Building a portfolio
Our instinctive reaction to statistics can warp our thinking
In this post I propose to try to sort out some misconceptions as to what drives portfolio performance. We will need to think about the ‘law of the vital few’ and the difference in the weighting of stocks in an actively managed portfolio, the weighting of stocks in an index and holding periods. It’s not really a law, but let’s go with that term.
This is not easy stuff. It is a good illustration of how our instinctive reaction to statistics can warp our thinking. We will contrast how Berkshire Hathaway weights the holdings in its portfolio compared to the indexes. We will also look at the contribution of long term holdings.
The 80-20 rule
Let’s start with something pretty basic. It has been noticed over the years that some 80% of consequences often come from 20% of causes. It’s usually called the 80-20 rule but also goes by the name of the law of the ‘vital few’ or the principle of ‘factor sparsity’.
It happens in the stock market. Most of the aggregate performance of a collection of stocks comes from just a few of them. You can take the stocks in the S&P 500 as a case in point. Most investors are aware of the FAANG stocks. This acronym was coined a number of years ago. They were Meta (formerly known as Facebook), Amazon, Apple, Netflix, and Alphabet (formerly known as Google). Investors have added Microsoft to the group. Most everyone knows that these U.S. technology stocks have driven stock market returns in the last 15 years. Hence, they are the ‘vital few’.
They have driven the S&P 500 index by three things. The first is their individual stock prices, the second is their individual market capitalization and the third is their period of high performance. Take away any of these things from any of these stocks and they do not drive the market. Hold that thought and we will look at some statistics. After we look at them, we will look at Berkshire Hathaway.
In August of 2021 Hendrik Bessembinder and his colleagues Te-Feng Chen, Goeun Choi and K.C. John Wei released their study titled: Long-Term Shareholder Returns: Evidence from 64,000 Global Stocks See here for paper.
I invite you to read five quotes from the report. Read slowly and quietly. You can’t just glance at them:
1/ “The five firms (0.008% of the total) with the largest wealth creation during the January 1990 to December 2020 period (Apple, Microsoft, Amazon, Alphabet, and Tencent) accounted for 10.34% of global net wealth creation.”
My comment: You might wrongly think that you had to identify, buy and then hold these stocks to succeed. Not so.
2/ “the top-performing 2.4% of firms account for all of the $US 75.7 trillion in net global stock market wealth creation from 1990 to December 2020”. (Emphasis added)
My comment: The natural but fallacious conclusion you might reach is that the other 97.6% of companies are total duds and guaranteed to destroy your wealth.
3/ “The fact that most individual stocks underperform U.S. Treasury bills even while the stocks in the sample on balance generated over $75 trillion in shareholder wealth as compared to a Treasury bill benchmark is attributable to strong positive skewness in the cross-section of compound long horizon stock returns.”(Emphasis added)
My comment: strong positive skewness refers to the distribution of the data. Most people have heard of bell curves. Bell curves have tails. Positive skewness means the tail on the right is fatter. The skewed bell curve is not symmetrical. While most stocks in the study underperformed U.S. treasury bill, this does not mean that you cannot build a portfolio that will provide handsome returns.
4/ “ In the period from January 1990 to December 2020 “55.2% of U.S. stocks and 57.4% of non-U.S. stocks, fall short of returns to one-month U.S. Treasury bills over matched time horizons.”
My comment: This one might incline you to give up on stocks altogether. Don’t give up yet.
5/ “The results are also relevant to the debate regarding active vs. passive investing. The results here show that the wealth created by stock market investing is largely attributable to large positive outcomes to a relatively few stocks. For those investors without a comparative advantage in identifying the few stocks that will create the most wealth (or in selecting a manager with the ability to do so) and without a substantial preference for positive skewness, the results reinforce the desirability of investing in a broad passive index. On the other hand, for investors with a sufficiently strong preference for positive skewness or for the (presumably few) investors with the appropriate comparative advantage in identifying stocks poised to deliver outsized long-run returns, the results highlight the degree to which successful stock selection can enhance wealth.” (Emphasis added)
My comment: This one would cause all but the most intrepid investors to retreat to the comfort of index investing and ETFs.
But we need to dig deeper. Remember what I said about stock weighting vs stock performance vs holding period.
Currently, the Berkshire Hathaway portfolio contains 44 stocks of which only 9 have a weighting over 2%. Those 9 make up 79.5% of the portfolio. The remaining 35 stocks make up 20.5% of the portfolio. Source CNBC see here.
It is my belief that over the years this weighting has been typical for Berkshire Hathaway. I know that Apple AAPL today is some 46% of the portfolio. The fact remains that less than 10 stocks make up 80% of the weight in the portfolio. My recollection is that over many decades this proportion has been pretty typical. Here’s the key point. The 9 stocks can move the needle. That is, movements up and down in 9 stocks make a significant difference. The other 35 stocks do not move the needle. A stock with a less than 2% portfolio weight can double and not make that much difference to the overall portfolio.
So, how does the ‘law of the vital few’ apply to Berkshire Hathaway? In effect Warren Buffett has chosen what he hopes will be part of his own vital few. Those are his 9 stocks. Those 9 stocks are what people call a concentrated portfolio.
A propos Berkshire Hathaway there is one comment by Charlie Munger I need to deal with. Morgan Housel in his recent book The Psychology of Money refers to the 2013 Berkshire Hathaway shareholder meeting at which Warren Buffett said that he’s owned 400 to 500 stocks during his life and made most of his money on 10 of them. This is consistent with the law of the vital few. Charlie Munger then said: “If you remove just a few of Berkshire’s top investments, its long term track record is pretty average.” (Housel, 2020) p.80
One critical thing to note is that Warren Buffett’s collection of 400 to 500 stocks include stocks he has pruned from his portfolio. The ability of an investor to prune out companies whose economic performance has started to flag is a big plus for active management.
To understand Berkshire’s top investments, you need to know what the portfolio weighting of each stock is, what the total return of each stock has been and the period over which is achieved that performance. The top investments Munger is referring to are Geico, Coca Cola, American Express and other long term high performing companies. And these are the companies Buffett is referring to as the one’s on which he has made most of his money.
Our own portfolio
Let me say at the outset that I have no “comparative advantage in identifying the few stocks that will create the most wealth” to use Bessembinder’s term. I have no information advantage. I only have a simple investment process that I follow carefully. Perhaps you could call that an advantage.
Our family’s portfolio is concentrated. We currently hold 12 stocks of which 7 are Canadian and 5 are U.S. The U.S. equities make up 53% of the portfolio. Our top ten holding by weight are 87.15% of the portfolio. Our 12 stocks are the makings of our vital few. Each one of them is carefully chosen and they can all move the needle. They are all superb companies. By portfolio weight, most have Morningstar wide moat ratings. Like any good team they must all contribute to performance. Volatility is tolerated.
I haven’t counted but there are probably more than a hundred stocks I have sold over the years. They were on the team for a goodly time but were cut from the team for poor economic performance. What has been left over the years have been the vital few. And sometimes the economic performance of one of the vital few will flag after producing wonderful returns for years. In that case, it gets the chop.
To illustrate the importance of holding period and performance over that period let me use the example of a Canadian company in our portfolio. I just checked. We have an unrealized gain on one stock of +589.12%. You might be thinking, ‘what a rocket ship’. It’s not Tesla. No, actually it’s pretty pedestrian. It’s a distributor of construction and mining equipment. The point is that we have held the shares for many years. It has had a significant weight in the portfolio; it has had excellent economic performance and we have held it for a long time. Hence, it is one of the select companies on which we have made most of our money over the long haul, part of the vital few.
Over the years I have never found it necessary to invest in next FAANGs. My best performing stock this year is a real estate brokerage firm. Others doing well this year include a toy company and a discount brokerage. It used to be said the best companies were those that made, sold or serviced widgets.
The secret, as Warren Buffett expressed it is: “Put together a portfolio of companies whose aggregate earnings march upward over the years, and so also will the portfolio’s market value.” (Buffett, The Essays of Warren Buffett: Lessons for Corporate America, Lawrence A. Cunningham, 1998) p.93
Let’s come back to where we started this post. The fact that the top-performing 2.4% of firms account for all of the $US 75.7 trillion in net global stock market wealth creation from 1990 to December 2020” does not mean that you have to find those vital few 2.4% of stocks to succeed in the stock market. The other 97.6% of companies are not total duds. In fact, many of them are superb companies.
The 2.4% have been good companies and they have driven indexes by a combination of their economic performance and their market capitalization for the period of the study.
It’s entirely possible to invest in superb companies like our equipment company, toy company or discount broker and enjoy superior performance over the long haul. The idea is to buy only superb companies and then only at very attractive prices and hold them for the long term. If the company’s operations begin to flag, it should be sold promptly and replaced by other great companies.
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