Fin 4201/ Focus Investing “Choose a few stocks that are likely to produce above- average returns over the long haul, concentrate the bulk of your investments in these stocks, and have the fortitude to hold steady during any short-term market gyrations.”

Fin 4201/ Focus Investing - Five rules CHOOSE = Find outstanding companies FEW = Less is More CONCENTRATE = Put Big Bets on High- Probability Events HOLD STEADY = Be Patient FORTITUDE = Don’t Panic over price changes

Fin 4201/ Find Outstanding Companies Graham part 12 tenets Consistent Franchise or low-cost Rational, honest, & skilled management

Fin 4201/ Less is More Fisher part Concentrate in outstanding firms Limit portfolio to firms you can comprehend Size - 10 is good number Scope - Circle of competence

Fin 4201/ Big Bets on High Probability Events Concentrate Weight best ideas most heavily Do your homework – have confidence in your “rightness”

Fin 4201/ Be Patient Hold Steady Think long term (10 years) Longer periods → economics of underlying business will dominate share price. Low turnover – (10 years → 10% turn)

Fin 4201/ Don’t Panic Fortitude Random walk Price changes happen – Mr. Market Shorter periods → ups and downs LTCM was right, just not soon enough

Fin 4201/ What about diversification? Good, if you don’t know much about the stock market and are happy with average returns with lower risk.

Fin 4201/ If not? Then focus, and you will have extreme returns: very high returns or very low returns. If you do it well, you have very high returns with higher volatility

Fin 4201/ Star investors of focus investing J.M. Keynes Charlie Munger Bill Ruane Lou Simpson Warren Buffett

Fin 4201/ John Maynard Keynes Chest Fund (%) U.K. Market (%) Average Return Standard Deviation Minimum Maximum Range (Max – Min)

Fin 4201/ Charlie Munger Partnership Ltd Partnership (%) Dow Jones Industrial (%) Average Return Standard Deviation Minimum Maximum Range (Max – Min)

Fin 4201/ Sequoia Fund Managed by Bill Ruane Fund (%)S&P 500 (%) Average Return Standard Deviation Minimum Maximum Range (Max – Min)

Fin 4201/ GEICO Lou Simpson GEICO (%)S&P 500 (%) Average Return Standard Deviation Minimum-10-5 Maximum Range (Max – Min)

Fin 4201/ Buffett Partnership Ltd Partnership (%) Dow Jones Industrial (%) Average Return Standard Deviation Minimum Maximum Range (Max – Min)5254.1

Fin 4201/ Berkshire Hathaway Inc Partnership (%) S&P 500 (%) Average Return Standard Deviation Minimum Maximum Range (Max – Min)64.0

Fin 4201/ Isn’t it possible that the performance of these successful focus investors is a matter of chance?

Fin 4201/ W.D.’s Stock Pick Newsletter (or could be Sports Betting Tips) Ignore transactions costs Split population in half Send each half a different pick Send winners next pick Repeat until hooked Charge through the nose

Fin 4201/ Three thousand focus investors 3000 portfolios containing 250 stocks portfolios containing 100 stocks portfolios containing 50 stocks portfolios containing 15 stocks

Fin 4201/ Performance

Fin 4201/ Buffett’s answer (1984) Imagine a national coin-flipping contest in which 225 million Americans bet $1 on their guess. After each flip, the losers dropped out and the winners kept the pot and advanced to the next round.

Fin 4201/ After ten events, there would be 220,000 winners left who, by letting their winnings ride, would have gained $1024. After another ten tosses, there would be 215 winners, each with $1 million.

Fin 4201/ Business professors would claim that there is no skill, and this can be duplicated by 225 million coin-flipping orangutans.

Fin 4201/ However, if 40 of those winning animals came from the same zoo, wouldn’t we want to ask the zookeeper what he feeds his now very rich orangutans?

Fin 4201/ What are the odds? For buffet is weighted average. P(loss)*size of loss + P(gain)*amount of gain Set up Stock currently is $18 Announce possible takeover at $30 Stock price immediately goes to $27 Now what do you do: If you buy and deal goes through you make $3 If you buy and deal doesn’t price reverts to fair value ($18) or a loss of $9 Do your analysis and conclude a 90% chance of going through (.1)*(-9) + (.9)*(3) = $1.80 positive expected value. What is the return = 1.8/27 = 6.6% If deal takes 6 months ≈ 13.2% return How does this compare to alternatives.

Fin 4201/ Wells Fargo $58 in 1990 – real estate loans (specialty of Wells) most vulnerable (earthquake, overbuilding, economic collapse) He figured probability of total collapse at 10% and that 10% of wells loans might go bad to the tune of 30% of principal =.1*.1*.3*$48 billion of loans = 144 million loss but before collapse wells was EBT = $1B ≈ pretty large margin of safety.