Introduction

Conscientious employment, and a very good mind, will outperform a brilliant mind that doesn't know its own limits.

-Charlie Munger1

Concentration value investing is a little-known method of portfolio construction used by famous value investors Warren Buffett, Charlie Munger, long-time Berkshire Hathaway lieutenant Lou Simpson, and others profiled in this book to generate outsized returns. A controversial subject, the idea of portfolio concentration has been championed by Buffett and Munger for years, although it moves in and out of fashion with rising and falling markets. When times are good, portfolio concentration is popular because it magnifies gains; when times are bad, it's often abandoned-after the fact-because it magnifies volatility. Concentration has been out of favor since 2008, when investment managers began in earnest to avoid what they perceive as a risky business practice.

It is time to re-visit the subject of bet sizing and portfolio concentration as a means to achieve superior long-term investment results. We will start by examining some of the academic research on concentration versus diversification on long-term investment results. One central feature of the discussion surrounding concentration is the Kelly Formula, which provides a mathematical framework for maximizing returns by calculating the position size for a given investment within a portfolio using probability (i.e., the chance of winning versus losing) and risk versus reward (i.e., the potential gain versus the potential loss) as variables. The Holy Grail for any investor is a security with a high probability of winning and also a large potential gain compared to the potential loss. Given favorable inputs, the Kelly Formula can produce surprisingly large position sizes, far larger than the typical position size found in mutual funds or other actively managed investment products. In addition, some academic studies point to the diminishing advantages of portfolio diversification above a surprisingly small number of individual investments, provided each investment is adequately diversified (no overlapping industries, etc.). Also, portfolios with a relatively smaller number of securities (10 to 15) will produce results that vary greatly from the results of a given broadly diversified index. To the extent that investors seek to outperform an index, smaller portfolios can facilitate that goal, although concentration can be a double-edged sword.

Investors can employ the traditional value investing methodology of fundamental security analysis to identify potential investments with favorable Kelly Formula inputs (a high probability of winning, and a high risk/reward relationship), in order to maximize the chances of significant outperformance, as opposed to significant underperformance, with a concentrated portfolio.

We have unparalleled access to investors in Warren Buffett's inner circle. Interviews with several highly successful investors who have achieved their success employing a concentrated approach to portfolio management over the long term (at least 10 to 30 years) will be incorporated throughout this book. One common feature of these investors is that they have had permanent sources of capital, which has changed their behavior by allowing them to endure greater volatility in their returns. Most people seek to avoid volatility in general because they perceive increased variance as an increase in risk. The investors we examine, however, tend to be variance seekers. At the same time, however, they are able to produce returns with low downside volatility compared to the underlying markets in which they invest.

This book profiles eight investors with differing takes on the concentration investment style. The investors and the endowment interviewed are contemporary. One of the investors profiled, Maynard Keynes, is now a historical figure, but was the early adopter of many of the ideas that came to be held by his successors. The purpose of the book is to tease out the principles that have resulted in their remarkable returns. Though they operated through different periods of time, all have compounded their portfolios in the mid-to-high teens over very long periods-defined as more than 20 years. The investors in this book are rare in that they all have either permanent or semi-permanent sources of capital. We hypothesize that this is an important factor in allowing them to practice their focused style of investment. The book also puts forward a mathematical framework, the Kelly Criterion, for sizing investment "bets" within a portfolio. The conclusion of both the profiles of these great investors and of the Kelly Criterion is remarkably coincident.

Modern portfolio theory would have us believe that markets are efficient and that attempts to beat market performance are both foolhardy and expensive in terms of return. Yet the fact remains that there is at least a small cadre of active managers who have beaten the market by a significant margin over prolonged periods. This book and the investors profiled in it agree with the proponents of efficient market theory on two points:

1. Markets are mostly efficient.
2. They should be treated as efficient if you are, as Charlie Munger puts it, a "know-nothing" investor.

In other words, it requires a lot of hard work and a significant amount of knowledge to produce market-beating returns. If you do not have this, it is to your benefit to diversify and index. If, however, you possess knowledge and the capability for hard work as well as a few other characteristics outlined in the book, it is to your benefit to focus your energies on a small number of investments. The degree of focus is a stylistic choice and cannot be prescribed for any given individual, but the investors in this book concentrate on anywhere from 5 to 20 individual securities. The larger the number, the more the benefits of diversification, the lower the volatility of the portfolio, but also, in most cases, the lower the long-term returns. The trade-off between larger bets and more volatility is an individual choice, but both the Kelly Formula and the participants in the book point to the advantages of larger bets and more concentrated portfolios. In fact, the reader will probably be quite surprised by how large the bets can be calculated to be. Once again, placing bets of significant size depends on appropriately skewed probabilities, and these types of probabilities are uncommon, but both the mathematics and the investors argue for large bets when situations with unusual risk/return arise. It is important to note that the risk referred to here is the risk of permanent loss of capital and not the more commonly used academic metric of volatility. The investors in this book are willing to suffer through periods of temporary (but significant) loss of capital in an attempt to find opportunities where the probability of the permanent loss of capital is small. In other words, they attempt to find situations that offer a strong margin of safety where one's principal is protected either by assets or by a strong franchise and an unlevered balance sheet.

The investors in this book come from very different backgrounds ranging from an English major to an economist, but somehow they ended up in quite similar places in terms of their general investment philosophy. The singular trait that unites these investors, and separates this group from the herd of investors who try their luck on the stock market is temperament. Asked in 2011 whether intelligence or discipline was more important for successful investors, Buffett responded that temperament is key:2

The good news I can tell you is that to be a great investor you don't have to have a terrific IQ. If you've got 160 IQ, sell 30 points to somebody else because you won't need it in investing. What you do need is the right temperament. You need to be able to detach yourself from the views of others or the opinions of others.

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. Most people have, sometimes, a herd mentality, which can, under certain circumstances, develop into delusional behavior. You saw that in the Internet craze and so on.

. . .

The ones that have the edge are the ones who really have the temperament to look at a business, look at an industry and not care what the person next to them thinks about it, not care what they read about it in the newspaper, not care what they hear about it on the television, not listen to people who say, "This is going to happen," or, "That's going to happen." You have to come to your own conclusions, and you have to do it based on facts that are available. If you don't have enough facts to reach a conclusion, you forget it. You go on to the next one. You have to also have the willingness to walk away from things that other people think are very simple. A lot of people don't have that. I don't know why it is. I've been asked a lot of times whether that was something that you're born with or something you learn. I'm not sure I know the answer. Temperament's important.

Munger says of Buffett's theory:3

He's being extreme of course; the IQ points are helpful. He's right in the sense that you can't [teach] temperament. Conscientious...