Charlie Munger (Trades, Portfolio) has said “good ideas are rare.” Warren Buffett (Trades, Portfolio) often talks about the idea of a punch card with just 20 punches on it. Each time you buy a stock – you use up one punch. Buffett believes anyone who invests that way will become a better investor. Is that true, though? Just how many ideas does an investor need, and how much juice can you really squeeze out of just one idea?

The value of a stock idea can come from a combination of four sources:

1. How much money you put in the idea.
2. How cheap the stock is.
3. How fast the stock is compounding its value.
4. How long you own the stock.

The ideal stock would be a business quickly compounding its intrinsic value per share, which you are able to buy at a deep discount to intrinsic value, which you feel confident allocating a big chunk of your portfolio to and which you are going to hold for a very long time.

Ideas like that are rare. If you “settle” too much on one of these four measures, you need help from the other areas to offset your compromised standards – or the idea is not going to be worth much.

For example, say you put just 5% of your portfolio into a certain stock. The business is not growing much at all, but it owns land worth $50 a share and you paid $10 a share for it. In this case, the eventual return from this idea is worth 20% of your starting portfolio. The stock itself is a “five-bagger,” as Peter Lynch would say (it can go from $10 to $50 a share). But it can only do this once. And you – for whatever reason – were only willing to put 5% of your portfolio into this idea. A stock selling at an 80% discount to intrinsic value sounds like an amazing idea, but we can see in this case it is really nothing special in terms of what it is going to do for your overall portfolio. Since the stock is not compounding its intrinsic value, you hope to sell it quickly. There is one “puff” in this cigar butt. In this hypothetical case, it is a huge puff. But unless you are willing to allocate a lot of money to this idea, the actual return you get could be as little as just 20% of your starting portfolio (400% return * 5% allocation = 20% value growth in your total portfolio).

A return of four times your investment is excellent, so this is a good idea. But if that is really how you would invest in it – put just 5% of your portfolio into the stock, hope to hold it for as short a time period as possible and then get out – it has very limited upside. Compare this to a business that was never a deep-value stock but has compounded its intrinsic value per share.

Over the past 10 years, Sherwin-Williams (NYSE:SHW) has compounded its earnings per share by 10% a year. The compounding of earnings power over that time is capable of getting you a return of 160% on top of your original investment (every $1 of EPS becomes $2.60 within 10 years), but you would have to hold the stock throughout that whole period and you would have to allocate 100% of your portfolio to Sherwin-Williams to increase your portfolio by 160% over 10 years. No investor I know of is going to put 100% of their portfolio in one stock and hold it for 10 whole years, but there is an offset here. Sherwin-Williams’ price-earnings (P/E) ratio expanded from approximately 12 to approximately 29. This added another 9% a year to the annual return. If a stock’s earnings go nowhere for 10 years, but the P/E goes from 12 to 29 while you own the stock, you make about 9% a year over 10 years. In this case, your investment in Sherwin-Williams could have returned approximately 19% a year over 10 years.

But how much value would you have extracted from this idea?

Well, it depends on how much of your portfolio you put into Sherwin-Williams. Imagine you had a tremendous amount of confidence in a well-known and dominant company like Sherwin-Williams that you did not have in another stock selling for 20% of the fair market value of its assets but was not growing. So you decided to put 25% of your portfolio into Sherwin-Williams back in 2007 and never trimmed the position over the next 10 years. In that case, you have produced a gain that was about 117% of the total value of your portfolio in 2007 (since 25% * 1.19^10 = 142%, and 142% less the 25% initial investment is a 117% profit).

Even if we argue Sherwin-Williams is not expensive today (and a P/E of 29 certainly looks expensive historically), we would have to admit the stock was never as cheap as my hypothetical example of a five-bagger. A P/E of 12 divided by a P/E of 29 gives you a price to appraisal value of a little over 40% – not as low as the 20% example I gave. Yet, Sherwin-Williams could have been the more valuable idea for three reasons:

1. The stock compounded its intrinsic value (grew EPS) by 10% a year.
2. It is the kind of stock some people might actually hold for 10 years.
3. It is the kind of stock some people might actually put 25% of their portfolio into.

Someone recently asked me why I said in an earlier article that not investing in Sherwin-Williams around that time (10 years ago) was a mistake I should not have made. The answer is not Sherwin-Williams was the best investment you could have made in 2007. Rather, it is that it was an obvious investment. It was a well-known and long dominant branded business trading at a P/E of 12 and growing approximately 10% a year (sometimes 5% a year, sometimes 15% a year – but along that 10% trendline even then). There are some businesses that grew more than 10% a year over the past 10 years, and there are some businesses that had a P/E lower than 12 back in 2007, but very few stocks had the combination of those two things.

The way I try to get a lot out of each idea I have is to bet big.

As of last quarter, my favorite idea was 42% of my portfolio and my second favorite idea was 23% of my portfolio. So the two stocks accounted for 65% of my portfolio. This is the Munger way. Long ago, Munger decided he could be comfortable owning as few as three stocks. I am comfortable owning only three stocks right now. Though, to be fair, I hold a lot more cash than most investors do (about 30% of my portfolio is in cash right now).

In the early days (when running his own money and partnership money), this is how Buffett invested. He said in 2008:

“Charlie and I operated mostly with five positions. If I were running $50, $100, $200 million, I would have 80% in five positions, with 25% for the largest.”

And in 1998, Buffett said:

“I can guarantee that going into the seventh one instead of putting more money into your first one is…a terrible mistake. Very few people have gotten rich on their seventh 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…probably have half…(in) what I like best."

If you look at the 2008 quote, Buffett is saying he would have 25% in his number one idea and 80% in his top five positions. In the 1998 quote, Buffett is saying he would have six stocks total and 50% in his number one idea. If we take 80% and divide by five (from the first quote), we get a 16% position size. If we take 100% and divide by six (from the second quote), we get a 16.67% position size.

In the first quote, he says “with 25% for the largest,” and in the second quote he says “probably have half (in) what I like best.” So Buffett seems to be talking about a normal position size of around 16% overall and have 25% to 50% in your favorite idea. Essentially, Buffett is advocating putting 25% to 50% of your portfolio in your favorite idea and 10% to 20% of your portfolio in each of the ideas you like a little less. He has never made it quite that formalized – but that is a fairly good approximation of what he has said.

Munger was at least as concentrated in his investments during the partnership years. Buffett was not as concentrated an investor once he began working with bigger sums at Berkshire Hathaway (NYSE:BRK.A) (NYSE:BRK.B). His stock portfolio was often more concentrated – until the last decade or two – than a mutual fund would ever be. But it was not as concentrated even in most of the 1970s and 1980s as his portfolio had sometimes been during the partnership years. Buffett’s personal portfolio has always been even more concentrated than when he was running money for other people. For example, his biggest allocation we know of during the Buffett partnership years was 40% of the portfolio in American Express (NYSE:AXP), but we know years earlier he put 75% of his own net worth into one stock: GEICO.

So how did Buffett “offset” the greater degree of diversification at Berkshire? If Buffett put 20% or 25% of his partnership’s money into Sanborn Map and then pushed for change there – he could get a 10% to 12% return for the entire partnership just from getting a 50% return (50% of 20% to 25% is 10% to 12%). If instead of putting 25% to 50% of your portfolio in your favorite idea, you are only putting more like 10% to 15% of your portfolio into that idea – you need to have some way to still get a ton of juice out of a rare idea. If you fail to do this – the only way to still be a successful investor would be to discover a lot of good ideas. We know Buffett says he has very few good ideas, so he has to be offsetting the “watering down” caused by diversification somehow.

Take Buffett’s investment in Coca-Cola (NYSE:KO) for example. This was considered a big bet by Berkshire. By my calculations, however (admittedly, very approximate based on the data I have), Buffett allocated perhaps just under 20% of his entire stock portfolio to Coca-Cola at the time he built the position. Despite putting just 20% of his portfolio into the stock in the late 1980s, however, Berkshire ended up not only with a position that today is worth about 13 times what he originally bought – the one position alone is also worth several times what Berkshire’s entire portfolio was when he made the Coke investment.

How did he do that?

Let’s look at the four ways to get the most out of a stock idea:

1. You can put a lot into the stock (Buffett put 20% of his portfolio into Coke).
2. You can hold the stock a long time (Buffett has now owned Coke for just under 30 years).
3. The stock can compound is intrinsic value at a high annual rate (Coca-Cola compounded EPS at about 11% a year for the first 25 years Buffett owned the stock).
4. You can buy the stock when it is cheap (the P/E on Coke went from 15 when Buffett bought it to 30 recently).

Coke is pretty close to a perfect example of some value coming from all four possible sources of getting the most out of an idea.

These sources of value you can get from an idea are a good set to look at when deciding whether an idea is really worth your time and attention.

Ask yourself:

1. Does it seem likely I might feel comfortable putting more of my portfolio into this idea than any other idea I am looking at right now?
2. Does it seem likely I might end up holding this idea for longer than any other idea I am looking at right now?
3. Does it seem likely this stock will compound its intrinsic value faster than any other idea I am looking at right now?
4. Does it seem likely this stock is cheaper than any other idea I am looking at right now?

A big part of Buffett’s return in Coca-Cola came from the fact he was willing to allocate 20% to this idea and was willing to hold it for the long term.

That only worked up to a point, though.

In the case of Coca-Cola, the value the stock created for Berkshire really came from the first 10 to 12 years. It did not come from the last 15 years.

Still, a 10-year or greater holding period is long for your average investor, and a 20% allocation to a single stock is big for your average investor.

As investors, we tend to focus on the fact Coke grew its earnings per share by more than 10% a year and the P/E more than doubled while Buffett owned it. But that is just the objective side of the investment. The subjective (Buffett) side of the investment is just as important. To make a killing in Coke, Buffett was willing to put 20% of his portfolio into the stock for over 10 years.

Can you diversify widely and still get a lot of value out of each idea?

Oddly, yes. If the strength of an idea is so great to start with – it can still provide strong returns after you have watered it down by diversifying.

In fact, I have seen the records of a couple investors that prove it is possible to run a portfolio almost entirely of “watered-down” ideas. But the only two viable ways to offset a lack of concentration are:

1. Invest in deep-value stocks (the Walter Schloss approach).
2. Invest in ultra-high-growth stocks (the Motley Fool Rule Breakers approach).

Even then, it is only possible to get much out of a growth idea if you either:

1. Put a large part of your portfolio in that one idea (the Phil Fisher approach).
2. Never sell a growth stock once you buy it (The Motley Fool Rule Breakers approach again).

We come down to the same combination of four questions that determine the value you will get from a new idea:

1. How big a position will you take?
2. How long will you own it?
3. How fast is the stock compounding value?
4. How cheap is your purchase price?

As a value investor, the more diversified you become, the more you must either focus on:

1. A longer holding period.
2. Finding “deeper” value stocks (really cheap stuff, turnarounds, etc.).

And as a growth investor, the more diversified you become, the more you must either focus on:

1. A longer holding period (really, a “forever” holding period).
2. An exceptionally high rate of compounding.

The more you maximize one variable, the less you have to worry about another. For example, Buffett has never been good at finding super-high-growth businesses. However, Buffett never overpays for a stock, almost always holds a stock for an incredibly long time and usually puts a lot of his portfolio into each idea. Doing all that means he can afford to miss out on Amazon (NASDAQ:AMZN) and Starbucks (SBUX). He can just own things like The Washington Post and Coca-Cola because he was willing to put a lot of money into them, he did not overpay and the held them forever. If he was trying to invest in 100 stocks at once – he might actually need to invest in an Amazon or Starbucks to offset the weaker performance of the other 90-plus positions.

A comparison of Fisher and Benjamin Graham using these four factors helps illustrate how you can use one factor to offset another. Graham’s fund was widely diversified, but it was not an especially high turnover portfolio (ideas often stayed in the portfolio for three to five years) and it was a very deep-value portfolio. Some of the stocks were shockingly cheap. This means Graham could meet or beat the performance of the overall market without turning up more than about one new idea a month even if he held something like 100 ideas. That is because his returns came from the 60 good ideas not the 40 bad ones. He also held those 60 good ideas for closer to five years than five months. This only works if your good ideas are not “a bit cheaper” than average, but rather dirt-cheap. Graham’s returns came from some truly dirt-cheap stocks. Extreme cheapness can offset the need for growth in the businesses you own and concentration in your portfolio.

Fisher did not worry much about price. He could afford to do that because he did two things:

1. He put a lot into his favorite ideas.
2. He held stocks almost forever.

Yes, he also invested in high-growth ideas. But high-growth stocks as a whole do not outperform the market. It is only the “right” expensive stocks that outperform. If Fisher was investing in 25 to 50 stocks at a time instead of five or 10, his approach never would have worked. Fisher’s approach depended on the combination of big position sizes and long holding periods – fast growth alone was not enough.

In his early days, Buffett mostly got huge value from each idea by buying very cheap stocks in very big allocations. At Berkshire, Buffett mostly got huge value from each idea by buying fairly rapid compounders and holding them forever.

It is possible, however, to get a lot out of a single idea through any combination of these four factors:

1. High growth.
2. Low price.
3. Big position size.
4. Long holding period.

Some of the factors do not seem to mesh all that naturally. The worst combinations are probably low price, long holding period and high growth, big position size. It is worth remembering that if you cannot or do not want to do any of these four things – for example, you do not know how to find high-growth ideas or you are afraid of big position sizes – you need to learn to offset that fact by maximizing the value-creating factors that can offset this.

Decide which factors you are comfortable with and then push these to the extreme. So if you do not like big positions but you do like long holding periods – try to make yourself a “forever” investor. Doing so will make it easier for you to have good performance without needing as much concentration in your portfolio.

If you cannot find high-growth stocks – you really need to look for truly low-priced stocks, not just good businesses at a good enough price.

The alternative to all this is simply finding more ideas than the other guy over your investing lifetime, which is a very hard thing to do. Peter Lynch was the master of doing this. However, he was a professional and burned himself out after just 13 years of this approach. The man retired in his mid-40s. Turning over more rocks and finding more good businesses and cheap stocks is certainly possible, but I have met very few people with Lynch’s work ethic. So my suggestion is to try copying Buffett instead of Lynch. Whether that means “early Buffett” (low price, big position size) or “late Buffett” (high growth, long holding period) is up to you.

Disclosure: None.

Geoff Gannon