Position sizing and Portfolio Management for fundamental/value investors

[Value Hunter]

Like many value investors I have a tendency to use fairly loose and arbitrary position sizing and portfolio management.

I have a concentrated portfolio and tend to base my position sizing on:
-How risky is the investment?
-What is the possible/probable return profile of the investment?
-How much capital do I have left to invest?
-I have no real strict or measured process for selling. I tend to let both winners and losers run and but am quick to sell an investment if I think the long-term outlook has deteriorated. I don't usually sell just because something is 20% overvalued to try and buy it back when its 10% undervalued, etc. In other words I tend not to trade in and out of positions. More buy and hold until the fundamentals change.

The risk of my methodology under a hypothetical scenario based on how I typically invest goes something like this:
I think a stock is a fantastic company and well run and crazily undervalued so I put lets say 40% of my net worth into it (e.g. like Buffett buying into American Express when running the Buffett Partnership). The company produces strong earnings and goes on to triple in share price over the next three years. It now represents 65% of my net worth. Over the next year due to a surprise sudden change (e.g. sudden regulatory change, a competitor brings out a technologically superior new product which takes the majority of market share quickly, etc) the business has permanently deteriorated and the stock price has dropped 70% from its all time high. I decide to sell out due to the deterioration in fundamentals. I have now severely dented the return of my portfolio over the four year period.

Note: the above type scenario has not quite happened to me yet but is definitely possible based on my investment style.

As Buffett points out, a concentrated portfolio can lead to lower risk because you have superior knowledge of what you are investing in and are therefore less likely to be sloppy or make ill-informed or marginal bets. It can also be higher risk if you are not as good a stock picker as you thought yourself to be.

Here is Buffetts view: “The strategy we’ve adopted precludes our following standard diversification dogma. Many pundits would therefore say the strategy must be riskier than that employed by more conventional investors. We disagree. We believe that a policy of portfolio concentration may well decrease risk if it raises, as it should, both the intensity with which an investor thinks about a business and the comfort-level he must feel with its economic characteristics before buying into it. In stating this opinion, we define risk, using dictionary terms, as ‘the possibility of loss or injury.‘”

Whereas you have Ben Graham for example who had lived through the great depression and was shaped by the experience. He practiced wide diversification (except for rare exceptions like GEICO). Below is a quote from an article
http://www.joshuakennon.com/benjamin-graham-value-investing-strategy/

Benjamin Graham insisted that those who followed a value investing strategy structure their portfolio to take advantage of the benefits of diversification. This included diversification of asset class just as much as individual investments. Examining his January 31, 1948 letter to shareholders of the Graham-Newman Corporation, we see that Graham invested:

15.82% of the money in bonds, which were sub-divided into railroads, utilities, real estate, holding companies, and the United States Government,
22.93% of assets into preferred stocks, which were sub-divided into industrials, investment companies, utilities, insurance companies, and holding companies, and
61.25% into common stocks, which were sub-divided into industrials, holding companies, investment companies, railroads, utilities, and insurance companies.

The 61.25% invested in common stocks were spread among 57 different companies, ranging from ship builders to sugar companies in Puerto Rico. This meant that each of Graham’s value investments had a margin of safety all their own, plus the protection of sitting in a larger, extremely diversified portfolio of bonds, preferred stocks, and common stocks. This was consistent with Graham’s belief that the primary goal of value investing was to avoid losing money first, and then to enjoy a satisfactory return on capital thereafter.

I am keen to hear from other value investors how concentrated their portfolios are, how they do position sizing and what are their risk management strategies.

 

[Rainman]

I am keen to hear from other value investors how concentrated their portfolios are, how they do position sizing and what are their risk management strategies.

I tend to concentrate when I find stocks that have a great risk/reward profile.

Your post is very timely because I am currently reading Concentrated Investing by by Allen C. Benello, Michael van Biema, Tobias E. Carlisle. I think you'd find the book useful: http://www.amazon.com/Concentrated-Investing-Strategies-Greatest-Investors/dp/1119012023.

I had a quarter of my Australian portfolio in GMA. I have sold out of it now but I still like it. It is a hugely profitable insurance company that the market fears because of its misguided view that GMA would be decimated if property prices fall. I have a fifth of my U.S. portfolio in a company called Assured Guaranty (NYSE: AGO) and will add to it if drops (I have sold January 2017 put options on it).

The risk to concentrated investing that you've referred to is real. But I think the kind of scenario that you've set out is something that one can envisage fairly well and, for that reason, it can be factored into one's assessment of how risky the company's business is. A situation where a company's business is or could be severely affected by the advent of a new product or technology is real enough. But it typically occurs in businesses that are subject to frequent change like consumer products or technology and biotechnology companies. I can't imagine a company in either of these industries where I would feel confident of betting the farm - at least where I would need to hold the stock for an indefinite period into the future.

The decline of print media might be an exception in this respect. Newspapers, for example, used to be among the best businesses around until the internet slowly but surely reduced them to less stellar businesses, then to not-so-good businesses and finally to not good businesses at all. But the decline of print media did not happen over night. Investors had years to see the writing on the wall and to get with their capital more or less in tact.

For that reason, I feel that concentrated investing is best suited to industries that are reasonably stable like insurance, banking, food and beverages (this list is not intended to be exhaustive).

 

[Triathlete]

As Buffett points out, a concentrated portfolio can lead to lower risk because you have superior knowledge of what you are investing in and are therefore less likely to be sloppy or make ill-informed or marginal bets.

Here is Buffetts view: “The strategy we’ve adopted precludes our following standard diversification dogma. Many pundits would therefore say the strategy must be riskier than that employed by more conventional investors. We disagree. We believe that a policy of portfolio concentration may well decrease risk if it raises, as it should, both the intensity with which an investor thinks about a business and the comfort-level he must feel with its economic characteristics before buying into it.

I have to agree with the great man.

The rules I try to follow are these:

Rule 1: Irrespective of the amount of money you have to invest, you should always take the same amount of time researching your options to ensure you are protecting your capital on each and every occasion.

Rule 2: You should always aim to have between 5 and 12 stocks in your portfolio, although for traders it should be closer to 5. The reason here is to not have lots of stocks with small amounts invested in each. You only require a small number of the right stocks with larger amounts invested in each. This actually lessens your risk and increases your returns because:

* Smaller portfolios are easier to manage and represent lower risk. The more stocks you have in your portfolio the more work you need to do to manage your risk level.

* It is far easier to select a smaller number of stocks that are rising in price. Therefore ,the result is increased returns.

* You will have less transaction costs in buying and selling stocks simply because a smaller portfolio will have fewer transactions.

* When you purchase stocks, never invest more than 20% of your total capital in any one stock. If you invest in the share market you need to accept that some stocks will fall in value. However, this rule will help reduce your exposure to risk, while allowing you to achieve good returns simply because you are minimising the amount of capital you could lose at any one time.

Example: If you invested $50,000 in five different stocks, you would be investing $10,000 in each stock or 20% of your capital. If at the end of the first year one of the stocks dropped by 50%, you would lose $5,000 of your initial capital. If the other four stocks had risen in value by 10% you would have made $4,000. Therefore, your total loss would be $1,000 or 2% of your initial capital. You have now minimised your exposure to risk by spreading your capital across a number of stocks.

I use both types of analysis:

With Fundamentals I rely on my Lincoln stock doctor subscription to ensure that the companies are strong financially and growing going forward and then look to enter at what I believe is a good entry point technically which will give a decent return.

I will also close a position if the stock falls 15% from my entry price. My reason here is that even though the company may be strong based on previous reports there may be something going on within the company that has not been made public as yet to the market. The only people that know what is really going on are sitting in the board of directors. Some information may have made its way to larger players and so are starting to reduce there position prior to any announcement.

I am sure we all know companies that were reported to be financially sound only to see share price collapse.
I prefer to just cut my losses and move on, but that's just me.!

 

[So_Cynical]

I'm more of a contrarian/light fundamental investor, currently holding about 55 ASX stocks across 3 portfolios and 6 PSE stocks though just small positions on the PSE, with the ASX stocks i have 2 position sizes, 2.5% for the low risk stocks, and about 1 to 1.5% for the more risky.

Roughly 35% my PA return is dividends and 65% trading profits, depends on the year im having, i like a big spread of stocks because it opens up opportunities, i get 3 or 4 takeovers per year and 2 or 3 discounted cap raisings, most of them coming out of the blue and so far always profitable with SGH being the lone exception.

I can see the benefits of concentration, have 1 outsized position at the moment of about 18% of my main portfolio, a few times i have added the same stock across 2 or 3 portfolios thus gaining extra exposure to stocks i like, have done so with.

• CPU (hasn't turned out so well)
• RIC (a reasonable success)
• VOC (a large success)
• CLV (a mixed success)
• ABC (a medium success)
• ALC ( work in progress)
• WLD (work in progress)

My muddled approach has been somewhat successful over the years so i will just keep on going slowly building a revenue stream, if my big trade comes to completion (Dec 16) with a 50%+ return i will probably be more inclined to continue with a concentrated strategy...looking good so far.

 

[Value Hunter]

So_Cynical did your big trade come to a completion in December 2016? Was it successful?

 

[dreamxite]

Here is my take. There are the 2 extremes end of spectrum: Moat & Cheap stocks

Moats are those that have durable economics with strong competitive advantage, that's one end. On the other end, you have cheap stocks with poor economics, like cigar butts, net-net, whatever you want to call them.

The rational is simple, moat stocks, you don't find them often, and they are not available at fair price that frequent either, look at Sequoia Fund, so if you find these stocks, it make sense to load it up and take large positions.

On the other hand, cheap stocks you are more hoping on market surprise, changes in market expectation, mean reversion to make a profit, and it is hard to know which, so in this case, they will make you money collectively, but fail individually. Collectively, that means you need to own them by a dozen or more, it doesn't work in concentrated numbers, you will be putting yourself on great risk. Even though one might say yea it is cheap but for 20 reasons it has minimum downside. When a stock has poor economic, time is the enemy.