Why: You're going to own your time and work for no one but yourself. Independence.

“We made a lot of money but what we really wanted was independence. What’s really great is if you can do what you want to do in life and associate with who you want to associate in life, and we’ve both had that spirit all the way through, (it’s) one of the luxuries of life.” - Warren Buffett

What: You’re going to have a highly concentrated, value-oriented investment portfolio that’s held for the long-term, compounding capital over time. 

"Your goal as an investor should be simply to purchase, at a rational price, a part interest in an easily understood business whose earnings are virtually certain to be materially higher, five, ten, and twenty years from now. Over time, you will find only a few companies that meet those standards-so when you see one that qualifies, you should buy a meaningful amount of stock." - Warren Buffett

"My life has been a product of compound interest. The first rule of compounding: Never interrupt it unnecessarily.” - Warren Buffett

How:

1. You’re only going to have “10 units” in your entire portfolio.

“With each investment you make, you should have the courage and conviction to place at least 10% of your net worth in that stock.” - Warren Buffett

“We believe that a policy of portfolio concentration may well decrease risk if it raises, as it should, both the intensity with which an investor thinks about a business and the comfort level he must feel with its economic characteristics before buying into it.” - Warren Buffett

Growing up, I was always told to diversify my stock portfolio. We’ve all seen the models on asset allocation depending on one’s age and aggressiveness. But, if you’re going to actively manage your stock investments, much of that goes out the window. As Buffett warns, good ideas are rare, and you should only be willing to invest in something if you’re comfortable putting 10% of your net worth into it. I take this quite literally and think about my portfolio as only containing 10 units. I’ll usually start with a pilot position and look to scale into it as my conviction rises. It’s not uncommon for a single position to be 20-30% of my portfolio.

2. You’re going to swing at your pitch and ONLY your pitch.

“The trick in investing is just to sit there and watch pitch after pitch go by and wait for the one right in your sweet spot. And if people are yelling, ‘Swing, you bum!,’ ignore them. You don’t have to be an expert on every company, or even many. You only have to be able to evaluate companies within your circle of competence. The size of that circle is not very important; knowing its boundaries, however, is vital.” - Warren Buffett

“You have to figure out what your own aptitudes are. If you play games where other people have the aptitudes and you don’t, you’re going to lose. And that’s as close to certain as any prediction that you can make. You have to figure out where you’ve got an edge. And you’ve got to play within your own circle of competence.” - Charlie Munger

This is the most subjective part of actively managing your investments. You must determine your “pitch.” Mine has evolved through the years and will probably continue to do so in the future. However, I currently look to invest in smaller public companies that have undergone a management change and are demonstrating sound capital allocation, with the results starting to appear in their financial performance (an approach copied from Buffett). One such example for me has been Lattice Semiconductor, which at one point was my largest holding. A very capable and highly motivated CEO, Jim Anderson, took the helm in 2018, and he focused the company on a single market segment where it had a competitive advantage: low power chips that can be reprogrammed. Meanwhile, the demand for such chips was exploding, thanks for 5G, edge computing, and the internet of things. Anderson succeeded in revamping the company culture, with the employees committed to delighting their target customers, which started to show in financial performance. Having been involved with turnarounds for my day job, I appreciate the importance of cultural transformation and extreme focus on a competitive advantage. So, even though these investments can take years to develop, it’s what best suits me. And, especially when the markets plummeted in early 2020, I added significantly to my Lattice holding.

3. You’re going to “bet” more when your conviction rises (higher percentage of units).

“The wise ones bet heavily when the world offers them that opportunity. They bet big when they have the odds. And the rest of the time, they don’t. It’s just that simple.” – Charlie Munger

“My American Express history includes a couple of episodes:  In the mid-1960's, just after the stock was battered by the company's infamous salad-oil scandal, we put about 40% of Buffett Partnership Ltd.'s capital into the stock - the largest investment the partnership had ever made.” - Warren Buffett

I messed this principle up for a long time, too often being content with a decent gain instead of adding more capital to a winning position. But, it’s very much like a poker game where you have to bet big when you believe that you have the best hand. I now use a modified version of the Kelly Formula, which adjusts as assets grow and still leads to heavy bets when I believe that the outcome is auspicious. A recent example that I’ve discussed openly is Atlas Corporation (NYSE: ATCO). A miniature version of Berkshire Hathaway, I would have been comfortable with it occupying 50% of my portfolio. It was a perfect “pitch,” with David Sokol taking the top post in 2017 and orchestrating a brilliant turnaround. Furthermore, it was an excellent capital allocator, with strong ownership, and even paid a decent dividend. I would have happily held the stock indefinitely, but it is likely being taken private by its largest shareholders.  

4. You’re going to do a lot of waiting, reading, and learning but not trading.

“Lethargy bordering on sloth remains the cornerstone of our investment style” - Warren Buffett

“The real money is in the waiting, not the trading.” - Charlie Munger

While my day job is building early-stage tech companies, I dedicate the first 1.5 hours of my work schedule to value investing. During this time, I read, think, meditate, etc., mostly trying to learn and be on the lookout for the perfect pitch. I copied this habit from Charlie Munger who, when he was still practicing law, would dedicate the first hour of his work day to his personal investments. Figuring I’m not nearly as smart as Charlie, I give myself an additional 30 minutes. My actual transactions during this time, however, are minimal. While there are some amazing traders out there, I'm just not one of them. For me, the time is better spent learning and reminding myself of key concepts from the “6 Best Books on How Warren Buffett Invested before Becoming a Billionaire.”

5. You’re going to be a contrarian, typically doing what others are not and completely ignoring most pundits.

“But it’s not enough to do the opposite of what others are doing. You have to understand what they’re doing; understand why it’s wrong; know what to do instead; have the nerve to act in a contrary fashion; and be willing to look terribly wrong until the ship turns and you’re proved right.” - Warren Buffett

This principle is mostly about temperament and might be the least teachable. By definition, you’re going to be in what David Swensen called “uncomfortably idiosyncratic” positions as a value investor. This suits me because I’m competitive and also like to reach my own conclusions. Companies are like puzzles to me, and I enjoy reviewing financials, listening to earnings calls, and scrutinizing shareholder letters. I’ve also been the chief marketing officer of multiple companies and have a media background, so I know that a lot of nonsense gets published each day and don’t struggle to tune most of it out. I actually wrote down the attributes that make me an effective investor and would recommend the exercise to others. Investing is a game. I like being an investment committee of one, where you make money when you’re right and pay a price when you’re wrong.

6. You’re going to use your relatively smaller amount of capital to your advantage.

"Clearly you run into companies that are less followed as you get smaller and there's more chances for inefficiency when you're dealing with something where you can buy $100,000 worth of it in a month rather than $100 million." - Warren Buffett

“The highest rates of return I’ve ever achieved were in the 1950’s. I killed the Dow. You ought to see the numbers. I think I could make you 50% a year on $1 million. No, I know I could. I guarantee that.” - Warren Buffett

This is another principle that took me a while to understand. As the smaller investor, you have an incredible advantage because your investment universe is much larger. For example, Berkshire Hathaway is now far too big to invest in small companies, like it once did. In order to move the needle, it has to deploy and return billions of dollars, whereas you and I can invest in almost anything. This includes small and microcap companies (<$2B market cap), which represent more than half of the equities listed in the US but are often out of reach of institutional investors.

7. You’re going to capitalize on the inevitable market cycles and price discrepancies but not try to time them.

“Be fearful when others are greedy and greedy when others are fearful” - Warren Buffett

“Following Ben’s (Graham) teachings, Charlie and I let our marketable equities tell us by their operating results – not by their daily, or even yearly, price quotations – whether our investments are successful. The market may ignore business success for a while, but eventually will confirm it. As Ben said: ‘In the short run, the market is a voting machine but in the long run it is a weighing machine.’ The speed at which a business’s success is recognized, furthermore, is not that important as long as the company’s intrinsic value is increasing at a satisfactory rate. In fact, delayed recognition can be an advantage: It may give us the chance to buy more of a good thing at a bargain price.” - Warren Buffett

Especially in bear markets, you’re going to be presented with buying opportunities, as your margin of safety typically widens. I was alive for the bubble bursting in 2001, began investing more actively during the crash in 2008, and have now experienced big corrections in 2020 and 2022. I also try to study the dynamics of market cycles, in hopes of recognizing and capitalizing on them. For example, Howard Marks’ book, Mastering the Market Cycle, is an excellent overview on booms and busts, which are largely driven by credit. Meanwhile, Edward Chancellor’s book, Devil Take the Hindmost: A History of Financial Speculation, is a great breakdown on the world’s biggest market implosions, and it reveals that human nature causes the same circumstances to repeat themselves. As Ben Graham taught us, “Mr. Market” will habitually present great stocks at cheap prices, but the key is to identify and act on them. 

8. You’re going to leverage yield, especially “yield on cost,” for extremely long holding periods.

“Generate funds at 3% and invest them at 13%” - Charlie Munger

“Most companies pay consistent dividends, generally trying to increase them annually and cutting them very reluctantly. Our “Big Four” portfolio companies (American Express, Coca-Cola, IBM and Wells Fargo) follow this sensible and understandable approach and, in certain cases, also repurchase shares quite aggressively. We applaud their actions and hope they continue on their present paths. We like increased dividends, and we love repurchases at appropriate prices.” - Warren Buffett

Coke example: Berkshire is a long-term investor. Buffett first purchased shares of Coca-Cola in 1988. That year, Coca-Cola paid 7.5 cents per share in dividends. The stock traded for approximately $2.50 per share after adjusting for stock splits along the way. Based on Buffett's original purchase price and the current annual dividend payout, Berkshire will receive 56% of its original investment in dividends this year alone (2016). This is called yield on cost, and it explains the awesome power of dividend growth investing. If an investor owns a stock for many years, those reinvested dividends allow the investor to acquire more shares of stock. These shares then generate their own dividends, which can reinvest in even more shares. This creates a sort of "snowball" effect of compounding interest. This lowers an investor's cost basis. In some cases cost basis can go to zero, if the investor owns the stock for long enough. With enough time, it is possible to generate annual dividends at or above 100% of the original investment. In this instance, the investor is receiving more in annual dividend income than the entire original investment amount.

Imagine owning a stock that returns your entire initial investment every time that you receive a dividend payment. You only need to get one or two of these right in your investment career, as Buffett has demonstrated with Coca-Cola and American Express. Yet, I’ve made horrendous mistakes around this principle. First, my prescient grandmother bought 100 shares of Exxon stock for me in the mid-1980s, shortly after I was born. The stock later split (2:1) in 1987, 1997, and 2001. The money was intended for my college education, but I was able to keep the 800 shares after graduating, thanks to academic scholarships. Thinking that I was wisely “diversifying,” I sold half of the shares in 2007. Of course, it would have been amazing if the dividends were reinvested back into Exxon stock the entire time, but I’m quite certain that my single mother didn’t know the concept of a dividend reinvestment and also relied on those dividends to make ends meet at times. Even still, imagine what the position would be worth if I had not sold any shares and had automatically reinvested the dividends when I took control of the stock in the late-2000s. I made the same mistake another time, when I exited Innovative Industrial Properties (NYSE: IIPR) after quickly tripling my money. That position would have grown to over seven figures if dividends had been reinvested, with healthy yield as a REIT. 

9. You’re going to sell when the investment thesis changes or something better arises.

"We would sell if we needed money for something else -- I would reluctantly sell something terribly cheap to buy something even cheaper." - Warren Buffett

“We sell really when we think we're reevaluating the economic characteristics of the business. We probably had one view of the long-term competitive advantage of the company at the time we've bought it, and we may have modified that.” - Warren Buffett

Since the goal of a concentrated portfolio is to hold a small number of positions for an extremely long period of time, determining when to sell is another highly subjective principle. While the ideal holding period is “forever,” when you find a better use of capital or when the thesis changes, it’s likely time to get out of the position. With Macerich, for example, I began buying too early, in hindsight. I started when the stock was in the 30s but added more to the position when it was in the single digits, ultimately bringing my cost basis to the low teens. After holding it for several years, the thesis changed when its largest competitor offered to acquire the company for $91 per share in 2015. I sold the entire position once the stock surged on the news, feeling that it was a significant premium on a stock that I didn’t want to hold forever.

10. You’re going to judge your performance against the S&P 500 over rolling 5-year increments 

“While I much prefer a five-year test, I feel three years is an absolute minimum for judging performance. It is a certainty that we will have years when the partnership performance is poorer, perhaps substantially so, than the Dow. If any three-year or longer period produces poor results, we all should start looking around for other places to have our money. An exception to the latter statement would be three years covering a speculative explosion in a bull market.” - Warren Buffett

“However, in our partnership business I not only can’t say whether December will be better than July, but I can’t even say that December won’t produce a very large loss, it sometimes does. Our investments are simply not aware that it takes 365-1/4 days for the earth to make it around the sun.” - Warren Buffett

Value investing is hard. It requires the right temperament, in addition to a voracious appetite for learning, some skill and a lot of patience. While Buffett and Stan Druckenmiller have been able to produce incredible streaks of outperformance in their careers, most investors are going to have down years. Even great investors like Charlie Munger and Bill Miller have had down years. Plus, a concentrated portfolio is prone to significant swings and may show paper losses. Taking Buffett’s advice, a simple barometer is to compare your returns to the S&P over 5 year increments. If you’re not able to beat it, it’s probably wise to index, which is laid out well in Morgan Housel’s book, The Psychology of Money: Timeless lessons on wealth, greed, and happiness.