Focused Value Investing Strategy
The focus value investing strategy is different from traditional, Benjamin Graham value investing strategy because it is based upon the idea of putting money into more of an investor’s “best ideas”, as Warren Buffett put it. Some value investors despise focused investing, while others swear by it. I’m always very hesitant to talk about this particular strategy on Investing for Beginners where I publish my investing articles for total newbies, mostly because some lazy person may not study far enough and realize that focused value investing is only possible when someone has diversified income sources. Done wrong, it can be financially devastating.
Warren Buffett, arguably history’s most famous focused value investing strategy practitioner, has said that the reason Berkshire Hathaway is able to concentrate so much of its investment capital in a handful of equities is because it owns 70+ major operating subsidiaries in a vastly diversified collection of industries so that if something were to go wrong in the portfolio, the profits being generated from the businesses could provide the cash to take advantage of the situation and buy more shares or, in a worse case scenario, repair the damage done to the balance sheet.
Unless you can adjust GAAP financial statements at a glance, focused value investing is likely not appropriate at all for you. Still, some of you ask questions about how we manage the portfolios so I thought I’d at least respond with an explanation of how it works.
How a Focused Value Investing Strategy Works
With a focused value investing strategy, as much as 50% of a person’s assets could be concentrated in their top 4 or 5 favorite investments. Often, this is the result growth in successful investments. For instance, someone may have 20% of their net worth in shares of Coca-Cola, but this isn’t because they put 20% of their money into the stock. Instead, they may have put 5% into Coke shares, reinvested dividends, and over time, the position grew. Instead of rebalancing the portfolio, as most investors do, focused value investors are willing to take the volatility and risk that comes along with holding a large portion of your net worth in a handful of companies.
The theory behind the focused value investing strategy is that humans have a natural limitation to to the amount of businesses they can truly understand, monitor, and value. The people who follow this school of thought think that no investor can truly understand a portfolio with 100 stocks in it – there simply isn’t enough time in the day. Those who favor diversification, on the other hand, say that is beside the point. Diversified value investors want to put together a collection of stocks that, on average, display certain characteristics that have statistically returned high returns, such as low price-to-book values, low price-to-earnings ratios, high dividend yields, etc. (for more information read Common Characteristics of Value Investing Stocks). In their opinion, they don’t need to know everything about the companies. They just need to continue monitoring the overall composition of the portfolio to ensure that it conforms with the types of securities they wish to own.
How a Focused Value Investing Strategy Can Be a Double Edged Sword
[mainbodyad]The same thing that makes a focused value investing strategy so profitable can also make it a disaster if you get it wrong. It is the classic double-edged sword. Just consider if you had put 5% of your assets into Coca-Cola and watched it grow into 99% of your portfolio over decades. Today, you would still be doing very, very well, collecting millions of dollars a year in dividends. Yet, had you done the same with Enron, you would have grown very wealthy, only to watch your entire fortune disappear.
The best way to deal with this may be a needs based approach. Once you have enough money that the annual dividend and interest income can sustain your standard of living, this money should be taken “off the table” and put in a collection of conservative, diversified securities such as stocks and bonds. Any money above the amount required for your standard of living could remain invested in your favorite stocks, if you so desire and are willing to take that risk. A general rule of thumb when determining how much you need to support your standard of living is to take your required annual income and divide it by 0.04. There is a body of empirical evidencethat investors with broad, diversified portfolios that only withdraw 4% of their assets each year are highly unlikely to ever run out of money, even in a Great Depression scenario.