6/11/22, 11:58 PM A Good Filter For Finding Winners

Chris Mayer Feb 16 8 min read

A Good Filter For Finding Winners

I hope you are doing well and holding up through the market turmoil. Once again, the overall
indexes mask the pain of the typical shareholder. While the S&P is down only 6-7% year-to-date, I
have a handful of stocks in my portfolio down at least 17% and as I scroll through my watch list,
there are plenty of stocks down more than 20% year-to-date.

Well, hang in there and keep your eye on the horizon. Below, I share two short pieces on things I've
been thinking about lately. They may help you get through the choppy waters with your sanity
intact. I hope you enjoy them in any case.

Family Ownership: Paying the Price that Longevity Requires

“My experience as a money manager suggests that entrepreneurial instinct equates with sizable
equity ownership.”

I think it must be 20 years ago now when I first read that line in Martin Sosnoff’s book Silent
Investor, Silent Loser. It made a deep impression. Ever since, I’ve tried to never lose sight of the
power of ownership, of having “skin in the game.”

I made this idea a key filter in my investment philosophy. I want to invest alongside people who
have a sizable equity ownership in the business. The first thing I do when I look at a business is
pull up the proxy. If there are no significant shareholders among the executives and directors, it’s
an easy pass. I go on to the next name.

Does it mean I will miss out on great investments run by hired hands with very little skin in the
game? Of course. A good investment filter makes the investable universe manageable and is
absolutely essential for managing your time and attention. Filters, by design, exclude. You have to
be comfortable with the idea that a lot of good ideas will slip through your nets.

A good filter should focus on things that help you find winners. You want to fish in good waters.
Stocks with higher levels of insider ownership tend to outperform their peers, as backed up by
various studies. In short, there’s good fishing in these pools.

There are many kinds of owners, though. When you start to delve into this subject, you discover a
lot of nuance to the whole thing. Over the years, I’ve developed my own list of sub-filters and rules.
(For example, never buy anything sold by private equity). I have my reasons, and good ideas
always slip by, but my rules have kept me out of trouble. (Another one to watch for: The
advantages of insider ownership do not necessarily translate across cultures).

But one kind of ownership I’ve been especially fascinated by is family ownership. My interest in
family businesses led me to work with the Bonner family office in 2016. I’ve known the Bonners
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since I started publishing my own newsletter back in 2004. Bill Bonner is a partner in Woodlock
House Family Capital. And the Bonner family is a major investor in the fund.

It seems to me that family ownership is naturally fitted to making decisions with the long-term in
mind. If anybody can resist the siren song of short-termism it would be a family. A good body of
academic research out there that indicates this is, indeed, the case. And my experience working
with the Bonners affirms what I have read. They have been ideal partners and investors.

As for that academic research, I recently came across a piece by the Harvard Business Review
(HBR), in which they write the following:

“Rather than being obsessed with hitting quarterly earnings targets, as public companies are,
family businesses tend to think in terms of generations, which allows them to take actions
that put them in better position to endure the tough times.”

And here is a specific example of a quantifiable action that allows for that survival:

“Debt is a great way to fund growth and goose return on equity, but it also puts the company
at risk during the inevitable downturns in the economy. Family businesses last longer because
they are able to pay the price that longevity requires.”

Family businesses tend to use less leverage than their peers. I would add, however, that public
companies with family ownership often display many of the same traits of privately owned family
companies. When I look at my portfolio, I have several family-owned businesses, such as Brown &
Brown (the Brown family) and Heico (the Mendelsons). Certainly, I would say they are great
examples of what good family ownership can bring to the table and fit what HBR’s research is
saying.

Another, harder to quantify, advantage for family businesses mentioned by HBR:

“In many studies, family companies have been shown to be better employers and community
citizens than their non-family–run peers. That’s a distinct competitive advantage, one that
represents capitalism at its best.”

There are always exceptions, but again it’s about fishing in a good pond.

I’ve been reading through bits of the HBR’s Family Business Handbook: How to Build and Sustain a
Successful, Enduring Enterprise. The second chapter is titled “The Power of Family Ownership.”

The authors note that in a typical public company, the classic corporate pyramid has the CEO on top
and then managers and employees below. “But in family businesses,” they write, “an inverted,
hidden pyramid sits on top of the classic one.” Here is the diagram:

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The authors write:

“The idea of owners at the top makes little sense at a widely held public company, given their
limited influence beyond selling their shares. In the long-term potential of a public company,
the owners aren’t terribly important. The board and the CEO are the voices that matter.”

Sadly, this is all too true in my experience.

Anyway, I like the idea of the inverted pyramid. It’s a way to think about your companies. Where
does the power lie? Is it with the CEO? The board? The owners? Are you okay with the answers to
these questions?

Thinking through these issues is essential if you are a long-term investor in businesses. Having
confidence in the people at the helm will make holding through corrections, such as what we’ve
experienced of late, that much easier.

Often troubled times present opportunities for the entrepreneurial. And you know what Sosnoff says
about entrepreneurial instinct...

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How many stocks?

How many stocks in a portfolio is enough, or not enough, or too many?

There are lots of ways to answer this question. I don’t think there is an ideal for everyone. It’s a
matter of personal taste, psychology and skill set. I like to run with 10-12 names. Below I’d like to
share how I think about the question.

First, I think it’s important to say that owning more stocks will not save you. Many people seem to
believe if they own more stocks then they are “diversified.” Owning fewer stocks is somehow
“riskier” and “dangerous.” But what is prudent can be quite the opposite (though there is an
exception, which I’ll get to below.)

Let me relate to you a great story as told by Joel Greenblatt:

GREENBLATT: Right, well Warren Buffett has a good response to that as well. He says listen,
let's say you sold out your business and you got $1 million. And you are living in town and
you want to figure out something smart to do with it.

So you analyze all the businesses in town. Let’s say there’s hundreds of businesses. If you find
businesses where the management’s really good, the prospects for the business are good, it’s
run well, they treat shareholders well, and you divide your million dollars between eight
businesses that you researched well in town, no one would think that’s imprudent. They would
actually think that was pretty prudent.

But when you get to call them “stocks,” and you get stock quotes daily on these pieces of
paper that bounce around, people put numbers on it. And there’s volatility and all these other
things that are really not that meaningful.

So, in one sense you’re investing in businesses and you did a lot of research and invested in
eight different businesses with the proceeds of your sale. Most people would think you’re a
pretty prudent guy.

But if you invested in eight “stocks” and did the same type of work, people would think you’re
insane.

[I’ve slightly edited the above for clarity.]

There is an exception, as I mentioned. Note, Greenblatt says “you did a lot of research.” It would be
crazy to buy eight businesses without understanding them really well. Most people can’t dedicate
the time and resources it takes to study businesses. So if you can’t do that, then you maybe
shouldn’t buy individual stocks at all – at least not with serious money. You may be better off in a
fund.

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Greenblatt also wrote, in his famous book You Can Be a Stock Market Genius, that owning just
eight stocks eliminates 81% of the nonmarket risk of owning just one stock. And you can eliminate
93% of the nonmarket risk by owning just 16. As he writes, “without quibbling over the accuracy of
these particular statistics, two things should be remembered:”

There is another important point that sometimes gets overlooked: If you want to run a
concentrated portfolio, then certain stocks must be off-limits (for example, highly-leveraged
businesses) or you risk disaster. Your focus needs to be: “don’t lose money.” And you can do that by
raising the quality of what you own. Search out wonderful businesses as Warren Buffett has often
said, and ignore everything else.

I’ve been watching old Berkshire meetings, which you can watch on YouTube. (It is addicting).
There is a great clip from the 1996 annual meeting where Buffett and Munger talk about
diversification. Here is some of what Buffett said:

“If you want to make sure that nothing bad happens to you relative to the market you own
everything. There's nothing wrong with that. That is a perfectly sound approach for somebody
who does not feel they know how to analyze businesses.

“If you know how to analyze businesses and value businesses then it’s crazy to own 50 stocks
or 40 stocks or 30 stocks… because there aren't that many wonderful businesses, and that are
understandable to a single human being, in all likelihood… To have some super wonderful
business and then put money in number 30 or 35 on your list of attractiveness and forgo
putting more money into number one just strikes Charlie and me as madness.

“If you look at how the fortunes were built in this country, they weren't built out of a portfolio
50 companies. They were they were built by someone who who identified a wonderful
business. Coca-Cola is a great example. A lot of fortunes have been built on that and there
aren't 50 Coca Cola's. There aren't 20. If there were, it would be fine; we could all go out and
diversify like crazy among that group and get results that would be equal to owning the really
wonderful one.

“But you're not gonna find it and the truth is you don't need to. I mean, if you had a really
wonderful business, it is very well protected against the vicissitudes of the economy over
time… And three of those will be better than a hundred average businesses. And they'll be
safer incidentally. There is less risk in owning three easy to identify wonderful
businesses than there is owning 50 well-known big businesses. It's amazing what has
been taught over the years in finance classes.” [Bold added.]

Everyone will have to find their own answer to the question of “how many stocks?” And there’s
more to think about than what I have addressed here.

For me, I love the idea of owning about a dozen wonderful businesses that I get to know really well
and then leave them alone. No trimming. No “trading around positions.” No fretting during
drawdowns. As long as the businesses continue to perform, I just let them be.

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Thanks for reading.

Sincerely,
Chris

***
Published on February 16, 2022
Please see our disclaimers

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