In the world of investing, we often hear the word diversification. The idea is the more you diversify the less systematic risk you are taking on. And for most individual investors, this makes sense and buying an index fund is a very rational thing to do.
But what if investing is not your full time job and you want to achieve superior returns than the market? Well, there are a few ways for non-professional investors to achieve better returns than the market in my opinion. But the one that makes most sense to me is through focus investing. You can interpret the idea of focus investing differently but to me, focus investing means knowing a small number of companies really well and investing in them when the price is right.
Alan Mecham of Arlington Value Management and David Rofle of Wedgewood Partners are great examples of masters of focus investing. For those of you who are not familiar with Alan Mechem, this article is a good read.
I'm assuming most of the readers have heard of Wedgewood Partners. Their most recent letter to investors is a must read.
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Both Arlington Value Fund and the Wedgewood Partners have beaten the market consistently with lower than market risks. What's remarkable about their process is the simplicity embedded in their systems, which is so rare in the asset management business that when Alan Mecham went to New York to meet with the want-to-know-how hedge fund managers, he left them dumbfounded. "Most people left the room mystified."
Now let’s take a closer look at their investment approach:
Alan Mecham (from the article The 400% Man):
“By his own account, and those of other investors who have vetted his fund, Mecham has no secret sauce or amazing algorithm; what's extraordinary about this young man is how ordinary he is. But his investment approach relies on a handful of common-sense tactics -- focusing on just a few stocks.”
"Mecham says his habits today are roughly the same as they were back when he had $200,000 to invest. He sits in that armchair by the window, carefully reading company filings and other records from atop a giant pile of material that he prints out each day. (Mecham prefers to read only on paper, not online -- old school.)”
“His investment approach will be familiar to anyone who has been even a casual follower of Buffett. Mecham looks for businesses with great long-term prospects, great management, strong cash flow and big defensive "moats," or barriers to entry for potential competitors. And he stresses the importance of sitting still and doing nothing. ‘Activity is the enemy of returns,’ says Mecham. ‘If I find two new ideas a year, that's phenomenal.’ Two ideas a year adds up to a pretty small portfolio -- Mecham typically owns between six and 12 stocks.”
“Mecham is bemused that so many people expect him to hold a broad basket of stocks and follow a benchmark, such as the S&P 500. ‘It's laughable to think that in this competitive world, you're going to find brilliant ideas every day,’ he says. ‘The world's just not set up that way.’”
David Rofle (from the 2013 Q3 Client Letter):
“Often we are asked where we come up with new stock ideas for your portfolio. Our usually response starts off with a disclaimer that as focused investors; we are decidedly not a new idea generating shop. Quite frankly, how many best of breed companies truly exist? 5% of publicly traded companies? Maybe 10%? In addition, it typically requires an outsized investment (great company and compelling valuation) to make its way through our investment due diligence process in order to displace an existing holding. Said another way, our research process is where new ideas go to die.
We seek to own growing businesses that exhibit peer leading profitability, so the longer time frame in which we own our businesses, the more opportunity they have to increase shareholder value. Compounding growth companies are a wonderful thing.
Rising valuations are a particular important risk to our holding period. All else equal, the more profits accounted for today, the less opportunity a business has for future compounding. So, in order to characterize valuation we typically refer to historical and relative price/earnings ratios - as well as include discounted cash flow and/or sum of the parts analysis. “
If you pay attention to the bolded words above, you will notice that focusing on a few ideas is the key to both of their investment processes. The beauty of their processes lies in the simplicity of the system.
You may ask, is this a coincidence? I doubt it. I think it is perfectly rational and reasonable. You see, in order for an investor to achieve better returns, he or she must have an edge whether it is information edge, temperament edge, analytical edge or a combination of them.
As value investors, naturally most of us have some sort of temperament edge, but that itself will not guarantee a better return.
What about analytical edge? Very few people possess analytical edge because the way the education system works. It doesn’t matter where you go to school. The education system inherently and unintentionally creates homogeneous thinking among the students. And you have the herding and social proof biases, which make it so hard to think differently.
That leaves us with information edge. Now you may think it’s impossible to gain an information edge against professional investors. But that’s absolutely not true in my experience. While professional investors have more time, not many of them are spending them on the right things and they have to spread the time among numerous companies. If a non-professional investor has 3 hours a day for him or her to spend on investing, what are the changes that one can generate an information edge if one studies 100 companies a year versus if one only studies 6 - 10 companies a year? You can have a tremendous edge if you focus on a few companies and especially a few small and micro-cap companies. You can also know more about a large cap companies but the knowledge gap will likely to be narrower. And better yet, very often information edge reinforces temperament edge.
And if you combine the temperament edge with the information edge, you will be a two legged man in an ass-kicking contest against a one legged man. You will be a master of focus investing. It’s so beautifully simple yet ironically hard.
Please allow me to use an example to demonstrate my point. Let’s say you have studied McDonald’s extensively (which I think 100 hours is enough) so you know the business really well. Here is the chart of McDonald’s PE during the past 10 years:
If you know the business really well, do you have to be a genius to find out that it’s cheap at 13 time forward earnings? And if you have the right temperament, is it that hard to buy something that you know is cheap? And if you buy it cheap, is it unreasonable that you outperform the market?
The above may sound too easy to be true. Yet I can guarantee only a handful investors can do that. In investing, the simplest thing are often the hardest to do. Think about Buffett’s advice on “starting with the A” or Munger’s “Invert, always invert.” You can teach a child to follow those rules but unfortunately, you can’t teach an adult. And how do I know that? Newton’s First Law of Motion.