INVESTOR COMPASS

Simple, but not easy

March, 2023

Concentrated value investing

 Eldred Rock Investor Compass March 2023

SIMPLE, BUT NOT EASY

“His strategy was the ultimate in simplicity and consistency.”
~ John Train on investor Mr. Womack

There once was a farmer who may be one of the greatest investors
that few have ever heard of. Mr. Womack was a rice and pig
farmer from Houston and an individual investor when he was the
subject of a 1978 article by John Train in Forbes Magazine. Mr.
Womack was not a sophisticated investor. He had not graduated
from college, and he had never heard of Benjamin Graham. His
investment process was simple – he read the Standard & Poor’s
Stock Guide and bought shares in companies when they were low-
priced. If shares fell further, he would add to his position. Years
later when shares were expensive – he would sell. Mr. Womack
took detailed notes of his transactions, and after 40 years of
investing, he never realized an annual loss (verified by his broker).

As the article notes, the secret to Mr. Womack’s long-term success

was his rational common sense. His process was simple and structured. He was unusually disciplined and
consistent in his method. He succeeded in the long run because he effectively removed emotion from the
investment process.

Process Driven

The best decision-makers are process-driven rather than performance-driven. They understand that by
focusing on process, favorable outcomes will inevitably follow (Mauboussin, et al, 2004). A process-driven
mindset maintains focus on what matters, maintains a long-term view, and removes emotion from the
process. Ultimately, dedication to a consistent process drives better decision-making.

Our investment process depends on rules-based decision-making. We have frequently talked about the
importance of our investment checklist. The checklist maintains our focus on those fundamental business
attributes likely to create long-term shareholder value.

We have also adopted rules to construct and manage portfolios, some of which are described in the
paragraphs below. Our consistent framework is backed by both academic research and empirical
evidence. Several years ago, we compiled this research as part of our firm’s white paper. Please let us
know if you would like a copy.

2
 Eldred Rock Investor Compass March 2023

Concentrated Portfolios

We manage concentrated portfolios. The U.S. Value and International Value strategies have typically
owned 20 companies.

As long-term investors, we want to build client portfolios with the highest quality companies at attractive
valuations. We seek to own proven business models that benefit from barriers to competition, maintain
conservative balance sheets, and are run by competent management teams. This is a demanding
checklist, and most companies simply fall short of our requirements.

Due to our quality bias, diversification matters less. Adding mediocre companies to the portfolio would
merely dilute the overall quality. We would rather own 20 of our best ideas rather than add unexceptional
ideas for the sake of diversification. Despite our portfolio concentration, our portfolios have historically
reported lower volatility than their benchmarks due to relatively higher quality and lower valuation.

Concentrated portfolios outperform. Perhaps surprisingly, a growing body of research has demonstrated
that most portfolio managers are competent stock pickers (Cohen et al, 2010). Their best ideas outperform
not only the rest of their portfolio, but also beat their benchmark by 300 bp per year (Yeung et al, 2012).
Yet managers consistently dilute this skill by adding non-conviction positions.

Exhibit 1: Manager top picks outperform their diversified portfolios

Holdings by Total Returns Standard Deviation

Sharpe Ratio
weights (annualized) (annualized)

Top 5 10.77% 26.33% 0.277

Top 10 9.39% 23.40% 0.255
Top 15 8.67% 21.83% 0.239
Top 20 8.12% 20.65% 0.228
Top 25 7.78% 19.79% 0.219
Top 30 7.44% 19.13% 0.210
All Funds 6.30% 19.51% 0.169
Own Index 5.05% 19.96% 0.080
Source: Danny Yeung & Paolo Pellizzari & Ron Bird & Sazali Abidin, 2012. "Diversification Versus
Concentration … and the Winner Is?" Working Paper Series 18, The Paul Woolley Centre for Capital
Market Dysfunctionality, University of Technology, Sydney). For the period 1999-2009

To “play it safe”, managers try to minimize their underperformance (tracking error) by owning too many
stocks across all sectors. To realize the benefits of both concentration and diversification, investors would
be better off investing in a handful of concentrated portfolios to meet their diversification needs. Ideally,
money managers would pick only their best stocks while clients would invest with several managers based
on their individual investment goals and risk tolerances (Yeung et al, 2012).

3
 Eldred Rock Investor Compass March 2023

High Active Share

To beat the market, you must be different from the market. Active share is a measure of the overlap of
portfolio holdings with the benchmark. While a high active share indicates little overlap, a low active share
suggests a more passive management strategy.

A high active share does not guarantee performance - the portfolio can be different but still underperform.
Yet research has shown that portfolios that combine both high active share and low portfolio turnover have
outperformed (Cremers, Pareek, 2016).

Eldred Rock portfolios are significantly different from their benchmarks with active shares of more than 95%.

Low Portfolio Turnover

We are buy-and-hold investors with a long investment horizon. Since inception, both investment strategies
have recorded around 15% portfolio turnover a year. This low level of turnover implies an average holding
period of nearly 7 years – unusually long in an industry where the average stock is now held for less than 6
months. We have always believed that an uncommonly long time horizon is the investor’s single greatest
advantage.

Warren Buffett has often remarked that if investors want to make fewer investment mistakes, they should
make fewer decisions. Trading is prone to the emotions of fear and greed – too often investors trade for
the wrong reasons. Truly great ideas are rare and the decision to trade should be infrequent.

The first rule of compounding wealth is to never interrupt it unnecessarily (Munger, 2021). Trading robs the
ability to compound capital over long periods of time. Morgan Housel has added, “if you understand the
truth behind compounding, then you realize that the most important question is not how can I get the
highest returns now, but what are the best returns I can sustain over the longest period of time” (Housel,
2020). Not selling requires incredible patience and discipline during the inevitable periods of
underperformance. The eventual reward of patience is decades of favorable returns.

Over several decades, academics have studied the impact of portfolio turnover on performance. Most
research concludes that investors trade too frequently (Bogle et al, 1999). For individual and professional
investors alike, portfolios with high turnover rates underperform portfolios with low turnover rates (Odean,
1999; Barber and Odean, 2000). Active trading increases the likelihood of bad decisions, raises investor
costs, effectively shortens the investment time horizon, and reduces the opportunity to compound
shareholder capital.

Summary

Success ultimately depends upon the quality of the investor’s systems. We have developed an investment
process that is simple, structured, and disciplined. All the stock-specific decisions we make for the portfolios
are through the lens of a long-term ‘business owner’. While portfolio concentration, high active share, and
low turnover cannot guarantee results, we believe that adopting these guidelines into our portfolio
construction tilts the odds of long-term success in our favor. We think that Mr. Womack would approve.