Focus Over Diversification: Investing in Wonderful Businesses

Modern corporate finance courses, particularly those teaching Modern Portfolio Theory, are often criticized as "twaddle" because they promote diversification across numerous average businesses rather than concentrating on a few truly exceptional ones. This approach, while seemingly reducing risk, ultimately leads to average returns and fails to capture the significant wealth creation opportunities found in identifying and investing in outstanding companies.

The Flaw in Modern Portfolio Theory

The core argument against Modern Portfolio Theory (MPT) is that it encourages investors to spread their capital across 50 or more companies, aiming for diversification. However, this strategy often dilutes returns because truly exceptional businesses are rare. Fortunes are not built by owning a diversified portfolio of 50 average companies; they are built by identifying and investing heavily in a select few "wonderful businesses."

For example, Coca-Cola has been the foundation of many fortunes, yet there aren't 50 or even 20 equivalent companies. If there were, diversification among them would be effective. Since they are scarce, focusing on a few outstanding ones is a superior strategy.

The Power of "Wonderful Businesses"

A "wonderful business" possesses characteristics that make it highly resistant to economic downturns and intense competition. These businesses are often so well-protected that they are virtually immune to effective competition. Owning just three such businesses is considered safer and more profitable than owning a hundred average ones, or even 50 well-known large businesses. The risk is lower because these businesses are easier to understand and their long-term prospects are more predictable.

The idea that diversification across many average companies is safer is a misconception often taught in finance classes. In reality, there is less risk in owning a few easily identifiable, wonderful businesses.

The "Dementia" of MPT

The proponents of this view describe Modern Portfolio Theory as a form of "dementia" because it offers no real utility beyond achieving average results. While it may involve complex mathematical models and Greek letters, giving a false sense of sophistication, it adds no real value. Anyone can achieve average results without such elaborate theories.

Identifying Enduring Businesses

The key to successful investing lies in identifying businesses that are likely to remain strong and relevant for decades, rather than those prone to rapid change.

Characteristics of Enduring Businesses:

• Predictable Future: Investors should seek businesses where the future is relatively predictable. For instance, the soft drink, shaving, or candy industries are likely to look similar in 10 or 20 years.
• Strong Moats: These businesses possess significant competitive advantages that are difficult to replicate or destroy. Examples include:
  • Brand Recognition and Trust: Companies like Gillette have built immense credibility over decades. When they introduce a new product, consumers trust it.
  • Distribution Systems: Established global distribution networks, like those of Coca-Cola and Gillette, are invaluable assets that are incredibly difficult for competitors to build.
  • Continuous Innovation in Core Products: While avoiding industries with rapid, unpredictable change, companies like Gillette continuously improve their core products (e.g., shaving technology) while maintaining their market dominance.
• Resistance to Disruptive Change: Avoid businesses where rapid technological or market shifts are likely to occur. While companies like Microsoft are sensational and run by excellent managers, predicting their landscape in 10 or 20 years is extremely difficult. Betting on such companies means betting on the ability of their management to navigate unpredictable change, which is a risk many prefer to avoid.
• Global Reach: Companies like Coca-Cola and Gillette derive a significant portion of their profits from international markets (80% for Coca-Cola, 70% for Gillette). This global presence, managed effectively by focused leadership, provides a strong and diversified revenue stream.

Focus Over Diversification

The emphasis is on deep understanding and focus. Instead of diversifying across many companies, investors should concentrate on a few businesses they thoroughly understand and believe will endure. This approach allows for better risk assessment and greater potential for wealth creation.

The success of companies like Coca-Cola and Gillette in international markets is also attributed to their renewed focus. In the past, these companies sometimes diversified into unrelated areas, which did not yield positive results. A strong focus on their core competencies and maximizing their existing advantages has proven to be a more effective strategy.

In essence, the advice is to bet on what you know and understand, especially if it involves businesses with enduring qualities and strong competitive advantages, rather than relying on complex theories that promote broad, often mediocre, diversification.