Can 2 simple rules beat the market...?
BEATING the market over the long term is hard to do, writes Chris Mayer in Daily Wealth.
If you want to learn how it's done, Berkshire Hathaway bears repeated study.
Earlier this year, I attended the annual Berkshire meeting in Omaha, Nebraska.
Berkshire was the top performer in 100 Baggers, my study of stocks that returned 100 to 1 from 1962 to 2015.
The stock had risen more than 18,000-fold, which means $10,000 planted there in 1965 turned into an absurdly high $180 million 50 years later versus just $1.1 million in the S&P500.
Berkshire – and the other 100-baggers in the study – affirmed that not only can you beat the market, but you can also leave it miles behind...
You need to consider two important factors in order to get that kind of outperformance. We'll go over them in today's essay...
#1. Don't own too many stocks
First, you have to be concentrated. You have to focus on your best ideas. You can't own a lot of stocks that just dilute your returns.
And in fact, this is what many great investors do. I highly recommend a book that came out last year called Concentrated Investing by Allen Benello, Michael van Biema, and Tobias Carlisle. The basic idea behind the book is that owning a portfolio of fewer stocks (10-15 names) leads to better results than a widely diversified one.
Warren Buffett, as is well known, did not hesitate to bet big. His largest position would frequently be one-third – or more – of his portfolio. Often, his portfolio would be no more than five positions.
For example, he bought American Express in 1964 in the wake of the Salad Oil Scandal, when the stock was crushed. He made it 40% of his portfolio.
Charlie Munger, too, is famous for his views on concentration. He's had the Munger family wealth in as few as three stocks. From Concentrated Investing...
"My own inquiries on that subject were just to assume that I could find a few things, say three, each which had a substantial statistical expectancy of outperforming averages without creating catastrophe. If I could find three of those, what were the chances my pending record wouldn't be pretty damn good...
"How could one man know enough [to] own a flowing portfolio of 150 securities and always outperform the averages? That would be a considerable stump."
The book also includes profiles of investors who ran such concentrated portfolios. These include Buffett and Munger, along with lesser-knowns such as John Maynard Keynes, Lou Simpson, Claude Shannon, and more.
Lou Simpson ran Geico's investment portfolio from 1979 until his retirement in 2010. His record is extraordinary: 20% annually compared to 13.5% for the market.
Simpson's focus increased over time. In 1982, he had 33 stocks in a $280 million portfolio. He kept cutting back the number of stocks he owned even as the size of his portfolio grew. By 1995, he had just 10 stocks in a $1.1 billion portfolio.
Claude Shannon is another. He was a brilliant mathematician who made breakthroughs in a number of fields. He might also be the greatest investor you've never heard of.
From the late 1950s to 1986, Shannon earned 28% annually. That's good enough to turn every $1000 into $1.6 million.
He also was extremely concentrated. At the end of Shannon's run, one of his positions (Teledyne) made up 80% of his portfolio, up 194-fold. That's concentrated to an extreme that few could stomach.
The point is, many great investors focus on their best ideas. They don't spread themselves thin. And the book also includes more formal research that supports the idea that focus is a way to beat the market.
#2. Leave your stocks alone
The second part of this is to hold on to your stocks. The power of compounding is amazing, but the key ingredient is time. Even small amounts pile up quickly.
In Omaha, we heard money manager Raffaele Rocco retell an old parable...
There once was a king who wanted to repay a local sage for saving his daughter. The king offered anything the sage wanted. The humble wise man refused.
But the king persisted. So the sage agreed to what seemed a modest request. He asked to be paid a grain of rice a day, doubled every day. Thus on the first day, he'd get one grain of rice. On the second day, two. On the third day, four. And so on.
The king agreed...and in a month, the king's granaries were empty. He owed the sage more than 1 billion grains of rice on the 30th day.
I have heard other versions of this story, but I like it because it shows you two things. The first is obvious: It shows how compounding can turn a little into a whole lot.
But the subtler second lesson comes from working backward. If the king pays 1 billion grains of rice on the 30th day, how much does he pay on the 29th day?
The answer is half that, or 500 million. And on the 28th day, he pays half again, or 250 million.
So you see that returns are back-end loaded. This is 100-bagger math. The really big returns start to pile up in the later years.
These two factors alone – a concentrated portfolio and low turnover – are important ingredients to beating an index and amassing serious wealth.
Buffett himself used a concentrated portfolio and low turnover to build Berkshire. And these two factors are also key parts of our project called Chris Mayer's Focus.
Our goal is to not merely beat the index, but to trounce the thing and make it irrelevant. We aim to compound our investors' capital at a high rate for years and years.
So far, so good. Three of the six open positions in my current model portfolio are already up by double digits, including one that is up nearly 90% in 10 months.