stated:

“The mathematics of this concept are simple. If you invest $100 each in three stocks and lose everything on two stocks over the next five years but make 10 times your investment on the third stock, your success rate is low, but the portfolio has appreciated from $300 to $1,000, a gain of 333 percent. For a growth company investor, the old saying, ‘let your winners run,’ is particularly appropriate.”

Buffett has also espoused the merits of focus investing when he stated the following:

“You don’t have to be right on everything or 20%, 10% or 5% of businesses. You only have to be right one or two times a year. You can come up with a very profitable decision on a single company. If someone asked me to handicap the 500 companies in the S&P 500, I wouldn’t do a very good job. You only have to be right a few times in your lifetime, as long as you don’t make any big mistakes.”

Simply stated, a focused investing strategy allows you to maximize the benefit from your top investment ideas. The reality is that if you truly want to outperform as an investor, the composition of your portfolio can’t mirror your benchmark. A focused investment strategy allows you to maximize the upside the potential of your portfolio. Based on my own analysis the world’s best investors typically follow some form of focused investment strategy. There is the occasional exception such as Peter Lynch, but by and large, you must follow a focused investment strategy if you truly want to become a great investor.

The risks of focus investing

Clearly, there are many benefits to pursuing a focused investing strategy. However, there are also a number of disadvantages. The biggest risk is that you may pick the wrong stocks. The recent travails of the Sequoia Fund and Valeant Pharmaceuticals represent a cautionary tale about how focus investing can lead to major failure. The Sequoia Fund runs a highly concentrated portfolio with its top 10 holdings comprising about 70% of the total portfolio. In August 2015, Valeant represented almost 30% of the fund’s assets. In the fall of 2015, Valeant came under intense scrutiny for its drug pricing strategies and business practices. I won’t go into the sordid details but the stock is now trading 74% below its 52-week high. Needless to say, the Sequoia Fund massively underperformed the market in 2015 due to its overweight position in Valeant. I’m not debating whether having a 30% stake in Valeant was a prudent decision. My point is to solely highlight that there are material risks to following a focused investment strategy. It’s highly probable that Valeant may come out unscathed. Bill Ackman of Pershing Square Capital, who is also a major shareholder, has recently added to his position and taken a board seat. Clearly, he’s in the stock for the long haul. At a minimum, you need to be able to deal psychologically with the greater volatility that a focused investment strategy entails. As with everything in life not just investing, higher rewards entails greater risks.

Conclusion

Despite the downside risks, I still believe it makes sense to be a focus investor if you have the ability to handle the excess volatility it entails. If you can consistently identify businesses with strong competitive advantages, then you should attempt to maximize the potential return from each investment idea by concentrating your portfolio. Excessive diversification will only lead to mediocre portfolio returns. Focused investing is not for everybody. Only those investors willing to put in the effort to truly research and understand the businesses they are investing in should pursue it. A focused strategy is hard to follow but well worth the effort in terms of the potential to compound your wealth. If you’re on a journey to become an exceptional investor your path will eventually lead you to a focused investment strategy.

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