Bend it Like Buffett

Diversification is only good in moderation

The S&P 500 hit a high today. 

I hope you own it. I hope you own it with the idea of holding it a long time. If all of your market-facing assets are in the S&P, you’ll do fine. The odds suggest you’ll do better than with individual stocks, at least over the long term. 

Some investors like a little more action. It’s fun to be right. Financial reward feels good, cranium-wise. Beating the market is a nice lift, ego-wise. There’s also schadenfruede. It’s fun to beat the bastards out of their money and add their losses to your winnings: We’re hard-wired to enjoy victory in competition. That’s been a good thing for humanity these last few million years. There’s nothing wrong with any of that if you understand opportunity cost. 

Sitting out the market costs you money. It costs you 10% a year – that’s what statistics tell you is available in the equity markets over the long term on a compound basis. Such a return doubles an asset’s value every seven years. That’s not bad – most professional investments managers can’t beat it.  

You can. I have. And the future – where all profit exists – is wide open. 

The idea behind the Oportunity Fund is not to bat anything out of the part. It’s a tortoise portfolio: Move carefully and decisively and beat the hare over the finish line. Simple. 

It will take just four trades a year. Once they’re done, you’re done. You can put the rest of your portfolio on autopilot. Hey, you’ve already beat the pros. No sense is being greedy.  

So: The typical trade is designed to return 15%, or half again as well as the S&P does on a compound basis in a year. Opportunity Fund trades are oriented toward a weeks- or months-long holding period. The idea is that the market overreacts in the short term and misprices assets. We buy them, wait for the market to regain its bearings and reprice the assets logically. If we’re right, it shouldn’t take long to notch the gains.  

I undertand that 15% doesn’t impress anyone when the market is cresting. It’s pretty easy to find megacap companies that have nearly triple-digit returns. Eli Lilly is up 500% in five years, thuis the current strategy among Wall Streeters known as JBL – just buy Lilly. Its weight-loss drugs are just getting started in a business forecast to reach a staggering $100 billion a year. This is backstopped by a larger and solidly profitable lineup of other outstanding medicines that generate their own (lesser) fortunes. Why aim lower? 

Math. 

Here’s how this works: 

We park the majority of market-facing assets in the S&P 500 or in the Heritage Portfolion, which is designed to exceed it. Assume that’s 75% of total stock holdings. We assume the S&P will return 10% a year. 

The remainder, a quarter of the portfolio, is allocated to the Opportunity Fund.

We conduct four trades. Each earns 15%. Because we’re really smart. The kicker is that each time we conduct an Opportunity Fund trade, we roll the winnings into the next trade. This generates an aggregate 74.9%. 

If three-quarters of the portfolio earns 10% and the rest pulls in 74.9%, the combined performance of these two teams works out to a 26.2% gain. According to the Rule of 72, which holds that an investment earnings 10% doubles every 7.2 years, our assets will double in half that time. That’s the goal. 

Now, let’s say that we overestimated. We’re not as good as we thought. For some reason, the Opportunity Fund trades only earned 10% each. Well, damn. That lowers our total portflio performance to 19.1% a year. Less impressive, you say? Not really: That is the exact number that Warren Buffett has posted as Berkshire CEO since 1965. It’s worked out for him nicely. And the fact is, this dual-portfolio strategy is cribbed from exactly what Buffett has been telling investors forever: Put most of your money in the S&P. Invest only in individual companies that you fully understand and are fully confident in – and that you can buy cheaply. 

Thus my current Xcel Energy trade. It’s a power company. It sells electricity. Does this business have a competitive advantage? A wide moat, as Buffett calls it? Yup. It’s a damn monopoly. Does it make money at a sustainable pace? Indeed it does: Its profit margin isn’t sexy, but it’s there, about 12.5%. Does it build shareholder wealth: Damn straight: In 2003, shareholder equity was $5.2 billion. Now it’s $17.6 billion – a gain of more than 240%, or a 6.3% compound rate. That’s not sexy, but it’s damn alluring. We know the company is worth $60 a share. That values the enterprise at a very modest earnings multiple far below the broader-market average. 

Now, the stock prices is NOT going to grow organically, at least not any faster than its longterm growth in equity. Fine. We’re not buying it because we want growth. We’re buying it because Wall Street overreacted to the Texas wildfires and sent the shares to a 52-week low, to their current price of about 50. We’re only going to hold until 60. That’s a 20% gain. When it reaches our target, we sell the shares, add the gain to the chips we have on the table, and redeploy the pot into another scenario where Wall Street has done something ill-considered, myopic and dumb. I assure you this will happen with sufficient regularity! Ignorance and overreaction are two commodities Wall Street has in abundance. This investment strategy is not just possible – properly executed, its results are probable, if we are prudent, disciplined and decisive. 

I hear you saying: Andy, if you’re right, then why don’t professional managers do this? Why do they buy dozens or hundreds of stocks? Because most investors are more comfortable with the idea of diversity – lots of eggs in the basket – than making relatively few concentrated bets. My response to this is the same as Buffett’s, who likes to quote Mae West, who said, “too much of a good thing is wonderful.” Investors seek diversity because of only one thing: Uncertainty. They spread risk. 

Well, the law of large numbers tells us that’s only going to do one thing – weaken returns. Because outcomes always regress to the mean. But we don’t want to do that, at least not in 25% of our portfolio. We’ve ALREADY spread our risk by buying the S&P, or, in the case of the Heritage Portfolio, XLG, which invests in its Top 50 companies. I’d rather concentrate some risk and collect a bit of disproportionate gain as a reward for doing our homework on good companies that Wall Street has mispriced. 

And it’s working, by the way: Xcel was up today. It might fall tomorrow. It might take a few weeks of topsy-turvey prices before we return to a logical $60 a share of Xcel. But it’s going to happen. 

Just watch.