Meet the top-ranked fund manager who only owns 17 stocks, with no more than one per industry. He explains his unconventional approach - and how he targets his best ideas.

Broad Run Investment Management

David Rainey of Broad Run Investment Management is one of the managers of the Hennessy Focus Fund, the top-ranked mid-cap fund of the 20 years as of November 2019.

• David Rainey co-manages the Hennessy Focus Investor fund, which aims to beat the market with a small and concentrated approach. Over the past 20 years, it's the top-ranked US mid-cap fund.
• The fund's portfolio is tiny compared to its competition, and Rainey says that's an advantage because he's investing in the companies where he has the most confidence instead of just covering his bases.
• Rainey says the fund invests in stocks that are trading at the market multiple relative to their earnings, but who look like they'll have much stronger earnings growth than the broader market.
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Hot investing tip: Just buy the best stocks.

There's more to it than that, but that's still a key idea for David Rainey of Broad Run Investment Management. He's one of the managers of the Hennessy Focus Investor fund, the top mid-cap fund of the past 20 years. It also has four stars and a bronze rating from Morningstar.

"We manage the fund in a concentrated best ideas style," Rainey told Business Insider in an exclusive interview. "We target around 20 holdings, with the top 10 holdings being between 60% to 80% of assets."

As of November 30, the fund has 17 holdings, each in a different industry. By comparison, Rainey says, similar mid-cap growth funds generally have between 50 and 120 stocks, and a broad market index like the S&P 500 or Russell 3000 might have stocks representing 50 to 80 different industries.

Rainey argues that investors don't have to target every industry or get the broadest exposure to get good returns. Trying to do that might compromise their investment process instead, pushing them to put money in companies they're not as enthusiastic about just to hedge their bets.

"We're selective, but we're also concentrated," he said. "Rather than owning a 2% position in our favorite idea and a 1% position in our 80th favorite idea, we'll own positions of 5% or 10% in various names.

He uses this example to explain his investment in auto parts retailer O'Reilly Automotive, which comprises 10% of the Hennessy fund's portfolio.

"There are four publicly-traded automotive focused parts retailers in this country," he said. "We like the industry and we like the fundamentals and we like the non-cyclical nature of the business. So instead of owning a piece of each of the four, we own just one."

Do you really need to diversify?

Diversifying is considered a basic building block of investing strategy - a way to improve returns when the market is up, and reduce losses when things get bad. Rainey isn't arguing against it, but says you can achieve it without the broadest possible ownership.

And he says it's a point of pride for him that the fund still protects losses, even without the most expansive type od diversification: Over the 10 years ending September 30, it's captured 93.5% of market upside and just 83.3% of its downside.

Stretching back two decades, the Hennessy fund has returned 12.8% per year. Rainey has been its co-manager since 2009, when he and two other managers took over for legendary Chuck Akre.

That's his argument that being very selective works as well as casting a wide net. But what is he selecting for? One must-have is a fair or discount price.

"We're looking to invest the mutual fund in a collection of businesses that are trading at roughly the market multiple, but with much higher EPS growth rates than people would expect in the market," he said. "We kind of think about this as growth at a reasonable price."

Rainey says he also looks for businesses with sustainable competitive advantages, which can include leading positions in their respective industries. They're also looking for companies that are in industries that are poised for strong growth over the long term.

He says the fund's two largest holdings, cell tower operator American Tower and online used car retailer CarMax, both exemplify those ideas: American Tower is the largest company in its field and is benefiting from Americans' skyrocketing demand for data, while CarMax has remade the used-car buying experience.

Also key to his approach is a great management team that is investing profits back into the business to maintain its growth. Lastly, Rainey said he wants "low tail risk," meaning little chance that something will go dramatically wrong.

"We're looking for items that could upset the apple cart," he said. "Is there a technical risk, a fashion risk, a bubble risk? Is there something going on to the business where demand today is unstable and likely too high? Is there excessive leverage on the balance sheet? Are the managements of the businesses doing something from a regulatory or legal standpoint that is suspect?"

Once they've found a company that ticks all of those boxes, Rainey says, they're going to stick with it for five to 10 years, if not longer. Sticking with those best stocks creates another advantage that a fund holding far more companies probably wouldn't be able to match.

"The fund has low economic turnover, and therefore it tends to be very tax efficient in terms of realized gains and losses," Rainey said. "It tends to have less embedded trading costs of other mutual funds."

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