“There is one other rule you ought to keep in mind and that is to concentrate, and not only in the Zen sense. Sweet are the uses of diversity, but only if you want to end up in the middle of an average” Adam Smith, the Money Game 1968
“Statistical analysis shows that security-specific risk is adequately diversified after 14 names in different industries, and the incremental benefit of each additional holding is negligible. We own 18-22 companies to allow us to be amply diversified but have the flexibility to overweight a name or own more than one business within an industry.” Mason Hawkins
“Empirical testing has proved beyond a reasonable doubt that the “riskiness” of a portfolio of 12-15 diverse companies is little greater than one loaded with a hundred or more” Frank Martin
“If you can identify six wonderful businesses, that is all the diversification you need. And you will make a lot of money. And I can guarantee that going into a seventh one instead of putting more money into your first one is gotta be a terrible mistake. Very few people have gotten rich on their seventh best idea. But a lot of people have gotten rich with their best idea. So I would say for anyone working with normal capital who really knows the businesses they have gone into, six is plenty, and I probably have half of what I like best. I don‘t diversify personally. ” Warren Buffett
This month’s issue of Value Investor Insight contains an interesting interview with Frank Martin of Hummingbird Partners.
Since his Martin Capital Management embraced equity investing in 2000, Frank Martin has achieved a truly impressive record of outperformance. His firm’s equity composite has beaten the S&P 500 by some 700 basis points per year since inception. However, thanks to his cautious stance, Martin has underperformed. Throughout the period he has only been 30% to 70% invested.
Still, Martin’s new venture, long/short hedge fund Hummingbird Partners, which he co-founded with Peter Wong, promises to replicate his strategy and help investors recognize his stock-picking acumen. Hummingbird is looking for opportunities in such areas as jet engines, agriculture and industrial and auto supply. Here are some of the key takeaways from the Hummingbird Partners interview.
Frank Martin of Hummingbird Partners on Cyclical Investing
Martin starts the conversation by discussing what makes a good business. He believes, along with many other investors that the key to a lasting business model is “structural competitive advantages, those inherent features that prevent rivals from entering a company’s business and/or competing effectively with it.” He goes on to give some examples such as “monopolies or oligopolies, razor/ razorblade businesses, enduring brands, network effects, high switching costs and economies of scale. Perfect business models don’t exist, but many come close to varying degrees.” An example of which is Gentex, which owns the market for auto-dimming mirrors and lights:
“It has such a strong position in a small-enough niche that companies trying to wedge their way into the market are likely to have a terrible return on capital for many years. It’s run by an owner-operator, Fred Bauer, who founded the company in 1974 and is just a first class operator who funds very-productive R&D and maintains a balance sheet with what some might call too much cash, but which we love because of the optionality it provides. That’s part of being anti-fragile.”
But Hummingbird’s co-founder isn’t just attracted to good businesses in niche markets; Martin is also interested in large companies trading at attractive valuations where he can act as a contrarian:
“For instance, we took advantage of the fairly recent break in oil prices to invest in energy-services companies like Baker Hughes. Rather than try to figure out which of the exploration companies to bet on, we went for “picks-and-shovels” type companies…We will also at times walk toward controversy when others are running away. In 2010 I bought BP in this case primarily as a trade, right in the middle of the Gulf-oil-spill mess…Sometimes the impetus is less dramatic. With Wal-Mart, we’ve seen sentiment ebb and flow over the extent to which Amazon is going to eat its – and everyone else’s – lunch. Our basic view is that there will continue to be space for Wal-Mart, especially given that 50% of its revenues come from groceries, which has proven a tougher sale online.”
Cyclical businesses are also an area of interest for Martin. While most investors would shy away from cyclical businesses fearing earnings volatility, Martin and team like to make the most of volatile earnings and the favorable share price movements they produce:
“Many people associate cyclical businesses with bad businesses because they don’t produce stable, consistent cashflows like bonds. We disagree. A good business to us is one where we can assess its earnings power over a full cycle and buy it when its shares are attractively priced relative to that earnings power.”
Agriculture is one such industry. The sector is currently suffering from an earnings recession “since the cycle turned in 2013, farm income in the U.S. is down approximately 40%, ” yet the “U.N. projects that world population by 2050 will grow by a third, to 9.7 billion. Nearly all of the increase will come from developing countries, where income levels are growing.” Farms will have to think up new ways to increase yield to get meet this growth. “Estimates are that crop production will have to grow by at least 60% from current levels to meet estimated demand by 2050…all of the 60% increase in crop production will have to come from increasing yield.” The best way to play this trend Martin believes is via “agricultural companies that reliably prove capable of facilitating yield growth.” Hummingbird’s goal: buy the best ones when they’re out of favor.
Martin’s entire investment strategy is based around business cyclicality. When it comes to valuation and timing acquisitions, he says:
“I’ve always found the best place to start is where the company has been priced over its history, relative to itself and to its industry. From there, we try to buy against some reasonable estimate of earnings power when it’s out of favor and to sell when it’s in favor. We use as a threshold that the price can at least double in five years through a combination of business performance and improved valuation.”
From all of the above, it’s clear Hummingbird’s investment strategy is a contrarian one so it could come as no surprise that the fund currently owns some down-and-out businesses. On top of Gentex above, Martin likes Rolls-Royce and Fastenal, both of which have seen their shares slide recently.
The original article appears on ValueWalk.com and is available here.