Thursday, October 27, 2005

Qualities of Successful Investors

A friend of mine was shopping at a local garage sale and came across a book for 25¢. She picked up the book and after reading the title, “The Money Masters”, quickly determined that she wouldn’t have much interest in it. A gift-giver by nature, she thought that at 25¢ she didn’t have much to loose by purchasing it and further thought that she might offer it as a grab-bag gift for the upcoming Christmas season. [It was only July. She does her Christmas shopping early.] After plucking her quarter down, she shoved the book in her bag and made her way to the neighborhood Starbucks for her daily chai tea.

One highly probably event she was likely to experience during her visit to Starbucks was that she would run into me. [My usual is the grande mild coffee.] When she arrived I noticed the tattered book sticking out of the top of her bag. After our usual salutation, I gloated. I told her that I was happy that I had had an influential role in her reading choices.

A little background is in order. My friend and I, during our many java induced conversations, have often talked about money. Everything from the evils of it, to the lack of it, to the pursuit of it, to the role of it, to the love of it, to the need of it. To be fair, she is much less interested in “money” as subject matter than I am. In any regard, I took most of the credit for her excellent book choice. [And undervalued no less. A used copy on will cost $11.65. She found her copy for 25¢ representing a 98% discount to intrinsic value!] But I had the suspicion that she did not realize what a gem she had stumbled upon.

In an attempt to show her the usefulness of the book I recalled one conversation we had about the genius it took to be a good investor. Her view was that most people were not “smart” enough to be investors. To counter her belief I paraphrased Warren Buffett, arguably the world’s greatest investor, by stating that successful investing requires a rational approach and fettered emotions, not a high IQ. My friend seemed slightly moved by my (and Mr. Buffett’s) stance but openly pondered, “What is meant by a rational approach?” I pointed out that one of the great benefits of possessing “The Money Masters” is that it more clearly spells out Buffett’s (as well as other great investors) approach and core beliefs better than I ever could. In the case of what makes a good investor Buffett lists to six qualities in the book:

“You must be animated by controlled greed, and fascinated by the investment process.
You must have patience.
You must think independently.
You must have the security and self-confidence that comes from knowledge, without being rash or headstrong.
Accept it when you don’t know something.
Be flexible as the types of businesses you buy, but never pay more than the business is worth.”
Anyone can possess these qualities. It doesn’t take a high IQ to be a good investor. If you find that you do not possess these qualities however you should find a financial advisor or investment manager that does.

Oh yes, I’m happy to report my friend will be holding onto her garage sale gem. She’ll be shopping for used neckties for her grab-bag gift instead.

[Disclosure: I and the clients of Brick Financial Management, LLC owned shares of at the time of this entry.]

Monday, October 24, 2005

Concentrate Your Bets

Those of you who have read our Client Letters and are familiar with our services know that we are proponents of concentrated portfolios. Of course this belief runs contrary to most of the discourse that exists in the investing public today. Most investors and investment professionals are devout followers of modern-portfolio-theory (MPT) and the efficient-market-hypothesis (EMH). MPT holds that the more diversified a portfolio, the less risk (in terms of volatility) from each of its individual positions. EMH states that stock market prices reflect the collective knowledge and judgment of all investors and thereby reflects the correct price. In other words, no individual investor can gain an advantage over the stock market by selecting specific stocks.

We think that both MPT and EMH are (mostly) bunk. We indeed think that it is possible to beat the market and at less volatility risk by choosing just a few stocks. Two recent articles support our view. A New York Times article about the record of concentrated portfolios points out that:

"...concentrated funds come out slightly ahead (of diversified funds). They returned 8.9 percent a year, on average, over the last 10 years, versus 8.7 percent for the diversified funds, according to Morningstar."
A Businessweek article addresses the volatility issue stating:

"A low-risk concentrated portfolio may sound like a contradiction in terms. After all, the belief in diversification as a way to reduce risk is sacrosanct, and the average domestic equity fund holds 175 stocks. But academic studies show that as few as 50 stocks can give a portfolio volatility levels equal to those of the Standard & Poor's 500-stock index. And many funds get by with less. A screen of those with fewer than 50 stocks on fund tracker Morningstar's database found that more than half had lower betas -- a measure of risk -- than the S&P 500. One-third had lower standard deviations -- which Morningstar measures as the month-to-month variation in the price of fund shares. What's more, according to a 2004 Morningstar study, some 80% of concentrated funds -- also known as focused funds -- outperformed their peers from 1993 through 2003."

An advantage of running concentrated portfolios not addressed in either article is the tendency for such funds to have much lower than average turnover ratios. The turnover ratio is the percentage of a fund's assets that have changed over the course of a given time period, usually a year. The turnover ratio for a mutual fund is calculated by dividing the average assets during the period by the lesser of the value of purchases and the value of sales during the same period.

Portfolios with high turnover ratios (i.e. high levels of buying and selling) tend to have a higher degree of taxable events. Managers that run concentrated portfolios usually create fewer of these events as they tend to buy and sell much less often. Concentrated funds also tend to have much lower trading costs than the average fund. A perusal of the Morningstar database shows that mutual funds with 40 or fewer stocks have an average turnover ratio of 40.7% while the average mutual fund is closer to 100%.

In other words, even if concentrated funds didn't outperform more diversified funds on an outright basis, once costs are considered concentrated funds would come out ahead anyway. Bottom line we tend to agree with the conclusion of a study on concentrated funds presented in The Journal of Finance:

"We find that funds with concentrated portfolios perform better than funds with diversified portfolios."

Saturday, October 22, 2005

Bottled Water (Redux)

Seems I'm not alone in the my feeling on bottled water. An article in the New York Times points out that:

"Ounce for ounce, it costs more than gasoline...depending on the brand, it costs 250 to 10,000 times more than tap water. Globally, bottled water is now a $46 billion industry. Why has it become so popular? It cannot be the taste, since most people cannot tell the difference in a blind tasting. Much bottled water is, in any case, derived from municipal water supplies...Admittedly, both kinds of water suffer from occasional contamination problems, but tap water is more stringently monitored and tightly regulated than bottled water."