Warren Buffett’s response to Shai Dardashti’s Letter
Found this through Fat Pitch Financials
In the margins of a letter to a 20-something year old money manager, Warren Buffett succinctly answers a deep philosophical question of value investing. If you had an optimum capital base, which investing style is better, cheap and narrow-moat companies or pricey and wide-moat companies?
Alas, Buffett’s response was not as definitive as one would hope. He said, “Either is fine. [Cheap and Narrow] is better for small sums. [Expensive and Wide] is better for large sums.”
Here is my interpretation. Buffett is referring to relative allocation within a portfolio, rather the total size of the portfolio. If you decide to invest in the cheap category, you need greater diversity to protect against a higher failure rate. Therefore the sums invested in each company should be small in comparison to the total portfolio. On the other hand, a portfolio focused on blue chips should be concentrated because failure is less likely in that group.
It is true that a large capital base cannot find enough small investments to justify the time invested. However the context of Shai’s question clarifies that the portfolio is small enough so that diminishing returns are not a consideration. So, the point of Buffett’s response is not that small investors should be only looking at small caps. Either small or large caps are fine, but the strategy must be appropriate to their size. Don’t concentrate in a few small caps, and don’t buy every blue chip.
I like your interpretation of Buffett’s response. I hadn’t thought about the total context of Buffett’s response. Shai was asking about investing a $10 million portfolio, not a small $10 thousand dollar port. It would indeed be tough to get enough to get a sufficient number of “cheap and narrow” stocks the way Graham did to diversify his risk.
This discussion is extremely interesting. Thank your for sharing your opinions on this subject.
Anyway, I remember Buffett being quoted saying that the more you know about a situation the less you should diversify and vice versa. It seems to me that this should be true in small caps and in large caps. So, to me it is not really a question of great diversification of a small or micro cap portfolio and heavy concentration on large caps or blue chips, just because small caps are smaller and therefore inherently riskier than the blue chips. What I think is the single most important question in any investment situation: Do I really know what I am doing here or am I rather following some general rules? If I appear to be following some general rules I should choose great diversification. If, on the other hand, I appear to know a lot about some little company that has the greatest prospects and healthy financials then I guess I should not try to dilute my interest in it just because it seems too small to be a decent investment.
Thanks in advance for any comments.
Well, let’s take the level of expertise out of the equation. Now that I’m looking at Shai’s question a year later, I think the fundamental issue is whether cheap valuation is more attractive than competitive advantage. I don’t think there is a definitive answer to this. I personally believe that competitive advantage is preferable. However, a minimum return on capital must be met regardless of the company’s moat.
This may not yield the maximum performance for all portfolios, but I would argue that the reduction in risk justifies the strategy.
Of course, your’re right. The central point is what yields the best performance. Because at the end of the day this is what really counts.
Anyway, I still think Buffett tried to say, that if you start with little money you can get the best performance by sticking to old Grahamian techniques, which is simply buying assets for much less than their true worth. True worth in this regard meaning the liquidation value or, at best, reproduction value. Very cheap stocks, in most cases, do not justify the invested time for a proper DCF valuation or maybe even an approach with profitable growth scenarios.
But the degree of diversification still depends on your individual degree of knowledge. If you know a lot about what you are doing then diversification still seems foolish. But if you have only little expertise in any field you should probably stick to a portfolio of 10, or better yet, 20 different stocks to allow for some real stinkers.
I would suggest myself that if you are starting with well below $100,000 you should probably not try to buy into huge companies with big moats since you’ll almost never be able to pick them up really cheap. The best way to accrete as fast as possible is in my opinion the “$1 for 50 cents”-approach that Buffett followed when he was starting himself and didn’t yet have a lot to invest. As he grew richer it was time for him to change his approach and look for bigger companies with enduring competitive advantages so he wouldn’t have to think his portfolio over each year again. As a small starter you cannot wait for years and years to gain a hundred percent if you want to grow fast.
Buffett said he would still be able to make 50% a year on $1 million (in 1999). I don’t know if he was really being serious but if so, that means to me that you can do it as well if you just stick to Graham. At least until you start investing tens of millions.