What If Your Portfolio Looks Like A Mutual Fund?

Includes: BRK.A, BRK.B, CVX, TOT, XOM
by: Tim McAleenan Jr.

Charlie Munger, the Vice Chairman of Berkshire Hathaway (NYSE:BRK.A), (NYSE:BRK.B), is on the short list of the three or four investors that have had the greatest influence on my own individual approach to stock selection. Having his read the biography of his life titled Damn Right: Behind The Scenes With Berkshire Hathaway Billionaire Charlie Munger, I have great respect for him as a man given that he had to endure the death of a son, a divorce, and near bankruptcy all within a fairly short sequence of his young adult life. When he has a viewpoint on something, it usually pays to listen up.

With that said, there is only one issue that I am aware of where I am not actively trying to follow in Munger's footsteps. And that is diversification. Munger makes it pretty clear how he feels about the issue:

The idea of excessive diversification is madness. We do not believe that widespread diversification will yield a good result. We believe almost all good investments will involve relatively low diversification. If you took our top fifteen decisions out, we'd have a pretty average record. It wasn't hyperactivity, but a hell of a lot of patience. You stuck to your principles, and when opportunities came along, you pounced on them with vigour. Berkshire in its history has made money betting on sure things.

That is the kind of approach that partially explains why Charlie Munger managed to become a billionaire. When he was becoming affluent, he practiced what he preached. At times, the partnership that he ran had 75% of its investable assets in only eight securities. And he had the insight to pick the right companies to achieve 19% annual returns.

But, of course, that is not the only way to accumulate wealth. In The Intelligent Investor, Graham recommended that conservative investors own two to three dozen securities for suitable diversification, and there were moments in the history of the Graham-Newman Fund in which Graham held over 100+ securities, while still managing to deliver returns of 20% annually (as an interesting aside, investors with Munger actually realized higher returns because Graham charged higher fees to his clients than Munger did).

In many of my articles, I discuss how all investment decisions should be made in relation to your own personal goals ( i.e., someone running a hedge fund with the expectation to "beat the market" is going to have a very different portfolio than a shrewd lottery winner that wants to generate reliable dividend income to live on).

To make the conversation more complete, I'd like to point out that Charlie Munger and Benjamin Graham had very different goals that drove them to the investing world. Munger had a straightforward desire to get rich quickly, and believed that a concentrated portfolio was the best way to accomplish that end.

In Benjamin Graham's case, he was scarred in his youth by the financial difficulties of his mother. When Graham was growing up, he later recalled the embarrassment of seeing his mother's checks declined at the grocery store because of her poor credit reputation. This basic desire for security drove much of Graham's thought process: Munger made investments to win, Graham made investments not to lose. Both strategies produced nearly equal results.

In Graham's personal life, he made a portfolio that had the diversification that you would expect to see in a mutual fund. The reason why Graham was able to do this successfully was because he realized that price was the great equalizer.

I'll use the big oil companies Chevron (NYSE:CVX), Exxon (NYSE:XOM), and Total SA (NYSE:TOT) as an example. When it comes to earnings growth, Chevron and Exxon are likely to grow earnings per share at a faster rate than Total because they have generally lower input costs, higher buybacks, better proven reserves, and so on. But there is a catch: Total SA gives investors a 14% starting earnings yield (on a normalized basis) and pays out a starting dividend in the 7% range. That is a meaningful "equalizer" in comparison to the 10% earnings yields from Exxon and Chevron, as well as the 2-3% dividends you can get from them. That is why a portfolio might contain all three stocks: the decision to add Exxon and Chevron would likely be fueled by a desire to realize future earnings growth, while a decision to add Total would likely be valuation driven. Based on current prices, I have no idea which of those three stocks will deliver the best returns to investors over the next ten years.

A lot of times, when you consider constructing a portfolio with 20-35 stocks, you will hear someone say, "You won't be able to beat the market with that! You're just creating your own mutual fund!"

First of all, owning 20-35 stocks does not reduce you to mediocrity. Since 1970, the Sequoia Fund has returned a total of 31,933% while the S&P 500 has returned a total of 7,432% (in annual terms, the Sequoia Fund has grown by 14.5% annually while the S&P 500 has grown by 10.5% annually). The average portfolio size of the Sequoia Fund has been 40-45 securities. If you desire to beat an index such as the S&P 500 over long stretches of time, the decision to own 20-35 stocks does not condemn you to mediocrity (particularly if your positions are not equally weighted or you happen to slip a company like Starbucks (NASDAQ:SBUX) or McDonalds (NYSE:MCD) into your portfolio at some point in time. You do not want to count on something like that, but all it takes is one winner or two in your life to greatly speed up the process of reaching your goals).

Secondly, even if you do create a portfolio that is a mutual fund and does not "beat the market," that does not mean you made a bad decision. According to Vanguard, the average fee for a large-cap mutual fund is 1.20%. That means that if you have $200,000 in assets, you are paying the mutual fund $2,400 each and every year. If you owned thirty securities that cost $8.95 per trade, you are looking at $268 in fees that do not have to be replicated unless you decide to sell. If you turned around and sold five stocks and bought five new ones each year, you are looking at $89 in annual charges while an actual mutual fund would still be charging $2,400 annually (in fact, this number would increase even more as your assets grew because of the nature of expense ratios that charge fees based on asset totals).

If you choose to construct your own portfolio of 20-35 stocks, you know exactly why you own each stock, and you got to select your price point. That is not a bad place to be. If your aim is to beat the market, the investment records of Benjamin Graham and the managers at the Sequoia Fund demonstrate that a relatively high number of securities do not prevent an investor from outpacing the S&P 500, even if his portfolio "resembles" a mutual fund. And more importantly, even if you do perform in line with the market, you will be saving thousands of dollars in mutual fund fees provided you are dealing with a $200,000+ sized portfolio and keep your own turnover to a minimum. And, of course, some investors want to own companies that provide the stable income necessary to reach financial independence, and the primary focus is on protecting the income stream (as opposed to beating the S&P 500). For those reasons, the criticism that owning 20-35 stocks turns your portfolio into a "mutual fund" should not deter you from taking that approach to diversification.

Disclosure: I am long XOM, MCD. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.