Position Sizing – Size Really Does Matter
There’s an interesting thread on TMF, which discusses the following thought by Random Roger.
Using moderate weightings mitigates the consequence for conversations you cannot hear. As portfolio management is a series of correct and incorrect decisions, I have said many times putting 3% into a stock that ends up going to zero is not a portfolio deathblow it is merely a bad day. I believe the worst performer I’ve ever put into client accounts was Macquarie Infrastructure (MIC). For most clients who owned it it was targeted at a 2% weight. I under estimated the impact of it being so transaction oriented and thus reliant on capital markets to function. Despite it being (probably) the worst holding ever I have no recollection of a client even asking about it.
Whether you manage your own portfolio or manage money for others there is no avoiding bad holdings–from time to time you will be wrong. Being wrong is not the thing, the thing is the consequence for being wrong. A 2-3% holding blowing up is not a big deal but at some point a holding becomes large enough that it is a big deal.
To pick but one of the good comments so far in the thread.
What I’ve gotten in the HORRIBLE habit of doing before this year (I’m fixing things) is putting small wages in companies where you KNOW the business well and know that the valuation is cheap and the business is not hard to grasp. In those cases, using allocations like 1.5% or 2.5% is not only illogical it is plain old stupid. …when you have a truly great and OBVIOUS idea, you load up, and you don’t worry about penny differences or anchoring to the lowest price. The key is betting on the obvious ideas. …
For me obvious idea is 1) strong cash-heavy balance sheet, 2) big free cash flow, 3) easy business to instantly grasp, in 4) an area where you’ve had success, with 5) a clear change in business momentum, and 6) a valuation that takes 15 seconds to get happy about. PETS is the sorta stock that fits this definition except perhaps the last – on that one, you just wait for the valuation to get to the point where you want it, as analyzing the business takes about 30 minutes tops after the initial evaluation.
The thread also has some good insights on the airline industry.
I’m not a Buffett clone, I’m not even the wart on a Buffett’s clone arse, but I recognise he has said many great things. Filtered through other stuff I end up with:
Concentrate to accumulate. To concentrate use the 20 punch card concept and only swing at pitches you’re really comfortable with.
If you’re going for 3% positions then you’re doing the reverse. You’re diversifying to preserve capital. Perhaps that is the role of a portfolio manager, I certainly concede it is the role of a portfolio manager (PM) who wants to keep their job as not many people get fired by being closet index tackers.
As I’ve said before I swapped from my concentrated ways to a diversified approach and frankly, for me it sucks. It takes all the fun out of investing. It makes beating the indexes harder. It leaves me feeling inadequate as I can’t properly cover all my companies. It means a home-run stock doesn’t deliver index smashing returns by itself. So I’m slowly swapping back to my concentrated ways.
If you’re looking at the market everyday it hard not to take a few swings. So I limit those swings to small positions, let’s say 3%. When occasionally I see an opportunity that I find irresistible then I load up with at least 10%. Some positions fall in between as I plan on going higher, but I still suffer from anchoring and hate chasing prices higher. I’ll work on that over the coming years.
Some numbers, nah let’s do it with a picture instead.
Does the graph make it clear?
Taking 3% bets on your best ideas gets you no where, whereas blowups on a 10% position don’t hit your portfolio much more than if it was a 3% position.
It all comes back to you concentrate to accumulate and diversify to preserve, that’s worth reiterating. May I boldly suggest many PMs are focused on preservation and I’m not talking about Buffett’s rule number one. If you layer on some Buffett then what the hell are you doing accumulating 3% positions anyway, you’d fill your lifetime punch card of 20 up in seven months. Let’s imagine turnover of .3, then you still gotta come up with 10 great ideas a year. Who can do that?
When you look at the market every day it’s hard not to swing at more pitches than you should. That’s what 1-3% positions are for. Though as soon as you start to think it’s only worth 1-3% maybe you shouldn’t bother swinging.
Personality and patience makes a good investor. Knowing your personality and matching an investment strategy to it and then exhibiting patience to follow your strategy.
I concede large portfolios may necessitate more positions as may certain investment strategies. I further concede I’ve never managed OPM and if I ever do then perhaps I’ll be wracked with more doubt than usual and so settle on 3% positions. Finally I may be totally wrong and if so I’d love to know why before I complete my return trip from diversified back to concentrated.
If you haven’t already I encourage you to read the whole thread linked above, there are lots of great thoughts on position sizing by smart people.
Further reading: If you enjoyed this or what to read more on position sizing then check out:
Related posts:
Hi Dean, position sizing and position balancing are certainly important and I spend a bit of time thinking about it. Currently I have 25% of my portfolio in TLS at a marginal profit. I’m not sure why. Actually I do know, I bought it because I thought it was a sure thing. Everything else which was a 3-5% position (other than the index which was a 60% position) reached my price target so I’ve sold. I like to enter swing trades for 10-20% with a 1-3 month timeframe. The core TLS holding has been holding back my performance significantly.
At them moment everything looks fully valued to me, although I’m running the ruler over EHL and PRY.
From my experience the sure things or deep value investments turn out to be the least profitable. So I reckon in retrospect I should have taken bigger positions in attractive situations eg in the last 3 months WOW at 25, RHC at 10. Although they were attractive they were not at load up the truck valuations. But they also had good fundamentals, 10 year track records and reasonable management. Interestingly Intelleigent investor rated their performance and their Excellent/sure thing buys did the worst also.
Hi Sean, I had a quick look at PRY and if I had more time would do a write-up. Here’s a few things for you to think about and answer if you wish.
- Sales in the recent half were down year on year. Always a bad sign. Though I guess that’s why the shares look so cheap now.
- ROE has and is terrible.
- The purchase of Symbion appears to have been a poor acquisition. Is the same management still in place? What are their views on this?
- Negative NTA.
- High debt, could hurt in the current rising interest rate environment.
- Low cash flow. I don’t have the interim report up anymore, but IIRC once you deduct capex from operational cash flow the business is not generation much cash at all.
On the plus side. If management are to be believed (how’s their track record?) then 15% growth in EBITDA for the next two on trailing eps of 39c or forward (double interim) of 33c makes the current price look attractive and a double in two years seem possible. First I’d need to get comfortable with the above.
I don’t know much about PRY, I’ve just considered it lately as it’s gone down. I haven’t bought into it in the past.
I’d go with a sum of parts for valuing it. wrt to your points :
1. Sales: People got a bit too excited about pathology in the past. To me it’s like a regulated utility. Some of the reduced revenue was due to their GP practise part charging a co-payment. They maybe able to get this through over time with the GP centres but where they’re located I’m not sure this will be as much as they expect. I think there is little scope for PRY or Sonic being able to implement co-payments for pathology services to preserve their margins. There is no direct relationship between the pathology provider and the patient. Few people are going to be willing to pay a gap for pathology services and if they try to introduce this, it will encourage new entrants into the market. I guess it depends on whether the government prices are rock bottom or whether there is still a reasonable margin. Even if they were able to get the co-payments for pathology this would probably encourage less pathology ordering and affect their volume. So you can’t have it both ways.
2. Low ROE due to pathology
3. Same management still in place as far as I am aware
4. Low NTA. Huge amount of goodwill. Arguably this is what can I say ?creative accounting. They used to pay GP’s for their practise and the GP’s would be on contract for 5 years. After 5 years I’d argue that goodwill is not worth much.
5. High debt at high rates when they bought Symbion, ?10% for the first year or so from what I can gather. Their interest expenses should go down even in a rising rate environment.
Their business model is not one that I am very keen on. There are lots of perceived conflicts of interests with them owning pathology and medical centres that write referrals for this. I think it’s likely to get negative regulator and government attention over time.
I think the pathology business (40%) is like a utility that I would buy on a PER of 9. The Medical centres (40%) I am not that keen on but would buy on a PER of 9. The health information bit (?5%) is worth a PE of 20 to me.
So I would buy it on a 9 PE or less (or about $3 at the current period). It may never get there, but the business model, management, track record and fundamentals are poorer than for Ramsay. Unfortuanately Ramsay has gone up a lot to reflect that. Still things happen in cycles and at some stage Ramsay will face pricing pressures also. Neither of them are solid businesses like Woolworths and are subject to more competition and government regulation risk.
For an earlier version of PRY, ONT is interesting. I had a look at it but haven’t bought any. I don’t know much about dentistry but this might be more amenable to corporatisation than the medical area where the medicare system means patient goodwill is worth less. At a PE of 15 for a microcap it seems a bit overpriced though.
As always, everyone should do their own research and this isn’t a recommendation to buy or sell anything.
“I concede large portfolios may necessitate more positions as may certain investment strategies. I further concede I’ve never managed OPM and if I ever do then perhaps I’ll be wracked with more doubt than usual and so settle on 3% positions. Finally I may be totally wrong and if so I’d love to know why before I complete my return trip from diversified back to concentrated.”
Well, I do manage OPM and it’s unfortunately simply not feasible to follow a concentrated portfolio strategy when you are dealing with 99% of clients. This is simply because most people, despite what they tell you, have no real conception of risk and return. They just cannot tolerate a 10% loss in their portfolio. Most people believe that the stockmarket provides a regular 10% return – losses are what happens to other people, the stuff they read about in the paper or see on the news. And when a blowup does occur, they’re shocked and go through the usual stages of shock, disbelief, anger etc etc.
Seriously, no matter how many times you tell someone that they could lose a part or all of their investment, they’re always amazed when it actually occurs. And of course the larger the loss, the more extreme the reaction. Managing a concentrated portfolio for OPM is unfortunately a quick way to either lose clients or be sued. Most people simply cannot live with losing 10% of their portfolio (or more) in one hit.
Thanks for the insight Justin. I’m sure that is one of many problems in managing OPM.
Hi Justin, perhaps it wouldn’t work in a conventional mutual fund but isn’t this what a lot of hedge funds do ? Concentrate on a particular strategy. I suppose with drawdowns, you have to have the outperformance to justify that but if you have the runs on the board people will probably stick but you’ve got to have the back to not take withdrawals personally. It also depends on selecting investors who have a simillar philosphy to investing as you do. I read this on Michael Burry today. Sounds like an interesting guy.
http://streetcapitalist.com/2010/03/24/learning-from-michael-burry/
“I have always believed that a single talented analyst, working very hard, can cover an amazing amount of investment landscape, and this belief remains unchallenged in my mind.”
“A lot of clients were glad to be done with it in the end… Perhaps I’d made the trade too big… It’s remarkable. There are investors that made tens of millions of dollars out of this, and they’re still pretty upset.”
“Thank you for visiting. Dr. Michael Burry has liquidated Scion Capital, LLC and is currently focusing on his private investments. Dr. Burry is not accepting outside investors.”
Leave your response!
SUBSCRIBE by RSS
or Subscribe by EmailTags
Categories
Archives
Free Spreadsheets
Blog of the Day
Blogroll
Aus/NZ Blogroll
Recent Posts
Most Commented
Quotes