Focus Investing: The Warren Buffett Way

by | Jun 26, 2006

An excerpt from The Warren Buffett Way, Second Edition by Robert G. Hagstrom. Status Quo: A Choice of Two The current state of portfolio management, as practiced by everyone else, appears to be locked into a tug-of-war between two competing strategies — active portfolio management and index investing. Active portfolio managers are constantly at work […]

An excerpt from The Warren Buffett Way, Second Edition by Robert G. Hagstrom.

Status Quo: A Choice of Two

The current state of portfolio management, as practiced by everyone else, appears to be locked into a tug-of-war between two competing strategies — active portfolio management and index investing.

Active portfolio managers are constantly at work buying and selling a great number of common stocks. Their job is to try to keep their clients satisfied. That means consistently outperforming the market so that on any given day should a client apply the obvious measuring stick — how is my portfolio doing compared with the market overall — the answer will be positive and the client will leave her money in the fund. To keep on top, active managers try to predict what will happen with stocks in the coming six months and continually churn the portfolio, hoping to take advantage of their predictions.

Index investing, on the other hand, is a buy-and-hold passive approach. It involves assembling, and then holding, a broadly diversified portfolio of common stocks deliberately designed to mimic the behavior of a specific benchmark index, such as the Standard & Poor’s 500. The simplest and by far the most common way to achieve this is through an indexed mutual fund.

Proponents of both approaches have long waged combat to prove which one will ultimately yield the higher investment return.

Active portfolio managers argue that, by virtue of their superior stock-picking skills, they can do better than any index. Index strategists, for their part, have recent history on their side. In a study that tracked results in a twenty-year period, from 1977 through 1997, the percentage number of equity mutual funds that have been able to beat the Standard & Poor’s 500 Index dropped dramatically, from 50 percent in the early years to barely 25 percent in the final four years. And as of November 1998, 90 percent of actively managed funds were underperforming the market (averaging 14 percent lower than the S&P 500), which means that only 10 percent were doing better.

Active portfolio management as commonly practiced today stands a very small chance of outperforming the index. For one thing, it is grounded in a very shaky premise: Buy today whatever we predict can be sold soon at a profit, regardless of what it is. The fatal flaw in that logic is that given the complexity of the financial universe, predictions are impossible. Second, this high level of activity comes with transaction costs that diminish the net returns to investors. When we factor in these costs, it becomes apparent that the active money management business has created its own downfall.

Indexing, because it does not trigger equivalent expenses, is better than actively managed portfolios in many respects. But even the best index fund, operating at its peak, will only net you exactly the returns of the overall market. Index investors can do no worse than the market, and also no better.

Intelligent investors must ask themselves: Am I satisfied with average? Can I do better?

A New Choice

Given a choice between active and index approaches, Warren Buffett would unhesitatingly pick indexing. This is especially true for investors with a very low tolerance for risk, and for people who know very little about the economics of a business but still want to participate in the long-term benefits of investing in common stocks.

“By periodically investing in an index fund,” he says in inimitable Buffett style, “the know-nothing investor can actually outperform most investment professionals.” Buffett, however, would be quick to point out that there is a third alternative — a very different kind of active portfolio strategy that significantly increases the odds of beating the index. That alternative is focus investing.

Focus Investing: The Big Picture

Reduced to its essence, focus investing means this: Choose a few stocks that are likely to produce above-average returns over the long haul, concentrate the bulk of your investments in those stocks, and have the fortitude to hold steady during any short-term market gyrations.

The following sections describe the separate elements in the process.

“Find Outstanding Companies”

Over the years, Warren Buffett has developed a way of determining which companies are worthy places to put his money; it rests on a notion of great common sense: If the company is doing well and is managed by smart people, eventually its stock price will reflect its inherent value. Buffett thus devotes most of his attention not to tracking share price but to analyzing the economics of the underlying business and assessing its management.

The Buffett tenets, described in earlier chapters, can be thought of as 4, a kind of tool belt. Each tenet is one analytical tool, and in the aggregate they provide a method for isolating the companies with the best chance for high economic returns. Buffett uses his tool belt to find companies with a long history of superior performance and a stable management, and that stability means they have a high probability of performing in the future as they have in the past. And that is the heart of focus investing: concentrating your investments in companies with the highest probability of above-average performance.

“Less Is More”

Remember Buffett’s advice to a know-nothing investor — to stay with index funds? What is more interesting for our purposes is what he said next:

“If you are a know-something investor, able to understand business economics and to find five to ten sensibly priced companies that possess important long-term competitive advantages, conventional diversification (broadly based active portfolios) makes no sense for you.”

What’s wrong with conventional diversification? For one thing, it greatly increases the chances that you will buy something you don’t know enough about. Philip Fisher, who was known for his focus portfolios, although he didn’t use the term, profoundly influenced Buffett’s thinking in this area. Fisher always said he preferred owning a small number of outstanding companies that he understood well to a large number of average ones, many of which he understood poorly.

“Know-something” investors, applying the Buffett tenets, would do better to focus their attention on just a few companies. How many is a few? Even the high priests of modern finance have discovered that, on average, just fifteen stocks gives you 85 percent diversification. For the average investor, a legitimate case can be made for ten to twenty. Focus investing falls apart if it is applied to a large portfolio with dozens of stocks.

*endnotes have been omitted. Copyright

Robert G. Hagstrom is Senior Vice President and Director of Legg Mason Focus Capital. He has authored the New York Times best-selling The Warren Buffett Way and The Warren Buffett Portfolio, as well as The Nascar Way. He lives with his family in Wayne, Pennsylvania.

The views expressed above represent those of the author and do not necessarily represent the views of the editors and publishers of Capitalism Magazine. Capitalism Magazine sometimes publishes articles we disagree with because we think the article provides information, or a contrasting point of view, that may be of value to our readers.

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