Concentrating like Buffett
Andrés is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
It’s a widely held belief that diversification is the only free lunch when it comes to investing, and it certainly makes sense. Holding different stocks or, even better, different asset classes (bonds, stocks, commodities, etc) can be a very effective tool to reduce volatility and even increase portfolio returns at the same time.
The value of diversification is taught as one of the most important aspects to consider when it comes to investing and portfolio management, both in university courses and all kinds of educational programs of different levels. Rivers of ink have been used to provide academic support for the benefits of diversification, and empirical research points in the same direction.
On the other hand, one of the greatest investors of all time, Warren Buffett, is precisely on the opposite side of the road. Buffett doesn´t advocate for diversification; the Oracle of Omaha recommends concentrating your holdings on companies with the best quality and forgetting about diversification. And the suggestion is more than just words; Buffett has demonstrated that his investment approach can produce outstanding returns.
"Diversification is a protection against ignorance. It makes very little sense for those who know what they’re doing." -Buffett.
It is important to notice that Buffett doesn´t recommend concentration for each and every investor. His advice is focused to those who understand how to select companies which offer superior returns and the best fundamental qualities.
If you think about that, what better stock to consider as a concentrated position than Berkshire Hathaway (NYSE: BRK-A) (NYSE: BRK-B)? Berkshire has built a collection of extraordinary businesses over the last decades, companies which have passed the test of being worthy of “holding forever” as Buffett likes to say. Many of these companies are among the most valuable corporations in the world, with indestructible competitive advantages.
One paradigmatic example of such a holding is Coca-Cola (NYSE: KO), one of the most valuable brands in the world with a gigantic distribution network and rock solid leadership in the carbonated drinks market. Investors in Coca-Cola can sleep smoothly at night without worrying too much about what will happen to their investment. When you are buying companies of this caliber, diversification is not that important, since the quality of the business reduces the risk.
One thing that concerns many investors when it comes to investing in Berkshire is the fact that Buffett and his long term companion, Charlie Munger, are not getting any younger. Both men are in great health for their age, but replacing a genius like Buffett would be almost impossible.
Fortunately for investors in Berkshire, many of the business owned by the company are managed by well-respected CEOs with deep knowledge of their industries. Also Buffet is famous for his hands-off approach in the day to day operations of these companies, letting these CEOs make all the important decisions. The many strong businesses that Berkshire owns will continue functioning smoothly, even without Buffett or Munger running the company.
On the other hand, certain kinds of deals will be very hard to replicate by new management.
In September of 2008, Berkshire invested $5 billion in Goldman Sachs (NYSE: GS) preferred stock, yielding a 10% dividend, in a deal which included warrants for Goldman common stock at $115 through October 2013. This deal was structured in a very short period of time and in the middle of one of the worst financial crises in history. I don´t believe Buffett´s successor - or successors – will be able to do that kind of thing again for Berkshire.
More recently, in August 2011, Berkshire made a similar deal with Bank of America (NYSE: BAC) by investing another $5 billion in a combination of preferred stock and warrants. Again, the deal was structured quite quickly in a moment in which the bank needed the capital and to recover investors' trust. The second consideration, public relations, may have been as important as the money for Bank of America, and Buffett is quite unique when it comes to generating respect.
Buffett is extremely smart at allocating capital; Berkshire has low funding costs, so the company doesn´t need to generate spectacular returns on capital to justify the investment. Still, these kinds of investments provide a juicy return of capital via income from debt, and also have a considerable degree of upside potential via long term warrants. Combine that with access to cheap financing, and you get a nice mixture of low funding costs and high return on investments for Berkshire.
After Buffett is gone, his successors can be trusted to make intelligent asset allocation decisions, but it won´t be so easy for them to rapidly negotiate funding deals with Goldman Sachs and Bank of America in times of global financial distress. Being Warren Buffett is an important asset by itself.
Yet shares of Berkshire are not too optimistically priced; in fact they are trading at historically low valuations in terms of price to book value. Buffett himself has expressed his willingness to buy back shares of the company if the price to book value falls too much, which should probably put a floor to downside volatility in the stock
There can always be some difficulties in the post-Buffett transition, but the company´s holdings will continue performing well, and the stock is cheap enough to reflect those concerns. After all, this is a great company which has a good chance of generating above average returns on its capital for the long term.
Buffett recommends concentrating in outstanding companies, and he has built an enormous collection of such extraordinary businesses over decades of savvy investing. Berkshire is in itself quite diversified: Insurance, utilities, transport and financials are included among many other sectors in its portfolio, so that reduces the uncertainty coming from industry specific factors.
For investors who are looking for a company to take a big concentrated position, Berkshire may be the ideal company to consider. If you agree with Buffett on the merits of concentrating, maybe you should agree with him on what kind of companies should be considered among the best extraordinary businesses worthy of buying for the long term.
acardenal has no positions in the stocks mentioned above. The Motley Fool owns shares of Bank of America, Berkshire Hathaway, and The Coca-Cola Company. Motley Fool newsletter services recommend Berkshire Hathaway, Goldman Sachs Group, and The Coca-Cola Company. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.