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Copyright © 2016 by Allen C. Benello, Michael van Biema, Tobias E. Carlisle. All rights reserved.
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Library of Congress Cataloging-in-Publication Data:
Names: Benello, Allen C., author. | Biema, Michael van. | Carlisle, Tobias E., 1979- author.
Title: Concentrated investing : strategies of the world's greatest concentrated value investors / Allen C. Benello, Michael van Biema, Tobias E. Carlisle.
Description: Hoboken : Wiley, 2016. | Includes index.
Identifiers: LCCN 2016002290|
ISBN 9781119012023 (hardback) | ISBN 9781119012054 (ePDF) |
ISBN 9781119012047 (ePub)
Subjects: LCSH: Capitalists and financiers--Biography. | Investments. | Portfolio management.
Classification: LCC HG172.A2 .B454 2016 | DDC 332.6—dc23 LC record available at http://lccn.loc.gov/2016002290
To my wife Julie, and to my daughters Sophie and Avery.
—Allen Carpé Benello
To Lavinia, Fiamma, and Tristan—my earth, my flame, and my hunter.
—Michael van Biema
For Nick, Stell, and Tom.
—Tobias E. Carlisle
Michael and I came up with the idea for this book while riding in a taxi on the way to a meeting with an investment manager. Michael interviews managers of value oriented funds regularly for his fund of funds business, and has met with at least a few hundred during the course of his career. On this particular occasion Michael asked me to come along to help evaluate a new manager, and I agreed to join him in between meetings of my own. As unlikely a place as it was to hatch the inspiration for this project, we were both puzzled by a strange paradox that we had observed over many years in the investment business: The returns generated by investors do not always correlate to their ability to analyze and understand companies.
With the initial idea for a book, and a set of interviews, Michael and I reached out to Bill Falloon at Wiley for help. Bill introduced Michael and me to Tobias Carlisle, the author of two other successful investment books, “Quantitative Value” and “Deep Value.” We found that they shared a very similar set of ideas about investing in general and about the theme for the book, concentrated investing, in particular. We hit it off immediately. Tobias agreed to come on board as a coauthor along with Michael and me. He has been instrumental in helping to take the raw interviews and put the investors and their flagship investments into their proper historical and theoretical context. He also helped to examine the strategy quantitatively to determine the drivers of outperformance: Was it a matter of selecting the right securities, or holding them in the right amounts?
I recall one individual, whom we’ll call Investor Number One, whose returns were decent, but who seemed to be totally off-base when it came to the highly subjective and trickier job of figuring out whether a company’s business and management were fundamentally attractive, or worth skipping over. He had made some notable blunders, on one occasion pounding the table to his colleagues about a soft goods company that was soon destined for bankruptcy. To me and a few others with whom I spoke at the time, it wasn’t difficult to comprehend that this company was not attractive and perhaps even precariously situated, so it left me scratching my head when I read his fund’s performance results, which seemed to have a way of levitating away from what must have been some costly errors.
On the other hand, another acquaintance whom we will call Investor Number Two was deeply insightful when discussing an industry or company and always grasped the investment case, for or against, with enviable precision and knowledge of the relevant facts. This second person’s returns, however, were decidedly lackluster. He somehow never managed to fully capitalize on his insights, which were tremendously valuable and, one would have thought, should have led to very outstanding returns.
This paradox got us thinking about the topics of security analysis and portfolio construction, and how they relate to returns. Apparently, analytical ability alone does not constitute a really good investor. Investor Number Two in the preceding example should have been doing better with his ideas, and just imagine what Investor Number One could have accomplished if he had been more analytically competent.
A lightbulb turned on when I realized the investors I admire the most (and this admiration comes only in part from the amazing success they’ve achieved) tend to share one characteristic: They are concentrated value investors. That is, they adhere to a concentrated approach to portfolio construction, holding a small number of securities as opposed to a broadly diversified portfolio. We set out to study the mathematical and statistical research that has been done by various academics on the subject of portfolio concentration, and to chronicle the methods and achievements of some of the people who have benefited from being concentrated value investors. Our first task was to approach Lou Simpson and Kristian Siem, two ultra-successful concentrated value investors who had never previously agreed to interviews on the mechanics of their investment style. As we completed their interviews, we began to compile material on the subject of portfolio concentration, a trail that ultimately reached back beyond the Kelly Formula to John Maynard Keynes.
In Concentrated Investing: Strategies of the World’s Greatest Concentrated Value Investors, we examine some of the methods these extraordinary individuals employ, providing the reader an insight into how they function and how they have managed to accomplish their returns. However, two very important caveats are necessary. First, concentrated investing is not for everyone. As Glenn Greenberg said, Peter Lynch (manager of the Fidelity Magellan Fund during its most successful period, earning truly amazing average annual returns during his tenure) was anything but a concentrated investor, owning a large number of securities in the fund. Furthermore, concentrated investing should only be undertaken by people who are prepared to do intensive research and analysis on their investments. People outside of the investment profession usually don’t have the time to do this, and are far better off with an index fund or finding a competent investment manager— preferably one who employs a focused approach.
The second caveat is more important, and applies to investment professionals and non-professionals alike (perhaps even more to professionals). It is summed up in an insightful and humbling quote from legendary martial artist Bruce Lee, which is as follows:
A goal is not always meant to be reached, it often serves simply as something to aim at.
Coming from one of the most disciplined and exacting athletes in the history of martial arts, this statement is illuminating. One can hardly imagine Bruce Lee trying to break a two-by-four with his fist and accepting, after a failed attempt, that this goal was not reachable. Evidently, beneath his hard-driving exterior, there was a more philosophical side. Similarly, in the context of this book, our intention is not to show that the great individuals profiled in the following chapters constitute the standard against which one should hold oneself, but to provide a road map with some concrete ideas on how to be a better investor. Not everyone should attempt to replicate their style or accomplishments. Rather, these profiles are a guidepost on the journey to successful investing.
With these caveats, we do believe that the average enterprising investor with the ability to perform in-depth fundamental analysis will be better off trimming the number of investments they hold and redistributing their capital into their top 10 or 15 ideas. To quote Bruce Lee a second time:
The successful warrior is the average man, with laser-like focus.
—Allen Carpé Benello
This book would not have been possible without the generous facilitation and support of Louis A. Simpson. In addition, we are the beneficiaries of a great deal of assistance in the production of the manuscript for Concentrated Investing. We’d like to thank the interviewees Lou Simpson, Charlie Munger, Kristian Siem, Glenn Greenberg, and Jim Gordon. Finally, we appreciate the assistance of the team at Wiley Finance, most especially Bill Falloon, Susan Cerra, and Meg Freeborn, who provided guidance and advice along the way.
Conscientious employment, and a very good mind, will outperform a brilliant mind that doesn’t know its own limits.
—Charlie Munger1
Concentration value investing is a little-known method of portfolio construction used by famous value investors Warren Buffett, Charlie Munger, long-time Berkshire Hathaway lieutenant Lou Simpson, and others profiled in this book to generate outsized returns. A controversial subject, the idea of portfolio concentration has been championed by Buffett and Munger for years, although it moves in and out of fashion with rising and falling markets. When times are good, portfolio concentration is popular because it magnifies gains; when times are bad, it’s often abandoned—after the fact—because it magnifies volatility. Concentration has been out of favor since 2008, when investment managers began in earnest to avoid what they perceive as a risky business practice.
It is time to re-visit the subject of bet sizing and portfolio concentration as a means to achieve superior long-term investment results. We will start by examining some of the academic research on concentration versus diversification on long-term investment results. One central feature of the discussion surrounding concentration is the Kelly Formula, which provides a mathematical framework for maximizing returns by calculating the position size for a given investment within a portfolio using probability (i.e., the chance of winning versus losing) and risk versus reward (i.e., the potential gain versus the potential loss) as variables. The Holy Grail for any investor is a security with a high probability of winning and also a large potential gain compared to the potential loss. Given favorable inputs, the Kelly Formula can produce surprisingly large position sizes, far larger than the typical position size found in mutual funds or other actively managed investment products. In addition, some academic studies point to the diminishing advantages of portfolio diversification above a surprisingly small number of individual investments, provided each investment is adequately diversified (no overlapping industries, etc.). Also, portfolios with a relatively smaller number of securities (10 to 15) will produce results that vary greatly from the results of a given broadly diversified index. To the extent that investors seek to outperform an index, smaller portfolios can facilitate that goal, although concentration can be a double-edged sword.
Investors can employ the traditional value investing methodology of fundamental security analysis to identify potential investments with favorable Kelly Formula inputs (a high probability of winning, and a high risk/reward relationship), in order to maximize the chances of significant outperformance, as opposed to significant underperformance, with a concentrated portfolio.
We have unparalleled access to investors in Warren Buffett’s inner circle. Interviews with several highly successful investors who have achieved their success employing a concentrated approach to portfolio management over the long term (at least 10 to 30 years) will be incorporated throughout this book. One common feature of these investors is that they have had permanent sources of capital, which has changed their behavior by allowing them to endure greater volatility in their returns. Most people seek to avoid volatility in general because they perceive increased variance as an increase in risk. The investors we examine, however, tend to be variance seekers. At the same time, however, they are able to produce returns with low downside volatility compared to the underlying markets in which they invest.
This book profiles eight investors with differing takes on the concentration investment style. The investors and the endowment interviewed are contemporary. One of the investors profiled, Maynard Keynes, is now a historical figure, but was the early adopter of many of the ideas that came to be held by his successors. The purpose of the book is to tease out the principles that have resulted in their remarkable returns. Though they operated through different periods of time, all have compounded their portfolios in the mid-to-high teens over very long periods—defined as more than 20 years. The investors in this book are rare in that they all have either permanent or semi-permanent sources of capital. We hypothesize that this is an important factor in allowing them to practice their focused style of investment. The book also puts forward a mathematical framework, the Kelly Criterion, for sizing investment “bets” within a portfolio. The conclusion of both the profiles of these great investors and of the Kelly Criterion is remarkably coincident.
Modern portfolio theory would have us believe that markets are efficient and that attempts to beat market performance are both foolhardy and expensive in terms of return. Yet the fact remains that there is at least a small cadre of active managers who have beaten the market by a significant margin over prolonged periods. This book and the investors profiled in it agree with the proponents of efficient market theory on two points:
In other words, it requires a lot of hard work and a significant amount of knowledge to produce market-beating returns. If you do not have this, it is to your benefit to diversify and index. If, however, you possess knowledge and the capability for hard work as well as a few other characteristics outlined in the book, it is to your benefit to focus your energies on a small number of investments. The degree of focus is a stylistic choice and cannot be prescribed for any given individual, but the investors in this book concentrate on anywhere from 5 to 20 individual securities. The larger the number, the more the benefits of diversification, the lower the volatility of the portfolio, but also, in most cases, the lower the long-term returns. The trade-off between larger bets and more volatility is an individual choice, but both the Kelly Formula and the participants in the book point to the advantages of larger bets and more concentrated portfolios. In fact, the reader will probably be quite surprised by how large the bets can be calculated to be. Once again, placing bets of significant size depends on appropriately skewed probabilities, and these types of probabilities are uncommon, but both the mathematics and the investors argue for large bets when situations with unusual risk/return arise. It is important to note that the risk referred to here is the risk of permanent loss of capital and not the more commonly used academic metric of volatility. The investors in this book are willing to suffer through periods of temporary (but significant) loss of capital in an attempt to find opportunities where the probability of the permanent loss of capital is small. In other words, they attempt to find situations that offer a strong margin of safety where one’s principal is protected either by assets or by a strong franchise and an unlevered balance sheet.
The investors in this book come from very different backgrounds ranging from an English major to an economist, but somehow they ended up in quite similar places in terms of their general investment philosophy. The singular trait that unites these investors, and separates this group from the herd of investors who try their luck on the stock market is temperament. Asked in 2011 whether intelligence or discipline was more important for successful investors, Buffett responded that temperament is key:2
The good news I can tell you is that to be a great investor you don’t have to have a terrific IQ. If you’ve got 160 IQ, sell 30 points to somebody else because you won’t need it in investing. What you do need is the right temperament. You need to be able to detach yourself from the views of others or the opinions of others.
You need to be able to look at the facts about a business, about an industry, and evaluate a business unaffected by what other people think. That is very difficult for most people. Most people have, sometimes, a herd mentality, which can, under certain circumstances, develop into delusional behavior. You saw that in the Internet craze and so on.
. . .
The ones that have the edge are the ones who really have the temperament to look at a business, look at an industry and not care what the person next to them thinks about it, not care what they read about it in the newspaper, not care what they hear about it on the television, not listen to people who say, “This is going to happen,” or, “That’s going to happen.” You have to come to your own conclusions, and you have to do it based on facts that are available. If you don’t have enough facts to reach a conclusion, you forget it. You go on to the next one. You have to also have the willingness to walk away from things that other people think are very simple. A lot of people don’t have that. I don’t know why it is. I’ve been asked a lot of times whether that was something that you’re born with or something you learn. I’m not sure I know the answer. Temperament’s important.
Munger says of Buffett’s theory:3
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.
In the next chapter we meet Lou Simpson, the man Warren Buffett has described as “one of the investment greats.”4