In his book, "The Dhandho Investor,"Â Mohnish Pabrai (Trades, Portfolio) suggests the size of our bets in an approach to reap most of the benefits of concentrated allocations. In practice, however, even Pabrai has switched back and forth on his suggestion, finally arriving at a revised methodology that enables him to maximize profits and minimize risk, the classic "heads I win tails I don't lose much" approach he embraces. Here is what he said during a UC-Davis lecture in 2012:
“In hindsight, I think the correct lesson to learn from 2008-2009 was to hold cash. And I didn’t have cash at the time. … I have now gone back to the 10% allocations that I had done for most of my investing career, with the caveat that I always want — except in times of extremely severe distress — to not be fully invested. And so for example, as I talk to you today, I’m sitting on plenty of cash. … It is an interesting market right now. There are very few bargains around, but the bargains we have been able to find are wildly undervalued so it actually lends itself very well to be a concentrated investor. I could not today come up with 20 stocks that I thought were undervalued, but I could easily come up with five or six. … I think the game is just perfect for me to play with a concentrated portfolio and holding cash. So that’s where we are, and I think it’s the way to go. I think (Charlie) Munger always says that a well-diversified portfolio just needs four stocks.”
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The main takeaways from these remarks are the following:
- Cash is king. While on Wall Street there is a very present sense of urgency, disciplined value investors rarely decide to be fully invested, as they commonly wait for a depressed market to fully allocate capital. Having cash at hand, but most importantly, the backup of your investors at market booms is critical. Having an investor base that understands this philosophy and does not suffer every time the neighbor brags about making money allows for opportunities to be seized and maximized when the time is right. Seth Klarman (Trades, Portfolio) not only allocated all resources available but even opened the fund to new capital additions during the 2008-2009 crisis.
- A limited number of ideas carry the freight. The number of great investments that we will find is reduced and limited. However, as Warren Buffett and Munger say, when we encounter great investment ideas they are likely to produce lolapalooza effects, which are compounded effects from different areas: valuation, business, science and psychology. When we think about how far a portfolio can go with concentrated holdings, we could think about what Coca-Cola (KO, Financial) has done for Berkshire or See's Candies. Not only have these proven critical for their success, they also have provided lessons that have helped in creating better investors.
What do you think?
