Investment PhilosophyInvestment Quotes

Practicing a “Punch Card” Approach to Investing

John Hempton, who runs a hedge fund and writes the blog called Bronte Capital, wrote a really interesting post over the weekend on investment philosophy. He basically calls out the majority of the professional money management community for cloning Buffett in word, but not in deed. His main point: many Buffett followers talk about the “punch card” approach to investing, but very few people actually implement this approach.

Here is Buffett explaining the Punch Card philosophy:

“I always tell students in business school they’d be better off when they got out of business school to have a punch card with 20 punches on it. And every time they made an investment decision, they used up one of their punches, because they aren’t going to get 20 great ideas in their lifetime. They’re going to get five or three or seven, and you can get rich off five or three or seven. But what you can’t get rich doing is trying to get one every day.”

It’s hard to describe how important and valuable this simple concept is. It’s one that I try to focus on, and try to get better at implementing each year.

But Hempton brings up a good point: lots of people talk about it, but very few people actually act this way. His reasoning for why people don’t follow such a sound approach is that it is hard to sell to clients. If you bought one stock every year or two, and you have a portfolio of say 7 or 8 stocks at a time, it may appear to clients (who see hardly any activity in their portfolios for months, sometimes years at a time) that you might not be working all that hard.

Trading activity has a way of making clients think that work is actually getting done. However, trading activity is almost always inversely correlated with investment performance. The client would be better off with the manager who charged his or her fee for selecting the punch card investments and then just sitting and waiting.

Bias Toward Activity

But human nature is difficult to overcome, and this type of an approach is difficult to implement. There are a few: Norbert Lou (who fittingly runs a fund named Punch Card) has built an outstanding track record of beating the market handily while making very few investments (his current portfolio consists of just three stocks and he makes very few new investments).

Hempton mentions that even Buffett’s two portfolio managers (Todd Combs and Ted Weschler) don’t follow a true punch card approach. I don’t know about Combs, but Hempton is wrong on Weschler I think, who is known for owning very concentrated positions in very few stocks and holding them for years (he compounded money at around 25% annually for 12 years in his fund before closing it to go work for Buffett, and the majority of his returns came from just a few positions that he held the entire life of the fund).

In fact, the majority of Weschler’s performance can be traced to two large investments that he owned throughout the life of his fund: DaVita and WR Grace. You could argue that those two investments were in large part responsible for his landing of a position at Berkshire. According to this article, he still holds a large personal stake in WR Grace (and what must be a massive personal deferred tax liability of something close to $100 million—he bought the stock for $2 in the early 2000’s).

So there are a few out there who walk the walk. But largely, I think Hempton is exactly right that most managers are biased toward activity. I also think many managers might not even consciously realize this bias. They intuitively want to convey to their clients that they are working hard, and one of the only ways to measure work progress (from the perspective of the client) is by looking at activity within the portfolio.

Some investment managers fear their clients think like this:

  • Lots of activity: the manager must be busy looking at lots of ideas
  • No change in the portfolio since last quarter: what has this guy been doing for three months? And why am I paying him?

Also, during a period of underwhelming performance, it can be difficult to stick with this approach. As Hempton says, these times can be extremely productive from a learning point of view:

But mostly I would have been just idle. So in the midst of underperformance a client might ask me what I did last year and I would say something like

a) I read 57 books

b) I read about 200 sets of financial accounts

c) I talked to about 70 management teams and 

d) I visited Italy, the UK, Germany, France, Japan, the USA and Canada 

This is such a great point. That type of workload will produce measurable results at some point in the future, but it won’t show up in this quarter’s statement that clients receive.

Just because there isn’t a lot (or any) activity in the portfolio doesn’t mean there isn’t a lot of activity going on in the research/learning department. I try and focus on getting better each day, regardless of whether I’m buying or selling anything. And in fact, the days I feel I’ve improved the most as an investor are usually the days where I am away from my computer screen deep in thought, reading something useful, or having productive conversations with someone that knows more about a particular business than I do.

Fortunately, I happen to have great clients who don’t expect activity from me, so I don’t feel any pressure to “come up with new ideas”. Instead, I can conduct my research efforts each and every day, and wait for opportunities. That said, I can improve on focusing more on my best ideas, and I try each year to get better at this.

The Concept Matters

Let me say that the concept is what is important here, not the actual number of punches. Buffett selected 20 as an example. Obviously, Buffett has made hundreds of investments over the years. He once said at an annual meeting that his partnership (from 1956-1969) made somewhere around 400 investments in various stocks. But he also said that the vast majority of those investments were small investments that didn’t have a significant net benefit to his returns. The vast majority of the money he made in his partnership was made from a handful of well-selected investments that he made a large portion of his portfolio (the famous example of course being American Express in the early 60’s, when he put 40% of his assets into that stock).

The key for Buffett was not his batting average, but his slugging percentage. He hit a lot of home runs in the stocks that he took big positions in. And even in the 70’s and 80’s when he was running a much larger portfolio, his best ideas made up a sizable portion of his portfolio. A quick glance at the equity portfolio from 1977 shows 24% of the assets in GEICO and another 18% in Washington Post. 2/3rds of his portfolio was concentrated in five stocks. By that point in his career, he was fully implementing the punch card approach, probably in large part because of his review of his partnership where he realized only a few big ideas were responsible for the entire performance record.

But again, there is no magic number that should be focused on. I think the concept is what is the key: there aren’t that many great investment ideas, and it’s crazy to think that you can find great ideas every day, week, month, or even year. Great ideas are rare, should be patiently waited on, and should be capitalized on when they come.

Easy to say, hard to do—especially when there is a built-in bias toward activity.

To Sum It Up

I really liked Hempton’s introspective review of his own investment philosophy, along with his honest observations. The strange thing is that he seems to imply that the punch card approach is the most sound, but yet he himself doesn’t practice it. This confounds me a bit. Either he hasn’t been able to shake the same bias he talks about (in his view it’s a very tough sell to clients), or maybe he thinks he can build a bigger business (more AUM) if he implements a more conventional long/short hedge fund strategy. I’m just completely guessing at his reasoning. Maybe I’m wrong and he doesn’t think the punch card approach is best.

But I think recognizing the “over-activity” bias is most of the battle—if you understand that you, as an investment manager, are going to be prone to activity and over-trading in an effort to justify your existence, then you at least have a chance to guard against it. It’s those who “don’t know that they don’t know” are the ones who don’t have a chance. Hempton clearly isn’t in the latter camp. He knows that he (like most humans) might be prone to this bias, so you’d think he would choose to guard against it and implement the better approach.

Either way, it was an interesting commentary, and one that I really agree with. Practicing a portfolio management strategy that involves very few (and very large) investments in high-quality companies at very infrequent junctures is a great approach, but one that can be viewed as unconventional, and thus difficult to practice in real life. I hope and plan to keep improving on this, one day at a time.

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John Huber is the portfolio manager of Saber Capital Management, LLC, an investment firm that manages separate accounts for clients. Saber employs a value investing strategy with a primary goal of patiently compounding capital for the long-term.

John also writes about investing at the blog Base Hit Investing, and can be reached at john@sabercapitalmgt.com.

20 thoughts on “Practicing a “Punch Card” Approach to Investing

  1. Through Berkshire Hathaway, Buffett owns around 100 operating companies. The investment portfolio holds around 50 positions (though probably closer to 40 since eight positions are Liberty group-related entities). I have trouble reconciling his “Punch card with 20 punches” comment with the actual structure of his holding company.

    1. Yeah, I think the key is to keep the concept of the punch card in mind, not the exact number. But I know what you’re saying. Although at this stage in the game, it’s hard to not own many investments just due to the sheer size of the firm. I think the key is looking at the equity portfolio, which has always been pretty focused, especially in the earlier years. Thanks for the comment!

      1. Out of curiosity, what is your opinion on Tom Gayner of Markel and Tom Russo of Semper Vic? They both have around 100 positions in their equity portfolio. Will their results end up tracking the index over time due to over-diversification?

        1. I haven’t looked at Russo’s portfolio lately, but any portfolio with 100 stocks (unless it’s weighted heavily toward a few ideas) is probably quite likely to track the index. Gayner’s stock portfolio is very diversified. I think of him as a very good, large growth mutual fund manager, who has beat the market by a couple points over time. That’s excellent performance given the size and scope of his portfolio.

    2. In my opinion, this is a classic Buffett “Do as I say, not as I do” moment. For some reference, check out this quote (which I have shortened up – it is from an interview where Buffett describes the structural advantages of investing smaller amounts of capital): “Citicorp sent a manual on Korean stocks. Within 5 or 6 hours, twenty stocks selling at 2 or 3x earnings with strong balance sheets were identified …The strategy was to buy the securities of twenty companies thereby spreading the risk that some of the companies will be run by crooks. $100 million was quickly put to work.” And like that, WEB punched a 20 investment card in 5-6 hours. In the quote above, Buffett’s “punch card approach” appears to be directed at students. This should probably be taken into some context as this mentality would prove extremely beneficial to anyone beginning to personally invest. It also has it benefits for the experienced investor as a reminder on the level of conviction that is often needed to make a successful investment. That said, Hempton seems to have a different direct quote (but the same message) on his blog. Anyway, I think the big picture is that it is probably more beneficial to learn the lessons of Buffett rather than trying to invest verbatim. I think John has nailed several of those in the post above. To keep the quote fest rolling, here is an incredibly insightful Michael Burry quote from The Big Short. “If you are going to be a great investor, you have to fit the style to who you are,” Burry said. “At one point I recognized that Warren Buffett, though he had every advantage in learning from Ben Graham, did not copy Ben Graham, but rather set out on his own path, and ran money his way, by his own rules. . . .” I have just quickly glanced at Bronte Capital’s blog post, but I am sure Todd Combs and Ted Weschler were not hired because they lived and died by Buffet’s word but rather because they manifested the teachings of value investing in their own styles.

      John – I have been reading your blog for a few years now and I really enjoy your writing. I find myself coming back often to reflect on many of your posts. I look forward to reading and learning more.

      1. Great comment. Yes, Burry’s comment about finding your own path as an investor is great. As for Buffett, yeah I think he’s trying to drill in the idea that you won’t get rich off finding new ideas frequently. And your risk will likely be lower if you wait for the truly exceptional ideas.

        But great points. Thanks for reading.

  2. Hey John,

    Another insightful perspective into portfolio management. Reading the BPL and even the BH letters you’ll notice he consistently owned the same few companies as his top holdings for long period of time. He has owned Wells Fargo for quite some time now. Just curious what your thought on Wells Fargo is with the latest scandal. I believe you wrote an article on the warrants not too long ago.

  3. I actually followed this approach but for a very different reason driven by fear. My mentor is one of the best in world in investing but no matter how hard I try, I really doubt I could beat people like him. So I choose a different path. My hurdle rate is a safe double in 2 years with minimum leverage, in other words, it is 40%+. In current environment, it is almost impossible to find such companies. So by extremely selective, I passed almost all investment opportunities, but I also skipped most traps along the way. So you see, my priority No.1 is always not to lose. Another thing is that when I find one, I do bet really really big. My last one was AENA. It is not so bad to have a good idea a year.

    I do not post much, but this article really resonates with me. Well done.

  4. Hey John,

    great post. Thanks!

    The problem is that the financial industry is one that obviously favors activity over inactivity. It appears to give them a buzz. It is the only explanation for the hilarious amount of company visits by many money managers. And it explains the dramatic rise in portfolio turnovers in the last decades.

    Activity signals that a money manager is dilligent and staying on the ball, that he is decisive. That he’a got a view about the state of the market and if his holdings are going to appreciate or depreciate in the immediate future.

    Inactive money managers, on the other end, are viewed as brain dead in an hyperactive and information overloaded world.

    Their lies the great danger of our times. In a world of information overload, permanent connectivity and hyperactivity we might eventually lose the connection to ourselves. Becoming strangers to our feelings and our needs. And finally loosing sight of whom we really are, as a human being as well as an investor.

    http://undervaluedjapan.blogspot.de/2016/08/inactivity-the-virtue-of-doing-nothing.html#more

    G O-tone

  5. Hi John, thanks for the post.
    I remember reading a post of yours about how turnover can be a good thing, if you can find ideas on a regular basis.
    Also, there is a nice recent post by Nate Tobik (OddBall Stock) that actually says: you can’t know everything, meaning something can always go wrong. So, no matter how sure you are about an idea, if you put 50% in it and a black swan comes – you’re doomed.

    1. Yeah I think most of the investors who have done 20% or more had some level of turnover. Allan Mecham is an investor I’ve cited recently. I think he follows the punch card concept, but he still has portfolio turnover (he might keep a stock for 2-3 years and eventually replace it with something that he deems to be better value). So while he doesn’t make many investments, he still has some turnover (and certainly will have more than 20 investments over a lifetime). As I mentioned, Buffett had turnover and also had many investments (although his investments became larger and more frequent as he got better as an investor). Weschler is very rare, in that he kept his two main holdings the entire duration of his fund and still did around 25% annual returns. But even Weschler had some turnover in his other investments. So I am not suggesting “buy and hold forever” is the approach that must be followed, but I do think that imagining each investment decision as if it were only 1 of 20 that you could make is a great way to think. It eliminates a lot of marginal investment ideas, and allows you to focus only on the ideas where you have a higher level of conviction on the business and the value.

  6. an unwarranted assumption that reading “books”, fin stmts, talking to mgmt, and travelling will produce “measurable results”.

  7. Nice post. I sometimes take the “20 hole punchcard” theory to mean that the market will only serve you 20 blatantly mispriced opportunities in your entire life and you need to size them up. You may get more than that but not be prepared for them due to liquidity, tax concerns, etc.

    1. That’s a good way to think about it. There aren’t that many home run investment ideas in a lifetime. When they come you have to capitalize on them.

  8. If you read the quote carefully and the context, it applies to individual investors (students in business schools who will pursue careers in management, marketing, sales, etc), not to sophisticated money managers. Key point is “they’d be better off” “They”

    Because individual investors trade in and out too often, they make a lot of mistakes and their returns are on average bad.

    Strict buy and hold of a basket of good companies would do much better. Hence the punchcard approach. You both missed the point.

    1. He’s said many times that professionals and individuals alike would be better off if they thought this way. Munger talks about it as well in his Art of Investing Talk.

      That said, I pointed out in the post that the concept is the thing that matters, not the actual number of punches. But the concept is relevant for both individuals and professionals.

  9. The pressure to wait for a pitch is hard to deal with at times.

    Even when you don’t have to swing there is alays , voice in the back of your mind telling you to act.

    I was playing a company soft ball game and it was slow pitch no strikes unless you swing and you miss.

    Not to paint a vivid picture but I struck out because I couldn’t handle not swinging because I felt like I was holding the game up. Likewise to investing I sometimes feel the pressure of inactivity.

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