#21 Portfolio management II: position sizing
A framework for decision-making and capital allocation: only the best will do.
Last week we saw how it is more efficient to have a reduced portfolio of high quality businesses. The key idea was to look for the smallest number of wonderful businesses with whom we feel confident. Remember the Holy Trinity: great business, great culture-CEO and a good price. We have to improve the quality of our decisions, not increase the number of them.
Today we will find a framework to translate all our qualitative knowledge and conviction into numbers, helping us to decide the optimal position sizing for our portfolios.
Welcome to Edelweiss Capital Research! If you are new here, join us to receive company analyses, economic pills, and investing frameworks by subscribing below:
The judgement around the long term outlook for companies is an inherently qualitative decision. However, by converting our qualitative judgement into quantitative scores we create a process coordinated with our deeper beliefs. It also provides an opportunity for us to intuitively assign our own weights to all of the tangible and intangible elements of a company being successful.
The following framework explores the 5 main areas to evaluate the positions in our portfolios: the capacity of a company to create new value; the people managing the company; our conviction, essential to avoid temperamental decisions; research time, because we get more knowledgeable with the time; and finally, the dichotomy value vs price.
1. Quality: drivers for value creation
The shares of a company can increase their price due to 3 principal reasons:
1. The shares were undervalued and somehow, the market changed its narrative and the shares passed to be correctly valued.
2. The “so called” multiple expansion: It happens when a company increases its quality with better returns or because its competitive situation has improved. Normally it is thanks to good management and a correct capital allocation. Another reason for a multiple expansion can be found in the expansive monetary policies by the central banks (nothing we can do about it, so we can forget about this one).
3. Intrinsic value creation: revenue growth at higher levels of returns on capital than the cost of this capital. It is maximized when the management reinvest the capital at high rates with adequate returns on this incremental capital invested.
In the following table you can see a list of companies with the ROIC, revenue growth, and compounded intrinsic value created for the last 12 months, 5 and 10 years.
To obtain my relative quality score, I use the following formula:
I assign the following parameter’s values: a=0,3, b=0,2 and c=0,5. p(LTM)= 0,3, p(5y)=0,5 and p(10y)=0,2.
Note: ROICs, reinvestment rates and ROIICs presented here are a first numerical approach. Each one has to do its own numbers and determine what is the correct invested capital to be considered for each company. The same applies to the parameters and variables used. This exercise only pretends to give an example on how to express qualitative information into numbers for a rational decision-making process.
2. Management
This one is easy, although completely subjective. I define 10 categories according to my framework on rebel capital allocators (you can find the link to the articles in the references).
You can choose your own parameters and weights for the final score. I don’t want to complicate things and each dimension has the same weight.
3. Conviction
Our gut also counts. We need to invest in companies we believe in. If not, at the smallest difficulty, doubts will hit us hard and we will be prone to make wrong decisions.
It is all about being able to answer questions such as how likely is that the moat will be still there in 10 years, how much do we trust the management will continue delivering value for the shareholders, or if I have the capacity to forecast the long-term outcomes of the investment.
If I believe the odds of answering these questions positively are about 75% with a particular company, then add 75% in the next column.
4. Research time
Similar to Ensemble Capital (2019), I consider a parameter based on research time. It simply happens that we might consider we have analyzed a company deeply, but we have not connived with it. It is like living with your partner. You date her, go on holidays, etc. But living together is a new whole world. The same happens with a company in your portfolio (even if the company is not a position yet but one you follow closely).
I consider 3 different levels:
Newbies: a surprising new incredible company that I consider it deserves to be added to the portfolio, substitute another company or at least follow in the future actively. We will discuss how to act under these circumstances next week. Nevertheless, the company gets 1 point during the 1st year.
Consolidation: Once we are following a new company, constant new information comes to us. It is like when you buy a new car. From this moment on, you start seeing it everywhere. Same happens here. You get more knowledgeable about the company. We became better primed to process what’s most important and can better focus on the critical information and filter out the noise. 2 points for another year.
Core: After following a company for more than 2 years, we begin to build confidence that there are no significant unknown unknowns that will impact our thesis. From this moment on, we can assign 3 full points.
5. Price vs value: It is all about probability
Bruce Flatt mentioned this week in his Q2 letter to shareholders:
“Price and Value are rarely the same… Price is often influenced by the news of the day, market sentiment, the availability of capital, and other factors that may or may not have any relevance to the Value of a specific security. Value, on the other hand, is the net present value of the future cash flows of a business or asset, based on assumptions for future growth and discounted at the appropriate rate for that particular investment strategy. The difficulty in ascertaining Value is that there is no absolute value for anything, so there will always be a wide range of views over an asset’s growth profile, profitability, and the appropriate discount rate” (Flatt, 2022)
When assessing the value of a company, we need to think about probabilities. The future is uncertain, but still it is important to think about the different scenarios out there. It will give us a sense of the risks a particular company could face.
My procedure is:
1. I establish different scenarios and associate them with different probabilities. I discount the FCF of the next 5 years in each of the different scenarios and assign in each one of them a final EV/FCF multiple, depending on how the competitive advantages of the company would remain in each one of the scenarios. In all the scenarios I try to be quite conservative and I always use a 15% discount factor as my opportunity cost. Risk is considered in the scenarios, not in the discount rate.
2. I do the same but being fair instead of conservative. I try to guess what would be the normal consequences of the different scenarios. Never optimistic. You can always consider an optimistic scenario as part of the process. After this exercise, I get my “fair” value.
3. Get my ratio value/price. I assign a=0,6 and b=0,4.
Note: Again, these are just rough estimations and they might not coincide with my real valuations. Make your own valuations.
“Optimal” portfolio
We have gathered a nice bunch of numbers, but how do we use them?
As you can see, price doesn’t have a big impact on my decisions. We might be suffering here from a survivor bias, since I haven’t added any company that I consider greatly overvalued. However, I am very much of the opinion of Mr. Munger:
"Over the long term, it's hard for a stock to earn a much better return than the business which underlies it earns. If the business earns 6% on capital over 40 years and you hold it for that 40 years, you're not going to make much difference than a 6% return—even if you originally buy it at a huge discount. Conversely, if a business earns 18% on capital over 20 or 30 years, even if you pay an expensive looking price, you'll end up with a fine result."
Price is important. But it is just one additional factor to consider. Not the only one.
We now have a framework to grade our companies. You can add the dimensions you consider the most important or change the formulas at will. The most important thing of this exercise is to have a process. To rationalize and write down our qualitative assessments. Each one adapted to his own investment philosophy.
We now have an “optimal” portfolio based on 7 companies. But what about if we do this analysis for our top 15 companies and we want to have only 5 in the portfolio. Furthermore, this “optimal” portfolio will change its weights every time the price of the shares changes. How should we proceed?
In the last post of this series on Portfolio Management, we will cover how to deal with different situations and how to allocate capital effectively, avoiding turnover, to our best long term ideas.
If you enjoyed this piece, please give it a like and share!
Thanks for reading Edelweiss Capital Research! Subscribe for free to receive new posts and support our work.
If you want to stay in touch with more frequent economic/investing-related content, follow us on Twitter @Edelweiss_Cap. We are happy to receive suggestions on how we can improve our work.
References
Edelweiss Capital, (2022). Rebel Capital Allocators: a trilogy discovering the 10 basic principles for finding outstanding CEOs. Part I, Part II & Part III
Ensemble Capital, (2019). Position sizing series. Link
Flatt, B., (2022). Brookfield AM: Q2 2022 Letter to shareholders. Link
Hagstrom, R.G., (1999). The Warren Buffett portfolio: mastering the power of the focus investment strategy. Wiley
Turtle Creek, (2013). Investment Edge 3: Portfolio Construction. Link
#21 Portfolio management II: position sizing
Wonderful read! Thanks for sharing.
such great content, your articles are a masterclass!