Perhaps the best advice Warren Buffett gave to investors was his "punch card" argument.
Put simply, Buffett argued that an investor at the start of his or her career should be given a punch card with only 20 holes in it, limiting the number of investments that can be made. Yes, only 20 investments allowed over an entire career.
Buffett certainly adhered to that philosophy on his journey to becoming one of the richest people on the planet. Much of his billions can be attributed to just a few great investments. (My colleague, Amy Calistri, explains the multiple benefits of Buffett's argument in this recent article.)
One that really sticks out is Buffett's investments in American Express (NYSE: AXP).
As a result of the infamous "salad oil scandal" in 1964 -- where the company was on the hook for guaranteeing $150 million of collateral for loans which didn't exist -- American Express shares were clobbered. The company's potential liability sent investors running for the hills. Its stock dropped more than 50% costing the company nearly $58 million.
While everyone was pulling out and cutting their losses, Buffett saw it as a golden opportunity. He believed the fears over the eventual liability were overblown, and he made a big concentrated investment in American Express.
In fact, Buffett actually changed his investment rules inside the Buffett Partnership, increasing the amount he was allowed to put into one position to 40% in order to fully exploit the opportunity. Prior to American Express, Buffett had promised investors that no single investment would make up more than 25% of the Buffett Partnership.
Obviously, Buffett was making a huge commitment, based on his belief in the strength of this one company. And within two years Buffett more than doubled his money on American Express, leaving his previously skeptical investors in awe.
Indeed, the fundamentals behind American Express's success have stood the test of time, through market highs and lows. And today the shares still make up almost 12% of Berkshire Hathaway's $117 billion portfolio.
I believe right now is a crucial time to follow Buffett's lead...
We are now five years past the most recent stock market crash. In early March 2009, the S&P index was at an all-time low of 666 (eerie right?), but has since then tripled.
It seems as if the stock market has had nowhere to go but up, making the past five years easy on investors. But the next five are likely to be more difficult.
Many of the stocks that have had the best run since the market bottom are the ones with smaller capitalizations, creaky business models, or weak balance sheets. You've probably heard the phrase: "A rising tide lifts all boats."
When the inevitable market correction comes, though, these are also the stocks that will fall the furthest. Now, at the end of a terrific five-year run, it could be the time to (like Buffett) concentrate wealth in quality.
I'm not suggesting that we should just try to be like Buffett. I'm saying we should concentrate our portfolios where Buffett has concentrated his.
The man has 55% of his company's $117 billion portfolio in four incredibly high quality stocks. These are stocks that have proven to hold up well in a more difficult stock market.
Here's a breakdown of Berkshire Hathaway's holdings in these four dominant companies:
|Company||Shares (millions)||Cost (billions)||Value (billions)||% of Portfolio||Yield|
|Wells Fargo (WFC)||483||11,871||21,950||18.68%||2.70%|
|American Express (AXP)||151||1,287||13,756||11.71%||1.10%|
Stock #1 Coca-Cola (NYSE: KO)
Buffett amassed Berkshire's position in Coca-Cola over a three year span in the late 1980s and early 1990s. According to Buffett, a competitor couldn't damage the moat around the Coca-Cola brand with an unlimited budget.
Stock #2 Wells Fargo (NYSE: WFC)
How much does Buffett love Wells Fargo? Let me count the ways. Almost $22 billion of them, which is the number of dollars that Buffett has invested in the bank on behalf of Berkshire. This is the most money that Buffett has ever invested in a publicly traded stock.
Buffett's love for Wells Fargo stems from its huge, stable, low cost deposit base which is a massive competitive advantage.
Stock #3 American Express (NYSE: AXP)
Yes, Buffett still holds American Express after all of these years. Berkshire's initial investment of $151 million has turned into $1.2 billion.
Like Coca Cola, American Express has a dominant global brand that allows it to compound equity at very prolific rates. And what American Express can't reinvest at high rates of return, the company returns to shareholders through dividends and share repurchases.
Stock #4 International Business Machines (NYSE: IBM)
Everyone was surprised when Buffett announced that he had invested $12 billion in a technology company. But Buffett sees IBM as more of a services firm than a hardware tech company at this point.
Of all of his big four, investors today can purchase IBM closest to Buffett's average original investment.
I think investors would do well to follow Buffett's lead and trim exposure to small and low quality companies and focus instead on Buffett's big four. In any sort of stock market retreat, these stocks are likely going to hold up much better than the market. And today is the time to focus on quality.
Risks to consider: If the raging bull market continues these large cap companies could temporarily trail the overall indices.
Action to take --> Buy shares of Buffett's big four and sleep well knowing that in a more difficult stock market these could be the best companies to own.