Concentrated Investing

1. Concentrated investing requires exceptional temperament and conviction

"You need to be able to look at the facts about a business, about an industry, and evaluate a business unaffected by what other people think. That is very difficult for most people."

Emotional discipline is key. Successful concentrated investors like Warren Buffett, Charlie Munger, and Lou Simpson share a rare temperament that allows them to:

• Think independently and avoid herd mentality
• Make decisions based solely on facts and thorough analysis
• Ignore short-term market fluctuations and media noise
• Maintain conviction in the face of criticism or temporary losses

This temperament enables them to hold a small number of positions with high conviction, often for many years. It requires the ability to detach oneself from popular opinion and withstand periods of underperformance or volatility. Most investors lack this level of emotional discipline, leading them to diversify excessively or trade too frequently.

2. Successful investors focus on a few high-quality businesses they understand deeply

"As time goes on, I get more and more convinced that the right method in 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."

Quality over quantity. The investors profiled in this book share a common approach:

• Concentrate on 5-15 positions rather than diversifying broadly
• Seek businesses with sustainable competitive advantages
• Develop deep knowledge of a company's economics, industry, and management
• Hold positions for years or decades, allowing compounding to work

This focused approach allows investors to develop true expertise in their holdings and profit from their best ideas. It contrasts sharply with the typical institutional approach of holding hundreds of positions. By limiting themselves to their highest-conviction ideas, these investors aim to outperform the market significantly over long periods.

3. Permanent capital enables long-term, contrarian thinking

"Industry, by nature, is long term, and the fund management business, by nature, is short term."

Patient capital is powerful. Having a stable, permanent capital base allows concentrated investors to:

• Take a truly long-term view, often 5-10 years or more
• Ignore short-term market fluctuations and volatility
• Buy aggressively when others are fearful
• Hold through temporary declines without facing redemptions

Many of the profiled investors, like Warren Buffett with Berkshire Hathaway or Joe Rosenfield with Grinnell College's endowment, had permanent capital structures. This enabled them to be greedy when others were fearful and maintain concentrated positions even during market turmoil. In contrast, most fund managers face pressure to show short-term results and avoid significant drawdowns, leading to more diversified portfolios and shorter holding periods.

4. The Kelly Criterion provides a mathematical framework for position sizing

"Berkshire-style investors tend to be less diversified than other people. The academics have done a terrible disservice to intelligent investors by glorifying the idea of diversification."

Optimal betting for long-term growth. The Kelly Criterion, developed by John Kelly in 1956, offers a mathematical approach to determine optimal position sizes:

• Considers both probability of success and potential payoff
• Maximizes long-term compound growth rate
• Often suggests larger position sizes than traditional portfolio theory

Key points about Kelly betting for investors:

• Requires accurate assessment of probabilities and potential returns
• Can lead to very large bets when odds are highly favorable
• Never risks entire bankroll, unlike "bet it all" strategies
• Half-Kelly (betting half the suggested amount) reduces volatility with modest return reduction

While few investors explicitly use Kelly calculations, many successful concentrated investors like Warren Buffett have intuitively followed similar principles. The criterion provides a theoretical foundation for why concentration can lead to superior long-term results when an investor has genuine edge.

5. Value investors seek a margin of safety through business quality or price

"The trick is to get more quality than you pay for in price. It's just that simple."

Two paths to value. Concentrated value investors generally seek a margin of safety through one of two primary approaches:

1. High-quality businesses at fair prices
   • Focus on sustainable competitive advantages
   • Willing to pay higher multiples for superior economics
   • Examples: Buffett's Coca-Cola, Munger's See's Candies
2. Average businesses at very low prices
   • Seek significant discount to intrinsic value
   • Often more short-term, catalyst-driven approach
   • Examples: Early Graham-style "cigar butt" investing

Most of the profiled investors evolved toward the quality-focused approach over time. They found that great businesses compound value for decades, while cheap mediocre businesses often remain cheap. Both styles can work, but require different skillsets and temperaments.

6. Concentration amplifies returns but requires thorough research and strong nerves

"As a concentrated investor, you had 'better really know what you're talking about.'"

High stakes demand deep diligence. Concentrated portfolios magnify both gains and losses, requiring:

• Extremely thorough research and analysis
• Constant monitoring of existing positions
• Emotional fortitude to withstand volatility
• Willingness to admit and correct mistakes quickly

Concentrated investors like Glenn Greenberg typically spend months researching potential investments before taking large positions. They develop deep industry expertise and often speak directly with management, competitors, and industry experts. This level of diligence provides the conviction needed to maintain large positions through market turbulence and negative headlines.

7. Great investors continuously learn and adapt their approach over decades

"The secret of [Munger, Buffett, and Simpson's] investment records is not the one people would ordinarily draw. In other words, they would not have been as good as they were except for the continuous learning that made each protagonist better and better as the decades rolled on."

Evolving edge in a changing world. The most successful investors profiled share a commitment to lifelong learning and adaptation:

• Started with different approaches (e.g., Graham-style deep value)
• Evolved to focus more on business quality and long-term compounding
• Expanded circle of competence into new industries over time
• Adjusted to changing market dynamics and competition

Examples of evolution:

• Buffett shifting from "cigar butts" to great businesses at fair prices
• Munger's influence in emphasizing quality over pure cheapness
• Keynes abandoning market timing for long-term fundamental investing

This willingness to learn and adapt allowed these investors to maintain their edge even as markets became more efficient and competitive over time.

8. Free cash flow yield and capital allocation are crucial valuation considerations

"The absolute best thing would be a business like Freddie Mac where all the money they generate every year was free cash flow but they have an investment opportunity that is very high and certain."

Cash generation and reinvestment. Top concentrated investors focus intensely on:

• Free cash flow yield (FCF/market cap) as a key valuation metric
• Management's ability to allocate capital effectively
• Opportunities to reinvest cash at high rates of return

Ideal situations combine:

• High current free cash flow yield
• Abundant opportunities to reinvest at high returns
• Shareholder-oriented management (e.g., disciplined M&A, buybacks)

Investors like Glenn Greenberg seek businesses generating 8-10% free cash flow yields with potential for that yield to grow over time. They're wary of capital-intensive businesses or those that continually need to raise external capital to grow.

9. Occasional mark-to-market losses present opportunities for concentrated investors

"If you buy and it goes down because you misanalysed the value of the business, left out some detail or a new regulation has come into effect that dramatically lowers the value, that's a problem. But if it's because the market gets in a tizzy, and if you confirm that your analysis is right, then it gives you the opportunity to really get a bargain."

Volatility creates opportunity. Concentrated portfolios inevitably experience periods of significant unrealized losses. Successful investors view these as chances to:

• Reconfirm and update their original investment thesis
• Add to high-conviction positions at lower prices
• Potentially find new opportunities amid market panic

Examples:

• Greenberg doubling down on LabCorp after a 50% drop
• Buffett increasing American Express stake during Salad Oil Scandal
• Siem buying distressed oil assets during industry downturns

This approach requires emotional discipline and a long-term mindset. It also highlights the importance of maintaining some dry powder (cash or borrowing capacity) to take advantage of periodic market dislocations.

Last updated: October 7, 2024