My Ideal Portfolio

I follow the way Warren Buffett invested while running his partnership. I also mix it up with his newer investment style and some of the riskier stuff the younger gurus do. Many other gurus that I follow have their portfolios set up this way. They have a few differences from Warren, but the foundation of their investment ideas is the same. This is the way my ideal portfolio will be set up.

A few of the differences that other gurus have from Warren are cigar butts, options trading, shorting, IPO’s, etc. Charlie Munger pulled Warren away from investing in cigar butts. I have seen some horrible looking companies that gurus buy into and I have to assume there are some cigar butt investments happening. Options, shorting and purchasing of recent IPOs are in the portfolios of a few gurus as well.

Risky Business

I got the risky business idea from Phil Town. His daughter, Danielle Town, and him talk about it in their book Invested. Risky business will be a category in my portfolio. It will contain all the things that I can’t comfortably place a value on, I’m not comfortable in the future prospects, there’s not enough history to research, etc.

The categories contained in the risky business portfolio will be cigar butts, sophisticated options trades, shorting, IPOs, and anything new I learn but haven’t tested. Risky business will make up 10% of my portfolio. The only way I will go above 10% is if I have a lot of confidence in an investment that I consider risky. I’ll have to be as confident as Michael Burry was about shorting the subprime market, which isn’t very likely anytime soon.

Cigar Butts

Cigar butts are companies that you can buy at a sufficiently low price. There will usually be a hiccup in the price and that gives you the chance to unload it at a decent profit, even though the long-term performance of the business may be terrible. Charlie convinced Warren that this approach wouldn’t scale, because the cigar butt opportunities wouldn’t have a meaningful impact on Berkshire Hathaway. Berkshire had grown too big.

Cigar butts won’t be a category in my portfolio. I don’t have plans to buy any cigar butts right now. I am more focused on wonderful companies. If I do find a cigar butt investment, it will go into the Risky business category of my portfolio.

A great business at a fair price is superior to a fair business at a great price

Charlie Munger

Options

Warren has used options, but he is too big now. Years ago, he sold puts on Coca-Cola and made an instant $7.5 million. The brokers have contract limits though. For the amount of stock he wants to buy, he would have to go through multiple brokers to sell enough puts on a security. It’s a waste of time for him, even though he can make some extra money.

I have to learn more about options before I attempt some of the more sophisticated trades. I don’t understand enough about Bull Put Spreads, Bear Call Spreads, Iron Condors, etc. These more sophisticated trades will be part of the Risky Business portfolio.

I understand selling puts and calls though. I do not consider these risky trades. Selling puts and calls is used in all of my portfolio categories.

Selling Puts

Selling puts can be a win-win situation. You know the price you want to buy a stock at and you sell a put option. If you get put the stock, that’s great because you wanted to buy it and you get paid a premium. Sure, you could have bought it at a lower price, but you’re already buying it at a margin of safety and you’re not worried about getting the last nickel. If you don’t get put the stock, that kind of sucks because you wanted to buy it, but it’s great because you get to keep the premium. Win-win.

Selling Calls

Selling calls can also be a win-win situation. You are now willing to sell the stock, at a great profit, and you sell a call option. If the stock gets called away, that’s great because you wanted to sell it and you get paid a premium. Sure, you could have sold it at a higher price, but you’re already selling it at a great profit and you’re not worried about getting the last nickel. If the stock doesn’t get called away, that’s great because you get to keep owning this wonderful company and you get to keep the premium. Win-win.

Waiting for the bottom is folly. What, then, should be the investor’s criteria? The answer’s simple: if something’s cheap, based on the relationship between price and intrinsic value, you should buy, and if it cheapens further, you should buy more

Howard Marks

Shorting

Warren believes that eventually shorting works out, but it’s painful. It’s a lot easier to make money on the long side. Making big money shorting is tough, because the risk of big losses means you can’t make big bets. It has ruined a lot of people and you can go broke doing it. There are some gurus that successfully include shorting in their portfolios though. Michael Burry is maybe the most famous for this. The Big Short was the book that put him on everyone’s radars. Then The Big Short movie really put him in the spotlight.

Being short and seeing a promoter take the stock up is very irritating. It’s not worth it to have that much irritation in your life

Charlie Munger

I have to learn more about shorting before I attempt it. My research with my gurus that have successfully done it. I’ll see what they have to say about it and look for books recommended by them on the subject. 

IPOs

The purchasing of recent IPO’s is something else I see in the portfolios of some of my gurus. This really interests me. It’s tough to get into venture capital or early stage investing with no money, so purchasing recent IPOs is the closest thing I’ve found to it. It’s exciting to buy that new, up-and-coming, hot stock every now and then.

Venture capital is so exciting because you get to help build or assist a startup for a portion of the company. The companies are usually cutting edge innovations that everyone loves. One day I hope to have the financial capability to get into venture capital and/or angel investing.

Recent IPOs will consist of small positions (around 1% of total assets) in each of five to ten IPOs. I want IPOs to make up 5% to 10% of my portfolio.

The Buffett Partnership

During the Buffett Partnership, Warren killed the market. He was able to kill it because he wasn’t managing nearly as much money. The law of large numbers states that as a company or fund grows, it becomes more difficult to sustain its previous growth rates. Many investors follow his partnership’s investment style, because it is applicable even today and many investors see the same returns.

You can see Warren’s investment style while managing his partnership by reading his Buffett Partnership Letters. In the letters, he split up his investments into three categories: Generals, Work-outs and Controls.

Anyone who says that size does not hurt investment performance is selling. The highest rates of return I’ve ever achieved were in the 1950s. I killed the Dow. You ought to see the numbers. But I was managing peanuts then. It’s a huge structural advantage not to have a lot of money. I think I could make you 50% a year on $1 million. No, I know I could. I guarantee that

Warren Buffett

The Generals

The “generals” were generally undervalued securities where he had nothing to say about corporate policies and no idea when the undervaluation would correct itself. This was the largest category of investment and the category that made the most money. The generals were made up of larger positions (5% to 10% of total assets) in each of five or six generals, with smaller positions in another ten to fifteen.

The generals are what make up the largest percentage of all my gurus portfolios as far as I know. They will also make up the largest percentage of my portfolio. I will have large positions (5% to 10% of total assets) in each of five or six generals, with smaller positions in another five to ten. The generals will make up around 50% to 60% of my portfolio.

The Smaller Positions

I believe I am going to split up my position totals by years since IPO. If there is 1 year of data, I’ll put up to 1% of my portfolio into that position. If there’s 2 years of data, I’ll put 2% of my portfolio into that position, and so on. When it gets to 10 years of data, I’ll put 10% of my portfolio into that position.

I like to see a company with at least ten years of data before I put double digit percentages into that position. You don’t really know how a company will act or the risks it’s taking until faced with adversity. I believe ten years gives a company sufficient time to face adversity and prove its durability.

Roughly every ten years our stock market has seen a crash of sorts. Warren calls them economic storms. This means the average company will face an event every ten years. Seeing how a company has handled an event in the past gives me the comfort of putting 10%, or maybe even more, into one position.

The Work-outs

The “work-outs” consisted of securities whose financial results depended on corporate action rather than supply and demand of buyers and sellers of securities. He could reasonably predict when he could get how much and what might prevent it from happening. Work-outs included mergers, liquidations, reorganizations, spin-offs, etc. He would have ten to fifteen work-outs in the portfolio. When he borrowed money, it was only as an offset against work-outs, and never more than 25% of the total portfolio.

Work-outs can be seen in the portfolios of gurus also. A great example is Fiat Chrysler Automobiles and the spin-off of Ferrari. The work-outs will consist of five to ten positions in my portfolio. The work-outs will make up around 20% to 30% of my portfolio. When I borrow money, it will only be an offset against work-outs and to do perform a control situation. I will never borrow more than 25% of the total portfolio.

The Controls

The “controls” were companies that he took control of or bought a large position and attempted to influence policies of the company. He would sometimes buy into a general with the thought in mind that it could develop into a control. I don’t see myself having the funds to perform any controls in my near future, so this category is on the backburner until I have the funds available.

Cash

Most of the gurus I follow keep cash. They want to be prepared when an opportunity arises to pile in to a company. Warren calls this being prepared with a bucket instead of a thimble when it rains gold.

Opportunities come infrequently. When it rains gold, put out the bucket, not the thimble

Warren Buffett

The Deceiving Public Portfolios

Guy Spier has said in the past that he likes to be fully invested. More recently, in one of his The Education of a Value Investor podcasts, he has said that he is selling off some of his profitable investments to get to 20% to 30% in cash.

You wouldn’t know that Guy was doing that without him making it public knowledge. 13F filings don’t require a manager to release how much cash they have. In the case of Guy, he jokingly said on the podcast that his portfolio size will shrink from $250 million to $200 million. It has been said that Mohnish Pabrai has close to $1 billion under management. According to Dataroma, his portfolio is $262 million. The other $700 million or so is in cash and companies not traded on the American stock exchanges.

I plan to follow Guy and constantly hold 20% to 30% in cash.

It’s Only Ideal

I know the math isn’t perfect, but it’s practically impossible to set up a perfect portfolio. Mine will grow organically and change as I obtain more knowledge. I will make investments as the opportunities arise. This is just my ideal portfolio that I am working towards.