FOCUSED-VALUE

Focused-Value Investing is summarized as follows:

• Invest only in a few companies
• Invest in businesses that you understand, where you can analyze the risk
• Invest when the potential return is very high
• Invest when the risk of permanent loss is low
• Patiently wait for great opportunities, buy great businesses
• Do not lower your standards by investing in marginal opportunities

  "If you took out our 15 best ideas, most of you wouldn't be here.”
  -Charles T. Munger (2001 Berkshire Hathaway Shareholder Meeting)

Focused-Value is a style of investment management utilized by a list of very impressive investors.  The list includes:

• Warren Buffett
• Charlie Munger
• John Maynard Keynes
• Lou Simpson
• Joel Greenblatt
• Edward Lampert

The idea of an entire portfolio that consists of less than 10 companies is in complete contrast to popular opinion regarding “appropriate diversification.”   As a result, a difference of opinion exists in regards to the merits (and risk) of a focused portfolio compared to that of a diversified portfolio.  The first group, the Financial Community (popular opinion) defines a prudent portfolio as one that holds a large number different companies spread across many industries, many different market caps, many different countries, etc . . .  The second group, the Focused-Value Investors (which includes the aforementioned list) believe a prudent portfolio consists of merely a small number of highly attractive companies.  

"The whole concept of dividing it up into 'value' and 'growth' strikes me as twaddle. It's convenient for a bunch of pension fund consultants to get fees prattling about and a way for one advisor to distinguish himself from another. But, to me, all intelligent investing is value investing." - Charlie Munger

Both arguments carry some merit in theory, though the track record (performance) of the two groups is very different. 

The first group:

The financial community (popular opinion), in aggregate, has failed to provide net value through the “conventional” methods of portfolio management.    The basis for the prior comment is the very high percentage (roughly 85-90% depending on the year) of managers that fail to deliver performance net of fees that outperform the fund’s underlying index.

"Of the 2,692 diversified stock mutual funds tracked by Lipper Analytical Services, only 134 have beaten the S&P 500 this year."
  - USA Today; June 18, 1998

This is not a group working with a high success rate.  If our Medical Community was wrong 85% of the time, I think we would stop listening to them.  There is no professional group that has made more money providing less value over an extended period of time than the financial community.  It is not even close. 

The second group:

Focused-Value Investors

Warren Buffett (1957-1969)	30.40% per year
DJIA Index (1957-1969)	8.60% per year
“We adopted a strategy that required our being smart - and not too smart at that - only a very few times. Indeed, we'll now settle for one good idea a year. (Charlie says it's my turn.)" – Warren Buffett
Charles Munger (1962-1975)	24.30 % per year
DJIA Index (1962-1975)	6.40% per year
"It's not given to human beings to have such talent that they can just know everything all the time. But it is given to human beings who work hard at it – who look and sift the world for a mispriced bet – that they can occasionally find one. And the wise ones bet keenly when the world offers that opportunity. They bet big when they have the odds. And the rest of the time, they don't. It's just that simple." – Charles Munger
John Maynard Keynes (1928-1945)	13.20% per year
UK Market Index (1928-1945)	-0.50% per year
“As time goes on, I get more and more convinced that the right method of investment is to put fairly large sums into enterprises which one thinks one knows something about and in the management of which one thoroughly believes. It is a mistake to think that one limits one’s risk by spreading too much between enterprises about which one knows little and has no reason for special confidence. One’s knowledge and experience are definitely limited and there are seldom more than two or three enterprises at any given time in which I personally feel myself entitled to put full confidence.” – John Maynard Keynes
Lou Simpson (1980-1996)	24.70% per year
S&P 500 Index (1980-1996)	17.80% per year
“An investor is not likely to obtain superior results by buying a broad cross section of the market. The more diversification, the more performance is likely to be average at best. We concentrate our holdings in a few companies that meet our investment criteria. Good investment ideas – that is, companies that meet our criteria are difficult to find.” – Lou Simpson
Edward Lampert (1988-2005)	29.00% per year
S&P 500 Index (1988-2005)	11.80% per year
“I started my firm in 1988 and began investing. I was inspired by Warren Buffett’s letters while still working on the Arbitrage desk at Goldman Sachs.  We consider ourselves ‘Aggressive Conservative’ investors” – Edward Lampert
Joel Greenblatt (1985-2005)	40.00% per year
S&P 500 Index (1985-2005)	12.65% per year
“There is no sense diluting your best ideas or situations by continuing to work your way down a list of attractive opportunities . . . If your goal is to do significantly better than average . . . then picking your spots is the way to go. The penalty you pay for having a focused portfolio - a slight increase in potential annual volatility - should be far outweighed by your increased long-term returns..” – Joel Greenblatt

 

How is it that conventional wisdom can be so statistically wrong?  Maybe this is what John Maynard Keynes meant when he said:

“The difficulty lies, not in the new ideas, but in escaping the old ones, which ramify, for those brought up as most of us have been, into every corner of our minds."

In my opinion this difference of opinion (between the financial community and the Focus Investors) is a matter of compensation structure and as a result, perspective on risk.   A key difference between the Focus Investors and the “Financial Community” has traditionally been their compensation structure.  In general,

The Focus Investors have been compensated on an incentive basis (% of the profits)
The Financial Community, as asset-based managers are compensated based on retention (% of assets)

The message of the Financial Community to its clients is “broad diversification.”  To evaluate the quality of a message one should view the situation from the eyes of the messenger.  Conventional wisdom regarding diversification has been delivered by a financial community dominated by asset-based managers.  An asset-based manager earns a percentage of the assets under management.  Although portfolio performance does contribute indirectly to the profits of an asset-based manager, the direct (primary) driver of compensation is its ability to retain assets.  A manager whose compensation is driven by asset retention defines risk differently than an investor does.  Having spent 10 years as asset-based manager, I can safely say that the number one goal of an asset-based manager is to avoid portfolio volatility. 

Volatility (fluctuation in account value) poses the greatest risk to an asset-based manager’s ability to retain assets, especially if the volatility is accompanied by significant underperformance (what an auditor would call “material” underperformance).  Slight underperformance generally will not impact the asset-based manager’s compensation.  Clients historically follow the path of least resistance and will not typically sever a relationship unless a manager has materially underperformed.  A volatile portfolio is virtually guaranteed to have periods of material underperformance.   The assets are most certainly at risk to leave during the down periods (the periods of underperformance).  Why would an asset-based manager structure a portfolio that is certain to have periods of material underperformance?  It is simply a bad business decision.   The most reliable way for a manager to avoid portfolio volatility is to diversify it away.  

Diversification reduces the volatility of the portfolio which reduces the advisor’s risk of losing assets.  Hence the message of diversification is delivered.  The trouble is, this message of diversification is defined from the perspective of the advisor not the client.  Much like the doctor who responds to a patient’s question: “Is it safe for me to eat peanuts?” with the answer: “No, I’m allergic to peanuts.”   The question becomes, who really benefits from conventional wisdom regarding an appropriate level of diversification, the client or the advisor?  In my opinion, it is the advisor. 

 

Jason C. Norbeck, CFA
Managing Partner
JCN Investments, LLC