Six Stock Portfolio Performance

It has now been roughly 3 and a 1/2 years since I first mentioned the Six Stock Portfolio. At that time, I considered those stocks attractive long-term investments, at the then-prevailing price levels, for my own portfolio.*

At the time, I felt the share price of each represented a very nice discount to likely intrinsic value a few years out (and beyond) and said as much. No estimate of value can be perfect, of course, but each seemed oddly cheap back then compared to even the most conservative estimate of their intrinsic worth.

None are selling at much, if any, discount to my judgment of their value. To me, at the very least, the margin of safety is now insufficient.

As a group, the six stocks have obviously done just fine since they were first mentioned.

Stock                                                | Total Return**
Wells Fargo (WFC)                                    91%
Diageo (DEO)                                           187%
Philip Morris (PM)                                 189%
Pepsi (PEP)                                                 52%
Lowe's (LOW)                                             67%
AmEx (AXP)                                             230%

Since April of 2009, the combined total return is 136 percent (including dividends) for these six stocks while the SPDR S&P 500 (SPY) returned 82 percent (also including dividends).

So that's a ~54% performance gap achieved in 3 and a 1/2 years with no portfolio turnover and little, if any, trading abilities required (well, actually none). It's always a focus on paying a price that's comfortably below my best estimate of intrinsic value (necessarily more of a range of values than a precise number).

The fact that shares of very fine businesses like these were that inexpensive back in April of 2009 still seems amazing.

Since none are particularly cheap at this point, some might ask why not switch from these somewhat expensive stocks (or, at least, a whole lot less cheap) into something a bit less expensive.

On rare occasions, I'll consider a switch if: 1) valuation becomes extreme on the high side, 2) I've lost confidence in (or significantly misjudged) the long-term prospects of the business, or 3) I understand an equal or better quality alternative investment pretty much as well that is clearly much cheaper.
(Something that is just plainly a superior investment alternative. I mean, it generally has to be just screaming at me.)

Otherwise, I'm just not that smart. Each move is just another chance to make a mistake. Buying and selling isn't just a chance to improve results, it's a chance to hinder them. It's all too easy to overweight the likelihood that a move will improve portfolio performance while not considering the possibility it might do just the opposite. It's an Illusion of Control. Of course, each move also creates unnecessary frictional costs.

I own these because my judgment is that they have durable advantages that support attractive business economics and it was, at one time, possible to buy the shares comfortably below my conservative estimate of intrinsic value. Once I own shares of a good business at the right price (at least those that I understand), my bias is to not sell for a very long time. That means sometimes holding onto shares of a business I like even if, due to increased market prices, the stock might temporarily no longer be a bargain relative to current estimated per share intrinsic value.
(As long as my expectation is that intrinsic value will still increase over the long haul at an attractive rate.)

I don't expect many to buy into this way of thinking but it's a recognition of my own limits. We'll see how these six perform over many years compared to the S&P 500. If I'm an idiot it will clear over time.

The blog is here to make sure of that.

This concentrated portfolio is meant to be an example of how above market returns can be accomplished with minimal to no trading. I'd imagine it takes a fair amount of energy to learn trading techniques and become proficient (though I don't plan to find out). My interests lie elsewhere. Instead, my energy and focus has always been on judging business quality and value, being disciplined about buying shares at a substantial discount to that value, and minimizing frictional costs of all kinds.

Returns are driven by the economics of each business not some unusual talent for trading.

Of course, many investors -- depending on the circumstances -- will want or need to own more than six stocks but portfolio concentration can make sense.***

At least for me, it's not possible to get a good understanding of 50-100 businesses.

Some may be able to do just that, but I can't.

I suspect there are a few who are kidding themselves that they understand so many businesses well enough to risk their capital.

So I think above average returns can be achieved without some unusual acuity for trading but, instead, via paying the right price for good businesses with sound economics and owning them for a very long time.

At some point each of these businesses (and maybe their stocks) will almost certainly not perform well for a period of time. Yet, considering both the quality of the businesses and the prices that became available for shares in April 2009, I'd expect this portfolio to outperform in the very long run with less risk of permanent loss of capital.

Of course, if the economic moat of one of these businesses was materially impaired (or if capital allocation decision-making by management becomes a serious concern), I will certainly consider switching one of these out.

It's probably obvious for those who've read some of my previous posts that I don't view it as a good thing this portfolio has doubled in value so quickly. Right now, I am comfortable with these six stocks long-term but, at current prices, neither I nor these companies can buy shares at an extreme discount to value.

In the long run, as Buffett pointed out using the IBM example in the most recent Berkshire letter, that will reduce returns for long-term owners. So it makes no sense to be happy the stocks have run up this much.

It does, in fact, actually hurt relative and absolute long-term performance.

The gap in performance more recently shouldn't be sustainable. If it does continue, then price action will certainly begin significantly outrunning increases to intrinsic value. Not a good thing. At the end of 2011, these six stocks combined, since April 9th, 2009, had a ~33% performance advantage over the S&P 500. Less than a year later, it is now already up to a ~54% advantage. It seems improbable these stocks will continue expanding the gap over the S&P 500 at such a rate over the longer haul.

These are good businesses, in my view, but their capacity to increase per-share intrinsic value is far more modest than that.

In other words, it seems likely some underperformance is overdue for maybe even an extended period of time.

I certainly hope so.

So, while I'm not surprised that these six are doing well compared to a broad-based index (and should look very solid over a 10-20 year and longer horizon), the extent of the more recent outperformance continuing simply is not likely at all.

Still, if they do produce nice risk-adjusted returns over the very long haul, it will because these six enterprises continued to have sound core business economics and were bought at a discount to per share value in the first place.

Finally, I'd add that 3 and a 1/2 years is still not really long enough to make a meaningful judgment on relative performance.

Adam

Long position in WFC, DEO, PM, PEP, LOW, and AXP

* This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here are never a recommendation to buy or sell anything and should never be considered specific individualized investment advice. In general, intend to be long the positions noted unless they sell significantly above intrinsic value, core business economics become materially impaired, prospects turn out to have been misjudged, or opportunity costs become high.
** Includes dividends and based upon closing price on April 9th, 2009 compared to this past Friday.
*** It comes down to reliably judging business economics. Index funds will be, of course, the more logical alternative for many investors. Portfolio concentration is a disaster waiting to happen for anyone not able to reliably judge business economics. As always, awareness of individual limits is key.

Six Stock Portfolio Performance

It has now been a little less than three years since I first mentioned the Six Stock Portfolio. At that time, I considered those stocks attractive long-term investments, at the then-prevailing price levels, for my own portfolio.*

At the time, I felt the share price of each represented a very nice discount to likely intrinsic value a few years out and said as much. No estimate of value can be perfect, of course, but each seemed oddly cheap back then compared to even the most conservative estimate of their intrinsic worth.

Some are still at a discount to my judgment of their value, but not by enough to warrant buying more shares. To me, the margin of safety is now insufficient.

As a group, the six stocks have a bit more than doubled in price since they were first mentioned.

Stock                           |4/9/09 Price| Current Price| Total Return**
Wells Fargo (WFC)        19.61                31.29                 65%
Diageo (DEO)                  45.54                 95.56              133%
Philip Morris (PM)        37.71               83.52               151%
Pepsi (PEP)                      52.10                62.94                32%
Lowe's (LOW)                 20.32                 28.38                48%
AmEx (AXP)                    18.83                52.89              195%

The combined return is 104 percent (including dividends) for these six stocks while the SPDR S&P 500 (SPY) (also including dividends) returned 68 percent over the same time frame.

Below is a quick summary of current trailing price to earnings ratio and dividend yield of each stock compared to the SPDR S&P 500.

Stock | Trailing P/E| Dividend Yield
 WFC        11.1                   1.5%
 DEO         19.8                   2.7%
 PM            17.1                   3.7%
 PEP          14.3                   3.3%
 LOW        17.1                   2.0%
 AXP         12.9                   1.4%

The combined yield of these six is 2.4% while naturally, since the stocks as a group have doubled, the yield on the April 2009 initial investment would be close to 5%.

The yield on the SPDR S&P 500 is currently 1.9% but would be more like 3% on the initial investment if bought back in April 2009.

So the bottom line for this portfolio is returns have been 104% in a little less than 3 years while the six stocks continue to pay nearly 5% in dividends on the initial investment.

Pepsi's been the laggard and probably will continue to do so as they sort out some of their problems. I still view it as a good business for the long haul but I'll be keeping an eye on their progress in improving business performance.

Intrinsic value of the other five businesses continues to increase at a nice clip. Each business seems to be performing just fine. Unfortunately, so have the stocks.

As far as valuations go, Lowe's certainly isn't cheap but that relatively high P/E is partly the result of where we are in the housing cycle. Philip Morris and especially Diageo are, unfortunately, getting rather expensive (though both look a bit more reasonably valued based upon current year earnings).

The fact that these stocks were that inexpensive back in 2009 still seems amazing to me.

So, unfortunately, none are cheap enough to buy more at this point. Some might ask why not switch some of these not so cheap shares into something else that is more plainly cheap.

On rare occasions, I'll consider a switch if: 1) valuation becomes extreme on the high side, 2) I've lost confidence in (or significantly misjudged) the long-term prospects of the business, or 3) I understand an equal or better quality alternative investment pretty much as well that is clearly much cheaper (I mean, it generally has to be something else that is just screaming at me). Otherwise, I'm just not that smart. Each move is just another chance to make a mistake and creates unnecessary frictional costs.

I own these because my judgment is that they have durable advantages that support attractive business economics and it was, at one time, possible to buy the shares comfortably below my conservative estimate of intrinsic value. Once I own shares of a good business at the right price (at least one that I understand), my bias is to not sell for a very long time. That means sometimes holding onto shares of a business I like even if, due to increased market prices, the stock might temporarily no longer be a bargain relative to current estimated per share intrinsic value.
(As long as my expectation is that intrinsic value will still increase over the long haul at an attractive rate.)

I don't expect many to buy into this way of thinking but it's just a recognition of my own limits. Let's just see how these six perform over many years compared to the S&P 500. If I'm an idiot it will clear over time.

The blog is here to make sure of that.
(The other 15 stocks I've mentioned in my Stocks to Watch posts are also as a group up quite a bit more than the S&P 500. That's unfortunate as few of them are easy to buy right now. It would be easier if at least some of them became a bit cheaper.)

This concentrated portfolio is meant to be an example of how above market returns can be accomplished with minimal to no trading. I'd imagine it takes a fair amount of energy to learn trading techniques and become proficient (though I don't plan to find out). My interests lie elsewhere. Instead, my energy and focus has always been on judging business quality and value, being disciplined about buying shares at a substantial discount, and minimizing frictional costs of all kinds.

Returns are driven by the economics of each business not some unusual talent for trading.

Of course, some may want or need to own more than six stocks but I generally view concentration as a good thing. At least for me, it's not possible to get a good understanding of 50-100 businesses.

Some may be able to do just that but I can't.

I suspect there are a few who are kidding themselves that they understand so many businesses well enough to risk capital.

So I think above average returns can be achieved without some unusual acuity for trading but, instead, via paying the right price for good businesses with sound economics and owning them for a very long time.

Naturally, like Pepsi, at some point each of these businesses will not perform well for a period of time (and stock performance will suffer). Still, considering both the quality of the businesses and the prices that became available for shares in April 2009, I'd expect this portfolio to outperform in the long run with less risk of permanent loss of capital.

Of course, if the economic moat of one of these businesses was materially challenged (or if capital allocation decision-making by management becomes a serious concern), I will certainly consider switching one of these out.

It's probably obvious for those who have read some of my previous posts that I don't view it as a good thing this portfolio has doubled in value so quickly. Right now, I am comfortable with these six stocks long-term but, at current prices, neither I nor the company can buy shares at an extreme discount to value.

In the long run, as Buffett pointed out using the IBM example in the most recent Berkshire letter, that will reduce returns for long-term owners. So it makes no sense to be happy the stocks have run up this much.

It actually hurts relative and absolute long-term performance.

If these stocks do well over the long haul, it will because the six companies themselves continue to have attractive core business economics and were bought at a discount to per share value in the first place.

Finally, three years or so is still actually not long enough to make a meaningful judgment on relative performance in my view.

Adam

Long position in WFC, DEO, PM, PEP, LOW, and AXP

* This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here are never a recommendation to buy or sell anything and should never be considered specific individualized investment advice. In general, intend to be long the positions noted unless they sell significantly above intrinsic value, core business economics become materially impaired, prospects turn out to have been misjudged, or opportunity costs become high.
** Includes dividends and is based upon the closing price on April 9th, 2009 compared to February 29, 2012.

Six Stock Portfolio Update

Portfolio performance since mentioning on April 9, 2009 that I like these six stocks as long-term investments if bought near prevailing prices at that time (or lower, of course).

While I never make stock recommendations each of these, at the right price, are what I consider attractive long-term investments for my own capital.

Intrinsic Value: The Six Stock Portfolio

The portfolio is made up of the following stocks: Wells Fargo (WFC), Diageo (DEO), Philip Morris International (PM), Pepsi (PEP), Lowe's (LOW), and American Express (AXP).

Stock | Total Return*
 WFC  |  44.4%
 DEO   | 110.5%
 PM     |  135.6%
 PEP    |  38.5%
 LOW  |  31.6%
 AXP   | 162.5%

The total return for the six stocks combined is 87.2% (including dividends) since April 9, 2009. By comparison, the S&P 500 SPDR ETF (SPY) is up 54.0% (also including dividends) over that same time frame.

While the S&P 500 is down since I last updated this portfolio, the six stocks as a group continued to build on their gains. As a result, the portfolio's performance advantage expanded further. That certainly won't be the case in every period considering the concentration.

Unfortunately, none of these are selling at the kind of discount to intrinsic value I'd require to buy more shares.

Hopefully that will change.

The above is a relatively low turnover and concentrated portfolio of high quality businesses. It is, in part, meant to be an example of Newton's 4th Law at work (or, alternatively, a way to avoid being tripped by the invisible foot).

Adam Smith felt that all noncollusive acts in a free market were guided by an invisible hand that led an economy to maximum progress; our view is that casino-type markets and hair-trigger investment management act as an invisible foot that trips up and slows down a forward-moving economy. - Warren Buffett in the 1983 Berkshire Hathaway Shareholder Letter

The approach rejects the idea that trading rapidly in and out of different securities is necessary to create above average returns. Instead, build a concentrated portfolio of high quality businesses that can outperform over the long-haul.

Buying shares at a discount to value (conservatively calculated), low "frictional costs", and the intrinsic value created by the businesses themselves becomes the driver of total returns not some special aptitude for trading or timing the market. In short, the outperformance, if it continues, will come from owning shares of good businesses bought with an appropriate margin of safety combined with little in the way of unnecessary fees, commissions, and related costs.

Buffett on Helpers and "Frictional" Costs

My view is that many equity investors would get improved long-term returns, at lower risk, if they: 1) bought (at fair or better prices) shares in 5-10 great businesses, 2) avoided the hyperactive trading ethos that is so popular these days to minimize mistakes & "frictional" costs, and 3) sold shares in these businesses only if the core long-term economics become impaired or opportunity costs are extremely high.

This six stock portfolio is clearly very concentrated by most standards but this approach to investing rejects the idea that vast diversification is needed.

I have more than skepticism regarding the orthodox view that huge diversification is a must for those wise enough so that indexation is not the logical mode for equity investment. I think the orthodox view is grossly mistaken.

In the United States, a person or institution with almost all wealth invested, long term, in just three fine domestic corporations is securely rich. And why should such an owner care if at any time most other investors are faring somewhat better or worse. And particularly so when he rationally believes, like Berkshire, that his long-term results will be superior by reason of his lower costs, required emphasis on long-term effects, and concentration in his most preferred choices. - Charlie Munger in this speech to the Foundation Financial Officers Group

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 in the 1993 Berkshire Hathaway Shareholder Letter

Clearly, many investors need to diversify holdings a bit more. As always, one of the most important things is to always stay well within one's own limits as an investor. Depending on background and experience, low expense index funds may make more sense for some than buying individual stocks. Yet, keeping trading and other frictional costs to a minimum is almost always wise.

Though I could surely be wrong, I consider these six stocks appropriate for my own portfolio (not someone else's) given my understanding of the downside risks and potential rewards. It doesn't make sense for others unless they do their own research and reach similar conclusions.

The above concentrated portfolio of six stocks obviously won't outperform in every period. In the long run, it has a reasonable probability of doing well compared to the S&P 500 due to lower frictional costs and the durable high return qualities of the businesses. While unlikely to outperform the very best portfolio managers**, it's likely to perform well on an absolute basis, especially when risk-adjusted, relative to the market as a whole over a period of 10 years+.

It's worth noting the unusual allocation of this portfolio.

When I put this together, I intentionally allocated one half the portfolio to consumer staples (DEO, PEP, PM), a third in financials (WFC, AXP), and a housing stock (LOW). At the time, none of these were exactly the hot trade of the moment.

Consumer staples were, of course, thought to be too defensive (lately, unfortunately, they've become a bit too popular...the substantial discounts to value that were available for many stocks in this sector have quickly disappeared) while many financial and housing stocks were in rough shape and in many ways continue to be so.

In part true, certainly, but you don't get bargains on good businesses when the outlook is sunny. Also, I consider the idea that one needs to jump in and out of stocks (or ETFs) based upon what the hot sector is to outperform is, to be kind, not a very good one (more a recipe to make mistakes and generate unnecessary fees and commissions).

Most readers of this blog will know the one thing I've said consistently is that the Coca-Cola's (KO), Pepsi's, and Philip Morris International's of the world are not defensive in the long-run.
(Okay, this has received more than its fair share of coverage on this blog but the fact is many consumer staple businesses, though each has a unique set of risks, often do not get enough respect as long-term offense while instead getting overplayed as short-term defense.)

Stocks in the consumer staples sector are, especially when bought well, often a lower risk way to outperform. For most of the time I have been making this point they've been priced from between extremely cheap to attractive. While not necessarily expensive now, most of these are no longer extremely cheap, either. So there are some great stocks in this sector to own for the long haul but the price paid still matters and the bargains, among consumer staples, have all but disappeared.

The point is I wanted this portfolio to be made up of businesses that, once shares were bought at the right price, could be, for the most part left alone to compound in value across multiple business cycles. Some may want exposure to other sectors not represented here which is fine if quality can be had at a fair or better price. We'll see how the portfolio continues to perform.

In any case, this simple example is designed so it's easy for anyone to check the results over time. If this six stock portfolio*** isn't performing well against the S&P 500 it will be obvious. The idea that a concentrated portfolio of quality businesses bought with a margin of safety can perform well while avoiding the hassle and risks of trading should, at least, be of some interest. Producing results via the increasingly popular hyperactive buying and selling of securities seems inspired by Sisyphus by comparison to me.

Finally, an opportunity may come along where the capital from one of these stocks is needed. My view is under such a scenario the threshold for making changes needs to be high. That hypothetical new investment must have clearly superior economics and relative price.

In addition, if something appears to fundamentally threaten the moat (ie. the effect of the internet on the newspaper biz) of one of these businesses a change may also be warranted.

So I may rarely add or switch some of the stocks in this portfolio but I will only make a change if the situation described above exists (ie. if the core long-term economics of one of these stocks become impaired or opportunity costs of not making a change is extremely high).

Keep in mind that even though the stocks I chose have done well versus the S&P 500, I still don't consider a little less than three years a meaningfully long enough time frame to measure performance.

Adam

Long position in DEO, AXP, PEP, PM, WFC, and LOW

* Total return is calculated using the closing price on December 31, 2011 compared to the closing price on April 9, 2011 (the date these stocks were first mentioned) plus dividends. I've used the closing price on April 9, 2011 (instead of something like average intraday price) even though it reduces the calculated total return slightly. The benefit is that it makes the calculation simpler and easier to confirm. In other words, better market prices were available intraday April 9, 2011 (and in subsequent days) so total returns could have been improved with some careful share accumulation. In any case, as always the comparison with the S&P 500 is apples to apples.
** There's no shortage of evidence that many actively managed equity mutual funds underperform the S&P 500. 

"Of the 355 equity funds in 1970, fully 233 of those funds--almost two thirds--have gone out of business. Only 24 outpaced the market by more than one percentage point a year--one out of every 14. Let's face it: These are terrible odds!." - John Bogle

Also, DALBAR's Quantitative Analysis of Investor Behavior (QAIB) study released in March 2009 revealed that over the past 20 years investors in stock mutual funds have underperformed the S&P 500 by 6.5% a year (8.35% vs. 1.87%). Beyond the performance of the funds themselves, it shows that much of these poor returns come down to investor behavior. The tendency of investors to buy the hot mutual fund that has been going up while selling when the market is going down out of panic or fear.
*** I don't think these are necessarily the six best businesses in the world, but I believe they are all very good businesses that were selling at reasonable to cheap prices on April 9th, 2009. At any moment, there is always something better to own in theory but I don't think you can invest that way (as if stocks are baseball cards) and have consistent success. So there are certainly quite a few other shares in businesses that would be good alternatives to these six. The point is to get a handful of them at a fair price and then let the businesses and time work.
------------
This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here are never a recommendation to buy or sell anything and should never be considered specific individualized investment advice. In general, intend to be long the positions noted unless they sell significantly above intrinsic value, core business economics become materially impaired, prospects turn out to have been misjudged, or opportunity costs become high.

Six Stock Portfolio Update

Portfolio performance since mentioning on April 9, 2009 that I like these six stocks as long-term investments if bought near prevailing prices at that time (or lower, of course).

While I never make stock recommendations each of these, at the right price, are what I consider attractive long-term investments for my own capital.

The portfolio is made up of the following stocks: Wells Fargo (WFC), Diageo (DEO), Philip Morris International (PM, Pepsi (PEP), Lowe's (LOW), and American Express (AXP).

Stock |Total Return*
 WFC |  70.9%
 DEO  |  83.0%
 PM    |  90.2%
 PEP   |  33.4%
 LOW |  37.6%
 AXP  | 172.4%

Total return for the six stocks combined is 81.2% (including dividends) since April 9th, 2009 while the S&P 500 is up 63.2% (also including dividends) over that same time frame. This is a conservative calculation of returns based upon the average price of each security on the date mentioned. Better market prices were available in subsequent days so total returns could have been improved with some careful accumulation.

The above is a relatively low turnover and concentrated portfolio of high quality businesses. It is, in part, meant to be an example of Newton's 4th Law at work (or, alternatively, a way to avoid being tripped by the invisible foot).

Adam Smith felt that all noncollusive acts in a free market were guided by an invisible hand that led an economy to maximum progress; our view is that casino-type markets and hair-trigger investment management act as an invisible foot that trips up and slows down a forward-moving economy. - Warren Buffett in the 1983 Berkshire Hathaway Annual (BRKa) Shareholder Letter

The approach rejects the idea that trading rapidly in and out of different securities is necessary to create above average returns. Instead, build a stable/concentrated portfolio of high quality businesses that can outperform over the long-haul.

Buying shares at a discount to value (conservatively calculated), low "frictional costs", and the intrinsic value created by the businesses themselves becomes the driver of total returns not some special aptitude for trading or timing the market. In short, the outperformance, if it continues, will come from owning shares of good businesses bought with an appropriate margin of safety combined with little in the way of unnecessary fees, commissions, and related costs.

Buffett on Helpers and "Frictional" Costs

Many equity investors would get improved long-term returns, at lower risk, if they: 1) bought (at fair or better prices) shares in 5-10 great businesses, 2) avoided the hyperactive trading ethos that is so popular these days to minimize mistakes & frictional costs, and 3) sold shares in these businesses only if the core long-term economics become impaired or opportunity costs are extremely high.

This six stock portfolio is clearly very concentrated by most standards but the Buffett/Munger approach rejects the idea that vast diversification is needed.

I have more than skepticism regarding the orthodox view that huge diversification is a must for those wise enough so that indexation is not the logical mode for equity investment. I think the orthodox view is grossly mistaken.

In the United States, a person or institution with almost all wealth invested, long term, in just three fine domestic corporations is securely rich. And why should such an owner care if at any time most other investors are faring somewhat better or worse. And particularly so when he rationally believes, like Berkshire, that his long-term results will be superior by reason of his lower costs, required emphasis on long-term effects, and concentration in his most preferred choices. - Charlie Munger in this 1998 speech to the Foundation Financial Officers Group

Clearly some, depending on background and experience, may need to diversify holdings a bit more. For others, low expense index funds may make more sense than buying individual stocks. Yet, keeping trading and other frictional costs to a minimum is almost always wise.

As always, one of the most important things is to always stay well within one's own limits as an investor.

Though I could surely be wrong, I consider these six stocks appropriate for my own portfolio (not someone else's) given my understanding of the downside risks and potential rewards. It doesn't make sense for others unless they do their own research and reach similar conclusions.

The above concentrated portfolio of six stocks obviously won't outperform in every period. In the long run, it has a reasonable probability of doing well compared to the S&P 500 due to lower frictional costs and the durable high return qualities of the businesses. While unlikely to outperform the very best portfolio managers**, it's likely to perform well on a risk-adjusted basis relative to the market as a whole over a period of 10 years+.

It's also worth noting the unusual allocation of this portfolio. First of all, there is not/has not been exposure to the hot sectors (commodities these days and surely something else down the road) and no attempt to do so. When I put this together, I intentionally allocated one half the portfolio to consumer staples (DEO, PEP, PM), a third in financials (WFC, AXP), and a housing stock (LOW). At the time, none of these were exactly the hot trade of the moment. Staples too defensive. Financials and housing a mess. All partly true but shares of a good businesses usually aren't cheap when the macro environment looks great.

Not to beat a dead horse but most readers of this blog will know the one thing I've said consistently is that the Coca-Cola's, Pepsi's, and Philip Morris International's of the world are not defensive in the long-run. They are often a lower risk way to outperform.
(Okay, maybe I've beaten this one dead but the best consumer staple businesses, while each having a unique set of risks, often do not get enough respect as long-term offense instead getting overplayed as short-term defense.)

The point is I wanted this portfolio to be made up of businesses that, once shares were bought at the right price, could be, for the most part, left alone to compound in value across multiple business cycles. Some may want exposure to other sectors not represented here which is fine if quality can be had at a fair price. We'll see how it continues to perform.

In any case, this simple example is designed so it's easy for anyone to check the results over time using this blog. If this six stock portfolio*** isn't performing well against the S&P 500 it will be obvious. The idea that a concentrated portfolio of quality businesses can perform well while avoiding the hassle and risks of trading should, at least, be of some interest. Producing results via the increasingly popular hyperactive buying and selling of securities seems inspired by Sisyphus by comparison to me.

Finally, an opportunity may come along where the capital from one of these stocks is needed. My view is under such a scenario the threshold for making changes needs to be high. That hypothetical new investment must have clearly superior economics and relative price.

In addition, if something appears to fundamentally threaten the moat (ie. the effect of the internet on the newspaper biz) of one of these businesses a change may also be warranted.

So I may rarely add or switch some of the stocks in this portfolio but I will only make a change if the situation described above exists (ie. if the core long-term economics of one of these stocks become impaired or opportunity costs of not making a change is extremely high).

Keep in mind that even though the stocks I chose have done well versus the S&P 500 I don't consider a mere couple of years as a meaningfully long enough time frame to measure performance.

Adam

Long position in DEO, AXP, PEP, PM, WFC, and LOW

* As of 4/11/11.
** There's no shortage of evidence that many actively managed equity mutual funds underperform the S&P 500. 

"Of the 355 equity funds in 1970, fully 233 of those funds--almost two thirds--have gone out of business. Only 24 outpaced the market by more than one percentage point a year--one out of every 14. Let's face it: These are terrible odds!." - John Bogle

Also, DALBAR's Quantitative Analysis of Investor Behavior (QAIB) study released in March 2009 revealed that over the past 20 years investors in stock mutual funds have underperformed the S&P 500 by 6.5% a year (8.35% vs. 1.87%). Beyond the performance of the funds themselves, it shows that much of these poor returns come down to investor behavior. The tendency of investors to buy the hot mutual fund that has been going up while selling when the market is going down out of panic or fear. 

*** I don't think these are necessarily the six best businesses in the world, but I believe they are all very good businesses that were selling at reasonable prices on April 9th, 2009. At any moment, there is always something better to own in theory but I don't think you can invest that way (as if stocks are baseball cards) and have consistent success. So there are certainly quite a few other shares in businesses that would be good alternatives to these 6. The point is to get a handful of them at a fair price and then let time work.
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This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here are never a recommendation to buy or sell anything and should never be considered specific individualized investment advice. In general, intend to be long the positions noted unless they sell significantly above intrinsic value, core business economics become materially impaired, prospects turn out to have been misjudged, or opportunity costs become high.