Position sizing - the underappreciated secret sauce of investing
Before we begin, we are currently running a 25% discount on GSN Invest Edge for all of our newsletter readers. Use code NEWSLETTER at checkout to join our family!
https://easebuzz.in/link/CQCX7
GSN Invest Edge includes indepth analysis of 200 business across the Indian markets, a forensic analysis primer and checklist, a premium community to discuss your analysis and FY22 updates of the analyzed businesses!
While you'll find a tonne of content on how to buy a stock, you won't find much on how much to allocate to it and when.
Before we begin, it's important to understand what were attempting to do when we invest:
+ Make a boatload of money when you're right
+ Lose as little money as possible when you're wrong (and yes, no matter how good you are, you will be wrong sometimes)
You can make boatloads of money fast and slowly:
+ Slowly: High quality business bought at a decent valuation held for a long time
+ Fast: Moderate quality business bought before a key catalyst and sold when the catalyst is factored in and then some
You generally lose a boatload of money in the following ways
+ Fast: Major governance issue identified, de-rating post bubble, increasing competitive intensity
+ Slowly: Sunset sector facing declining core business
Before we go further it helps to divide your portfolio constituents into three parts, and look at the opportunity, risks, and therefore sizing strategy in each of these.:
(A) Core: Stable consistent growers
(B) Tactical: Fast medium term growers
(C) Moonshots: High risk-return bets
(A) Core Portfolio The businesses you pick here will be champions in their field, growing well, generating strong returns, and market darlings. There are two ways ways you can go wrong with these- + Overpay for quality + Get stuck in a value trap
Paying very high valuations for a quality business can lead to a long period of flat returns (time correction). On the other trying to find quality at a cheap valuation can often drive you towards sectors in sunset businesses.
So how do we buy and size core positions: Maintain median position, scale when they are hated. I'll typically have a range for my core positions - Let's say 3-8%. I will typically add these businesses consistently every month, keeping the weight somewhere in between, say 5%.
Every once in a while even these quality businesses go out of favour due to a variety of factors: Perceived increase in competition, one off negative events (quality issue, fires etc), or fads driving money out of certain sectors. In times like these you size up how long the headwind will last and gradually scale up your position in that time - This could last from a few days (one off event at co) to a few quarters (fads/ industry challenges).
(B) Tactical Fast growers As Mr. Damodaran puts it, all businesses are a combination of numbers and narrative. When you identify businesses where the narrative is going to change sharply, you can have an opportunity to make disproportionate returns.
In these businesses you identify the catalyst and try to buy as close to that as possible. As always - two things can go wrong: + Buy too early: It was easy to spot the Auto business declining in FY19 - but folks that got in say FY20 would see another two years of muted returns. + Buy too late: Buying into these themes towards the end as they are gaining mass market acceptance can result in a sharp drop.
So how do you buy and size tactical positions: I'll typically maintain a lower range say 1-4%, and scale up to the higher range as we get closer to the catalyst The tricky part here is that the catalyst is not always the event, but sometimes the market recognizing the event.
For businesses like these the markets go through phases
1. Disgust - what an awful business
2. Curiosity - could this be interesting
3. Acceptance- this is beginning to change
4. Love- seems like a pretty good business
5. Euphoria- this is the best business in the universe
Ideally buy between disgust and curiosity, and sell at love.
Which brings us to the last part
(C) Moonshots - Typically two types - high valued businesses targeting large TAM, low valued business with governance concern looking at turnaround
The risk of derating is extremely sharp in both, hence better to keep these positions sub 2%. With stocks like these you have a lot of % upside it you're right, so don't rush into it.
Wait for the turnaround to show 2-3 quarters of good performance. Wait for the high valued grower to get to your price level post a macro change/bubble burst. Remember, these businesses can go up 50-100% and still have a tonne of juice left! Play the waiting game.
Finis. I put a lot of effort into writing this post, so please share in your network if it adds value.
Disc: This is a purely educational post to help you understand the fundamentals of position sizing better. This is NOT intended as investment advice.
Gentle reminder before you leave: We are currently running a 25% discount on GSN Invest Edge for all of our newsletter readers. Use code NEWSLETTER at checkout to join our family!
https://easebuzz.in/link/CQCX7
GSN Invest Edge includes indepth analysis of 200 business across the Indian markets, a forensic analysis primer and checklist, a premium community to discuss your analysis and FY22 updates of the analyzed businesses!