I buy very few stocks. Right now, 65% of my portfolio is in two stocks (Frost and BWXT). And 30% of my portfolio is in cash. So I’m less fully invested than most investors want to be. And I’m less diversified than most investors want to be.
Why is that?
Most people who email me asking about the subject of concentration – and that’s the topic I get asked about the most – assume I put so much of my account into my best ideas because they offer the highest returns.
They imagine I do a calculation where stock A offers 10% annual returns, stock B offers 15% annual returns, stock C offers 20% annual returns, and stock D offers 25% annual returns. The typical value investor would then put equal amounts into stocks B, C, and D because they all clearly offer above average returns. Meanwhile, I choose to only buy stock D – because that way I avoid watering down my returns.
That’s not why I concentrate.
To understand why I concentrate, think of a horse race.
We can ask two questions about a horse race.
Question #1: Which horse is likely to win this race?
Question #2: Which horse offers the best odds?
If you were forced to bet on a single horse race, only the answer to question #2 should drive your decision. You don’t need to know who the favorite is. If the favorite pays 6 to 5 and you know his likelihood of winning isn’t high enough to justify such a low payout, you shouldn’t bet him. Meanwhile, if you find a horse that pays 20 to 1 and you know he should be priced at 5 to 1, you should bet that horse even though you know he has a low probability of winning the race.
This horse race approach translates well to the stock market if we are talking about simple, special situations. It works perfectly for things like merger arbitrage.
It doesn’t work for buy and hold.
To understand why not – consider the difference between the decision to buy a race horse and the decision to bet on that same race horse.
What’s the big difference in your analysis?
I would say the huge difference is evaluating the possible payouts. It’s easy to bet a horse in a specific race based on the odds – because we have a good understanding of the possible payout for each and every horse. It’s hard to know which horse to buy based on the odds – that is, to intentionally buy a lesser horse because he’s cheap enough to offset his lower quality – because it’s hard to know how big the lifetime payout from racing and breeding a really great horse would be.
Let me illustrate this point with two stocks I’m on the record picking back in 2006. I made these picks about 10.5 years ago. I didn’t intend them to be buy and hold picks. Certainly, I never imagined someone would calculate the performance of those picks over more than a decade. But that’s exactly what I’m going to do now.
One pick was Posco. The other was Hanesbrands. Hanesbrands was a spin-off. So, I’ll use that spin-off date as a convenient measuring point for both. In the 10.5 years since that day, Hanesbrands has returned 15.5% a year. Posco stock has returned 0.3% a year in dollar terms (it’s a Korean stock). That means an initial investment of $10,000 in Posco has now become $10,291. And an initial investment of $10,000 in Hanesbrands has now become $45,406.
Hanesbrands is not some sort of phenomenal growth company. And 10 years is hardly a lifetime. For example, the difference between buying $10,000 worth of Omnicom (OMC, Financial) in 1997 or its ad agency rival Interpublic (IPG) and holding that stock for the next 20 years is the difference between now having $15,570 in Interpublic stock or having $74,629 in Omnicom stock.
The payouts for holding the right stock – not buying it, but actually holding it – are so big that it’s often difficult to believe the retrospective “fair value” for a stock. In the Omnicom example I just gave, a backwards look now shows that Omnicom needed to trade at a P/E ratio that would seem absurd for it to return the same amount as the S&P 500 over the next 20 years. In the years 1996 through 1998, Omnicom tended to trade at a P/E no lower than 20 and no higher than 40. That sounds expensive. The highest priced day I can find for the stock in those years was August 21st, 1998. Let’s say you bought Omnicom on August 21st, 1998 and held it through today. What would your annual return be? Over the next 19 years, your annual return would be 6%. But, that’s buying a high P/E stock on the most expensive day of its most expensive year. What did the S&P 500 do since that same day? The market has done 4% a year over those 19 years since August of 1998.
What does this prove? I found a stock I knew was a long-term winner. Then, I went back in time and tried to find the worst possible time to buy that stock. Even so, it outperformed the market if held long enough.
That last phrase “if held long enough” is key. It’s not hard to find points where a winner’s high price was enough to cause it to underperform the stock market. For example, Omnicom has done worse than the market over the last 5 years. If you hold a winner long enough, though, it becomes difficult to find any points where buying it would cause you to lag the market.
I’m not saying you should pay 30 times earnings for a heavy favorite. True, if you pick the right business – a true long-term winner – at a P/E of 30 and hold it forever, it will eventually beat the market. But, that still seems a bad bet to me.
What’s a good bet?
“Companies such as Coca-Cola and Gillette might well be labeled ‘The Inevitables.’ Forecasters may differ a bit in their predictions of exactly how much soft drink or shaving-equipment business these companies will be doing in ten or twenty years. Nor is our talk of inevitability meant to play down the vital work that these companies must continue to carry out, in such areas as manufacturing, distribution, packaging and product innovation. In the end, however, no sensible observer - not even these companies' most vigorous competitors, assuming they are assessing the matter honestly - questions that Coke and Gillette will dominate their fields worldwide for an investment lifetime. Indeed, their dominance will probably strengthen. Both companies have significantly expanded their already huge shares of market during the past ten years, and all signs point to their repeating that performance in the next decade.”
Once you’ve identified a true long-term favorite, pick the right time to buy it.
In other words, don’t start by saying “I have to buy a stock today, which stock offers the best odds right now?” Instead, say “I have to buy a long-term favorite eventually, is today the right day to buy one?”
If you insist on buying something today, you can’t also insist on buying the right merchandise. And if you insist on buying the right merchandise, you can’t also insist on buying something today. Something will always be on sale. And the best merchandise will one day be on sale. But, you can either start by saying “I want to buy something today” or you can start by saying “I want to buy the right stock eventually”.
The frequency with which you insist on adding a new stock to your portfolio is actually a constraint on your ability to add top-shelf merchandise to your collection.
There are 3 ways an investor can compromise:
- He can compromise by paying a higher price than he’d like to
- He can compromise by buying a lesser quality business than he’d like to
- He can compromise by not buying anything when he’d rather own something
You could use these 3 compromises as a test of what kind of investor you are.
A growth investor – like Phil Fisher – compromises by paying a higher price than he’d like. He won’t compromise on quality. So, he has to compromise on price. A value investor – like Ben Graham – compromises by purchasing a lower quality business than he’d like. He won’t compromise on price. So, he has to comprise on quality. Finally, a focus investor – like me – compromises by not owning any stock when he’d much rather be 100% invested.
I always want to be 100% invested. But, if you insist on two criteria:
- Never compromise on quality
- Never compromise on price
You have to compromise on:
- Never being as fully invested as you’d like
- Never being as diversified as you’d like
That’s a natural consequence of there being few chances to buy high quality at a low price.
Let’s assume you are willing to stress “patience” and “focus” over “value” and “growth”. You will sometimes buy the same stocks a growth investor would or a value investor would. However, if you stay true to your patient, focused approach – you should end up owning better businesses than the value investor and buying them at lower prices than the growth investor. The trade-off for you will be holding some cash at times and holding more of each stock than you might want. A patient, focused investor simply can’t make enough decisions to own enough stocks to be well-diversified all the time.
So, how can you implement such a strategy? How do you start looking for “inevitables”?
One, you look for the right industries. Some industries are more likely to produce long-term winners than other industries. For a patient, focused investor looking for long-term compounders to buy and hold – I’ve got 5 industries to recommend searching in right now:
- U.S. banks
- Advertising agencies
- MRO distributors
- Athletic apparel brands
- Travel websites
Let’s start with U.S. banks. I’ve written reports about 5 of them:
- Frost (CFR, Financial) – which I have 40% of my portfolio in
- Bank of Hawaii (BOH)
- Prosperity (PB)
- BOK Financial (BOKF)
- Commerce Bancshares (CBSH)
I was recently asked in an interview why I liked Frost. My answer explains why U.S. banks as a group are a good place to find long-term compounders:
“The deposit side of banking is…as non-commodity and non-competitive as a business gets. Customer retention is very high in this industry. For example, Frost retains about 92% of customers from year-to-year…And unlike insurers, banks tend not to have problems retaining customers even when they offer interest rates that are clearly lower than their cross-town rivals. I think a bank can ‘lose’ an existing depositor to another bank. I’m not sure a bank can ‘take’ an existing depositor from another bank. A satisfied depositor never really enters ‘search mode’, so they aren’t going to be stolen away as long as the bank they’re at treats them right. Deposit share shifts are glacial and close to infinitesimal even when one bank clearly has a better service than another bank. So, the deposit side of U.S. banking just isn’t a competitive industry. Banks keep the depositors they have out of habit and those depositors add to their accounts every year. That’s where almost all growth comes from. And it’s not growth banks have to compete for.”
This same dynamic – extremely high customer retention – helps explain why I also like ad agencies (which have even higher retention rates than banks do with their depositors) and MRO distributors.
The big ad agencies are:
But, there are many other publicly traded ad companies around the world that you can find.
The 3 MRO distributors you should start with are:
I’ve written reports about Grainger and MSC. Fastenal is also good. It just wasn’t cheap when I was writing my newsletter.
Athletic apparel brands have proven to be amazing long-term compounders. Lou Simpson (Trades, Portfolio), the former portfolio manager at GEICO, liked Nike (NKE) best of all the stocks he owned over the years.
Four athletic apparel brands stand out right now:
- Under Armour
On price – EV/Sales is usually how you should value a durable brand – Under Armour is the most interesting right now. The company’s non-voting C shares (they trade under the ticker UA – not UAA) are usually the cheapest way to invest in Under Armour. So, if you ever do buy into that company – buy the shares with the UA ticker not the UAA ticker.
There are a bunch of publicly traded travel websites out there like:
Priceline – which really consists of Booking.com as its key asset – is the company that seems to have the most certain long-term future. These companies are spending a lot on ads, developing apps, etc. There are signs of customer loyalty – simply out of habit – and network effects developing in this industry. Meanwhile, the proportion of hotel rooms booked online (which are now less than half of all rooms in the world) seems certain to double in the next decade or two. How many industries are likely to more than double in size relative to the global economy over the next decade or two? And how many of those industries are likely to have the same leaders in a decade or two as they do today?
So, now you’ve found some industries you think are clear long-term favorites. Maybe within those industries you’ve even found the specific companies you think are long-term favorites.
What do you do?
If you are sure these industries are better than average and these companies are better than average – you can buy the stock you like most on a very simple valuation basis. When the stock you like trades at the kind of price a “normal” stock usually trades for – buy it.
So, if a normal stock usually trades for 15 times earnings – wait till the stock you like gets close to that level (precision isn’t important here) and then pounce. It rarely happens. Most of the time, you’ll find there’s nothing to buy. But, if you have your list ahead of time and you don’t settle for buying lesser stocks now – you will have the cash on hand to buy the right stock at the right price.
Just not today.
Disclosure: Long CFR