Charlie Munger’s 3-stock Portfolio: Is it really what it pretends to be?

In a 2017 video, Charlie Munger famously claims that he owns just 3 investments, viz; Costco, Berkshire Hathaway and an investment in Li Lu’s investment partnership. He claims to have worked this out quite early in life and has apparently stuck to it.

This is a stark claim and he uses this to justify that most investors do not need many more stocks. Let us examine these claims from both a rational and an empirical point of view.

Warren Buffett himself has called Charlie Munger a genius. A genius who can pick 3 stocks which are unlikely to go bust individually and highly unlikely to go bust together could possibly provide enough safety to his portfolio of 3 stocks while generating high returns. We will examine the truth behind this statement.

However, for most others who aren’t Charlie Munger, how would a 3-stock portfolio fare? What if the stocks were Kodak — the photography company, or Blockbuster — the video rental company or Radio Shack — the electronics store? Each was a highly successful business with a strong moat. If one had all their investment assets in this 3-stock portfolio, would it have been a value investing portfolio?

If the investor was Munger, we can assume that he would either not have bought these stocks (why not?) or would have realized when to sell them before their moats were fully eroded. What if the investor was not that great a genius?

Is a portfolio strategy which requires the investor to be a genius a genuine investment strategy? Or should one reduce this constraint of requiring a genius?

Similarly, a 3-stock portfolio can go through a very rough time. Given that Berkshire itself has dropped by ~50% nearly 3 times in its life, it is likely that the 3-stock genius portfolio would go through periods of much larger drops. If the investor owning the portfolio has to live off this portfolio since all his investments are in this portfolio, could it be fatal to the future of the portfolio? Withdrawing from this portfolio for survival in a down-market where it is not clear when the market will revive could permanently erode the future value of this portfolio.

Let us examine whether Charlie Munger actually holds a concentrated or a diversified portfolio. Costco is definitely a single company, however well-entrenched and with moats it might be. So that one ticks the box. The second holding is Berkshire Hathaway.

Berkshire Hathaway has 200, possibly 250, subsidiaries as listed in its 10-K, from page 117 to page 122. In addition, the 13-F form filed by Berkshire shows around 50 holdings in listed companies.

Let us ponder if nearly 250–300 companies across multiple sectors and industries, with operations across the world and many of them publicly traded, is Berkshire Hathaway a single investment holding or an extremely diversified portfolio which has two geniuses who have assembled the portfolio of individual stocks or companies.

With a “single investment” like that who needs “diversification”?

Moving on to Li Lu’s investment partnership. We don’t have too much information about it but suffice it to say that it might be relatively concentrated given that it is run by a Munger fan. So we will not delve into it too much. Yes, it does, probably, have more Chinese companies, providing some diversification to the typical Berkshire holdings. You can be the judge as to whether one should do what Charlie says or one should do what Charlie does?

At OmniScience Capital, we owe a huge amount of intellectual capital to Charlie Munger (and Ben Graham and Warren Buffett among other foundational value investors). Our Scientific Investing approach is based on the philosophical foundations laid down by these stalwarts. OmniScience has developed the principles of Scientific Investing based on this philosophy.

We are discussing the merits and demerits of Charlie’s 3-stock portfolio concept, since in our opinion it could harm a lot of average investors (or even a lot of professional investors), who might be swayed by the personality backing the concept. We don’t mean to criticize Charlie. We understand that he is probably trying to sway the audience away from frequent trading and buying anything and everything that catches their fancy.

We would like to reiterate that the principles of Scientific Investing would suggest a 20–30 stock portfolio, say 25 stocks, for most investors. This could be assembled over a period of time for people who don’t have the time to do it all at once. Further, it could follow the exact same principles for stock picking that a 3-stock portfolio would. It would have diversification across at least 4 sectors and industries and have a maximum exposure limit to each sector (~1/3rd of the portfolio) and stock (~1/10th of the portfolio).

Disclaimer:

Past performance is not necessarily indicative of future results.

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