Someone who reads the blog asked me a question about why I don’t just use Joel Greenblatt’s Magic Formula to invest instead of picking my own stocks.
This lead to a discussion of what kind of results you can achieve picking your own stocks.
It’s a question closely related to portfolio concentration. I’ve never figured out how to perform well while holding a lot of stocks. When I’ve outperformed the market, that outperformance has really boiled down to just a few decisions.
Over the last 3 years, I’ve averaged less than one such performance powering investment.
The Power of One Good Idea a Year
I started managing a new account in January of 2009. That's close to the perfect timing imaginable for having good returns. So these numbers are wildly inflated over what anyone can expect in the future.
Because it's a single account, I have exact results for each year. Here are my returns:
You can see I'm underperforming the S&P 500 this year.
The average number of stocks I've held has been about 5. The highest I ever owned at once was 11 - and that included some positions that never reached the size I wanted. My lowest number of positions at one time was 1, but that was when the majority of the account was in cash.
My outperformance was driven entirely by a few major successes:
- IMS Health
- Sanjo Machine Works (and Japanese net-nets generally)
IMS Health was a fairly large - over $1 billion market cap - stock with a wide moat. It was selling for less than 10 times free cash flow when I first bought it. Eventually, it was bought out by a private equity firm.
Bancinsurance was a niche property and casualty insurance company. It usually had a combined ratio under 100. Meaning it made a profit on underwriting. Not just on its investments. It was selling at about 60% of book value when I first bought it. Eventually, the CEO bought it out.
Sanjo Machine Works
Sanjo Machine Works was a Japanese company. I first bought it around 50% of its cash. Eventually, the CEO bought it out.
Japanese Net-Nets (Generally)
My Japanese net-net investments were a departure for me in that I diversified across 5 stocks at once. They did better in Japanese Yen than I ended up doing because the Yen fell against the dollar. They still did fine. Sanjo was the star performer. The rest had modest positive results in dollar terms.
3 Years of Outperformance Really Just Due to 3 Decisions
I made other investments over the last 3 and a half years. But very few of them mattered. There were no big losses. Many of the other investments slightly outperformed or slightly underperformed the market while I owned them. But, together, they were pretty much a wash relative to the stock market.
So, my entire outperformance is really due to 3 decisions made over 3 and a half years.
This is why I talk about concentration rather than diversification. I haven’t figure out how to earn market beating returns while diversifying. I’ve done it while concentrating.
That doesn’t mean it’s the right approach for everyone.
But it’s worked for me.