Position Sizing: How to Construct Portfolios That Protect You

Four times a year I write a letter to IMA clients. These letters are long; the most recent Fall letter is 27 pages. I try very hard to bring IMA clients into our thinking about the economy, investing, stocks and decisions we’ve made in their portfolio (in this essay?I explain the reason for their length.)?

I believe the relationship with my readers has evolved over the years such that we don’t need to sanitize and rewrite these excerpts into essays:?Over the next few months, I’ll share with you excerpts (You can?read?the other parts here)?from the Fall letter.?

I’ll leave them in the raw, original, more honest form. Enjoy!

Position Sizing: How to Construct Portfolios That Protect You

Question: How do you construct portfolios and determine position sizes (weights) of individual stocks?

Answer: We have wanted to discuss this topic for a long time, so here is a very in-depth answer.

For a while in the value investing community the number of positions you held was akin to bragging on your manhood– the fewer positions you owned the more macho an investor you were. I remember meeting two investors at a value conference. At the time they had both had “walk on water” streaks of returns. One had a seven-stock portfolio, the other held three stocks. Sadly, the financial crisis humbled both – the three-stock guy suffered irreparable losses and went out of business (losing most of his clients’ money). The other, after living through a few incredibly difficult years and an investor exodus, is running a more diversified portfolio today.

Under-diversification is dangerous, because a few mistakes or a visit from Bad Luck may prove to be fatal to the portfolio.

On the other extreme, you have a mutual fund industry where it is common to see portfolios with hundreds of stocks (I am generalizing). There are many reasons for that. Mutual funds have an army of analysts who need to be kept busy; their voices need to be heard; and thus their stock picks need to find their way into the portfolio (there are a lot of internal politics in this portfolio). These portfolios are run against benchmarks; thus their construction starts to resemble Noah’s Ark, bringing on board a few animals (stocks) from each industry. Also, the size of the fund may limit its ability to buy large positions in small companies.

There are several problems with this approach. First, and this is the important one, it breeds indifference: If a 0.5% position doubles or gets halved, it will have little impact on the portfolio. The second problem is that it is difficult to maintain research on all these positions. Yes, a mutual fund will have an army of analysts following each industry, but the portfolio manager is the one making the final buy and sell decisions. Third, the 75th idea is probably not as good as the 30th, especially in an overvalued market where good ideas are scarce.

Then you have index funds. On the surface they are over-diversified, but they don’t suffer from the over-diversification headaches of managed funds. In fact, index funds are both over-diversified and under-diversified. Let’s take the S&P 500 – the most popular of the bunch. It owns the 500 largest companies in the US. You’d think it was a diversified portfolio, right? Well, kind of. The top eight companies account for more than 25% of the index. Also, the construction of the index favors stocks that are usually more expensive or that have recently appreciated (it is market-cap-weighted); thus you are “diversified” across a lot of overvalued stocks.

If you own hundreds of securities that are exposed to the same idiosyncratic risk, then are you really diversified?

Our portfolio construction process is built from a first-principles perspective. If a Martian visited Earth and decided to try his hand at value investing, knowing nothing about common (usually academic) conventions, how would he construct a portfolio?

We want to have a portfolio where we own not too many stocks, so that every decision we make matters – we have both skin and soul in the game in each decision. But we don’t want to own so few that a small number of stocks slipping on a banana will send us into financial ruin.

In our portfolio construction, we are trying to maximize both our IQ and our EQ (emotional quotient). Too few stocks will decapitate our EQ – we won’t be able to sleep well at night, as the relatively large impact of a low-probability risk could have a devastating impact on the portfolio. I wrote about the importance of good sleep before (link here). It’s something we take seriously at IMA.

Holding too many stocks will result in both a low EQ and low IQ. It is very difficult to follow and understand the drivers of the business of hundreds of stocks, therefore a low IQ about individual positions will eventually lead to lower portfolio EQ. When things turn bad, a constant in investing, you won’t intimately know your portfolio – you’ll be surrounded by a lot of (tiny-position) strangers.

Portfolio construction is a very intimate process. It is unique to one’s EQ and IQ. Our typical portfolios have 20–30 stocks. Our “focused” portfolios have 12–15 stocks (they are designed for clients where we represent only a small part of their total wealth). There is nothing magical about these numbers – they are just the Goldilocks levels for us, for our team and our clients. They allow room for bad luck, but at the same time every decision we make matters.

Now let’s discuss position sizing. We determine position sizing through a well-defined quantitative process. The goals of this process are to achieve the following: Shift the portfolio towards higher-quality companies with higher returns. Take emotion out of the portfolio construction process. And finally, insure healthy diversification.

Our research process is very qualitative: We read annual reports, talk to competitors and ex-employees, build financial models, and debate stocks among ourselves and our research network. In our valuation analysis we try to kill the business – come up with worst-case fair value (where a company slips on multiple bananas) and reasonable fair value. We also assign a quality rating to each company in the portfolio. Quality is absolute for us – we don’t allow low-quality companies in, no matter how attractive the valuation is (though that doesn’t mean we don’t occasionally misjudge a company’s quality).

The same company, at different stock prices, will merit a higher or lower position size. In other words, if company A is worth (fair value) $100, at $60 it will be a 3% position and at $40 it will be a 5% position. Company B, of a lower quality than A but also worth $100, will be a 2% position at $60 and a 4% position at $40 (I just made up these numbers for illustration purposes). In other words, if there are two companies that have similar expected returns, but one is of higher quality than the other, our system will automatically allocate a larger percentage of the portfolio to the higher-quality company. If you repeat this exercise on a large number of stocks, you cannot but help to shift your portfolio to higher-quality, higher-return stocks. It’s a system of meritocracy where we marry quality and return.

Let’s talk about diversification. We don’t go out of our way to diversify the portfolio. At least, not in a traditional sense. We are not going to allocate 7% to mining stocks because that is the allocation in the index or they are negatively correlated to soft drink companies. (We don’t own either and are not sure if the above statement is even true, but you get the point.) We try to assemble a portfolio of high-quality companies that are attractively priced, whose businesses march to different drummers and are not impacted by the same risks.?Just as bank robbers rob banks because that is where the money is, value investors gravitate towards sectors where the value is. To keep our excitement (our emotions) in check, and to make sure we are not overexposed to a single industry, we set hard limits of industry exposure. These limits range from 10%–20%. We also set limits of country exposure, ranging from 7%–30% (ex-US).

In portfolio construction, our goal is not to limit the volatility of the portfolio but to reduce true risk – the permanent loss of capital. We are constantly thinking about the types of risks we are taking. Do we have too much exposure to a weaker or stronger dollar? To higher or lower interest rates? Do we have too much exposure to federal government spending? I know, risk is a four-letter word that has lost its meaning. But not to us. Low interest rates may have time-shifted risk into the future, but they haven’t cured it.

Drawing is by my brother,?Alex Katsenelson. Prints available on?ArtistUSA.com.

Les Misérables

This is a continuation of my journey into musicals (previous musicals).

In 1997 I went to London with two friends who at the time were dating for a week. I was having a tumultuous relationship with a girlfriend at the time and we were taking a break from each other (we broke up a few months later). It was just the three of us.?

This was my first trip to Europe. Till this day I am amazed by the Continent’s deep history. On one afternoon we went to Westminster Abby and saw the tombs of Mary Stuart, Queen of Scots, and her rival, Queen Elizabeth I. The same evening, we went to see Donizetti’s opera?Maria Stuarda, which depicts the lives of Mary Stuart and Queen Elizabeth. Only in Europe.?

The next evening, I wanted to see a musical and my friends wanted to spend some romantic time alone (I don’t blame them), so I went to see?Les Misérables?(affectionately known as?Les Mis)?by myself. I knew nothing about the musical. I had no expectations. It was a random musical that I could get tickets to that evening. At the time I did not even know that?Les Mis?was based on Victor Hugo’s novel by the same name. (In Russian it is known as?The Rejected).?

I remember walking out of the theater onto a wet London street completely high on the music. It was raining. I didn’t care. This was a different high than the one from?Phantom of the Opera. Les Mis?is a rare marriage of an incredible story with great, complex characters and wonderful music. I was inspired. I was only 24, still in search of myself (I was a late bloomer). In Jean Valjean I found a role model – not perfect, yet a principled, honest, caring person who was in pursuit of always doing the right thing.?

So I wanted to be like Jean Valjean. Les Mis is inspiringly optimistic. It also provides a hope that people can change for the better if you show that you believe in them. There is a scene in the musical that has really stuck with me till this day. Valjean is released from prison. A bishop feeds him and takes him in for a night. Valjean assaults the bishop and steals his silverware. The next day he is caught and brought by the police to the bishop. Valjean claims that the bishop gave him the silverware. The bishop confirms to the policeman that the silverware was indeed a gift and scolds Valjean for forgetting to take the silver candle holders. After the police leave, the bishop tells Valjean, “You must use this precious silver. To become an honest man.”

Here is this scene from the 1998 movie starring Liam Neeson, Geoffrey Rush, and Uma Thurman:

Click here to listen.

Here is this scene in the musical:

Click here to listen.

This act of kindness shakes Valjean to his core and dramatically changes the trajectory of his life.

If you did not see the musical or the movie or read the book I don’t want to give away any more of the story and ruin it for you. As I am reflecting on this now, my reaction that night in London was to the power of Victor Hugo’s story, but the music was an amplifier of emotions. 1997 was literally a half-life ago, and I hope I have come a bit closer to being like Jean Valjean over the years.?

I introduced my then-6-year-old daughter Mia Sarah to?Les Mis?in a very odd way –?we watched James Corden’s Crosswalk the Musical.?It is funny and lighthearted. After the Crosswalk the Musical version, we watched the?Les Mis?10th?Anniversary Concert.?I had to explain the story line to her. Her favorite song is “One Day More".

P.S. My gentle suggestion is, don’t watch the 2012?Les Mis?movie, or at least don’t start your?Les Mis?journey with it. It has a great cast, but the singing is horrible. Unfortunately, I put it in the category of worst movies ever made, right next to?Dune?(1984 vintage). Some may say I am too harsh. Maybe, but it took sixty years for Hollywood to remake?West Side Story,?and I won’t live long enough to see the remake.?

Click here to listen.

Vitaliy Katsenelson, CFA

I am the CEO at IMA, an investment firm that designs all-terrain portfolios that survive the worst markets and thrive in good ones. (Get our company brochure in your inbox?here, or simply visit?our website).

In a brief moment of senility,?Forbes?magazine called me “the new Benjamin Graham.”

I’ve written?two books?on investing, which were published by John Wiley & Sons and have been translated into eight languages. (But you can learn the basics of my approach to investing by reading the?6 Commandments of Value Investing.

My first non-investing book,?Soul in the Game, is available for?preorder. You can get a sneak peak and some bonus chapters by forwarding your purchase receipt to?[email protected].

And if you prefer listening, audio versions of my articles are published weekly at?investor.fm.

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The information contained in this article represents Investment Management Associates’s (IMA) opinions, and should not be construed as personalized or individualized investment advice and are subject to change. Past performance is no guarantee of future results. Vitaliy Katsenelson, CEO and CIO, wrote this article. It should not be assumed that investing in any securities mentioned above will or will not be profitable. Portfolio composition is subject to change at any time and references to specific securities, countries, industries and sectors in this letter are not recommendations to purchase or sell any particular security. Current and future portfolio holdings are subject to risk. In preparing this document, IMA has relied upon and assumed, without independent verification, the accuracy and completeness of all information available from public sources. A list of all recommendations made by IMA within the past twelve-month period is available by clicking?here.