Value Investing

Position Sizing in Value Investing

Position sizing is something that can make the difference between whether you can be slaughtered by short-term fluctuations, or can stick around for the long run. This is tied very closely to diversification, the smaller the number of positions, the greater the ideas can make an impact on your portfolio, but the greater the volatility and the risk of permanent capital impairment if the ideas don’t work out. Conversely, the greater the number of positions, the closer your portfolio moves towards having average returns.

To figure how I should do position sizing, thought I would first survey the landscape and see how other famous investors are doing it.

Seth Klarman (Baupost)

  1. You diversify away most of the diversifiable risk by having a portfolio of 20 or 25 positions.
  2. You should be able to tell a great investment from a good investment, so there is no sense in having the same size position with your best idea and your 100th best idea.
  3. A position is defined as the total investment in a company’s securities (which could span different asset classes).
  4. A concentrated position is a ~10% position (every 2 years or so)
    1. A post here shows in the 5.5 years from Oct 95 to Apr 01, Baupost only made two 10+% investments, and five 7-10% investments.
    2. We would own a 10% position in a senior, distressed debt investment where there was a plan in place, where the assets were very safe – either cash or receivables or something where we could count on getting our money back, and where we saw almost no chance of principal loss over a couple of years and a chance of a very high, meaning 20% plus, type of return.
    3. We would not own a 10% position in a common stock that was just plain cheap unless we had a seat on the board and control, because too many bad things can happen.
  5. Most of the time, our most favorite ideas have 3%, 5%, 6% positions.
  6. Position size will increase when a cheap position becomes much, much better a bargain or when there’s a catalyst for the realization of underlying value.
    1. A catalyst gives you a much shorter duration on the investment and greater predictability that you will in fact make money on that investment and aren’t subject to the vagaries of the market  and the economy and business over a longer period of time.
  7. New inexperienced managers will have some 20% positions which might even be correlated, that’s absurdly concentrated.
  8. 1% positions are too small to take advantage of the relatively few great mispricings that you can find.
  9. Source: here.

Mohnish Pabrai

  1. Previously had a 10-position policy with each position at 10%. His reasoning then was based on the fact that estimating the probabilities and the odds (i.e. the gain if you win) is error prone, and his own experience is that many times the bottom three to four bets outperform the ones he felt the best about. Hence he decided to weight them all equally.
  2. Recently he realized that if he has 10% positions it’s very hard to recover from a mistake (in the mortgage crisis, his bet on Delta Financial Corp (DFC) got killed).
  3. Since 2008, most positions will be 2-3% (basket trade) or 5% (baseline) of the portfolio and if the seven moons line up he will allocate 10% (home run).
  4. Basket trade: when the risk is slightly elevated he will buy a basket of companies with small weightings.
  5. Sources: here, here, and his Dhandho Investor book).

Zeke Ashton (Centaur Capital)

  1. A 15-25 stock portfolio has enough concentration to allow a skilled investor to really stand apart from the market, but is not so concentrated that bad luck, bad timing, or one or two mistakes can sink an otherwise competent investor.
  2. Zeke did an excellent summary of position sizing styles:
    1. Ultra-concentrated
      1. Fewer than 10 stocks. Large position sizes usually ~20-25% and larger.
      2. Practitioners: Chieftain, Eddie Lampert, Tom Brown
    2. 10-stock model
      1. Standard position size of 10%, with 1 or 2 larger positions, and a handful of smaller positions. Total of 12-20 positions.
      2. Practitioners: Clipper
    3. 20-stock model
      1. Standard position size of 5%, best 2-3 ideas modestly larger, many ideas are smaller. Total of 25-40 positions.
      2. Practitioners: Robert Hagstrom, Bill Miller, Wally Weitz, Longleaf Partner, Tweedy Brown Value
    4. 20-stock model (super-sized)
      1. Same as 20-stock model but best 2-3 ideas are super-sized to 10-15%. Fewer sub-5% positions. Total of 20-30 positions.
      2. Practitioners: Tilson Focus, Fairholme, Sequoia, Oakmark Select
  3. Centaur long positions
    1. 6 – 7.5%: Outstanding idea, 1-2 best ideas per year, compelling valuation with significant margin of safety.
    2. 4 – 6%: Standard great idea, top 8-10 ideas.
    3. 2.5 – 4%: Solid idea with one or more minor risk factors (e.g. valuation, industry quality, liquidity, political risk)
    4. 0 – 2.5%: Interesting idea but may be illiquid, bet with a good reward-to-risk ratio, or a very cheap low quality business.
  4. Centaur short positions
    1. > 4%: Shorts or hedges using market or sector specific indices.
    2. 3 – 4%: Most compelling individual short idea with very low risk.
    3. 2 – 3%: Standard great idea, no more than 2 or 3 usually.
    4. 1 – 2%: Solid idea with one or more risk factors (e.g. high short interest, low float, low market cap)
    5. 0 – 1%: Typically a put option. Probability of good outcome is low but magnitude is significant.
  5. Consider what kind of investors you have (i.e. your capital base), whether they can take on huge volatility, whether you have safeguards to prevent capital from fleeing at the worst possible moment.
  6. Consider whether you like to work solo or in a team. A team will generate more ideas.
  7. Source: here, and here.

Warren Buffett (Quotes from Buffett Partnership Letter, January 20,1966)

  1. We might invest up to 40% of our net worth in a single security under conditions coupling an extremely high probability that our facts and reasoning are correct with a very low probability that anything could drastically change underlying value of the investment. We are obviously only going to go to 40% in very rare situations – this rarity, of course, is what makes it necessary that we concentrate so heavily when we see such an opportunity.
  2. Frankly there is nothing I would like better than to have 50 different investment opportunities, all of which have a mathematical expectation (this term reflects the range of all possible relative performances, including negative ones, adjusted for the probability of each – no yawning, please) of achieving performance surpassing the Dow by, say, fifteen percentage points per annum. If the fifty individual expectations were not intercorrelated (what happens to one is associated with what happens to the other) I could put 2% of our capital into each one and sit back with a very high degree of certainty that our overall results would be very close to such a fifteen percentage point advantage. It doesn’t work that way.
  3. We have to work extremely hard to find just a very few attractive investment situations. Such a situation by definition is one where my expectation (defined as above) of performance is at least ten percentage points per annum superior to the Dow. Among the few we do find, the expectations vary substantially.
  4. The question always is, ‘How much do I put in number one (ranked by expectation of relative performance) and how much do I put in number eight?’
    1. This depends to a great degree on the wideness of the spread between the mathematical expectation of number one versus number eight.
    2. It also depends upon the probability that number one could turn in a really poor relative performance. Two securities could have equal mathematical expectations, but one might have .05 chance of performing fifteen percentage points or more worse than the Dow, and the second might have only .01 chance of such performance. The wider range of expectation in the first case reduces the desirability of heavy concentration in it.
  5. The optimum portfolio depends on the various expectations of choices available and the degree of variance in performance which is tolerable.
  6. We probably have had only five or six situations in the nine-year history of the Partnership where we have exceeded 25%. Any such situations are going to have to promise very significantly superior performance relative to the Dow compared to other opportunities available at the time. They are also going to have to possess such superior qualitative and/ or quantitative factors that the chance of serious permanent loss is minimal (anything can happen on a short-term quotational basis …).
  7. In selecting the limit to which I will go in any one investment, I attempt to reduce to a tiny figure the probability that the single investment (or group, if there is intercorrelation) can produce a result for our total portfolio that would be more than ten percentage points poorer than the Dow.
  8. We presently have two situations in the over 25% category – one a controlled company, and the other a large company where we will never take an active part. It is worth pointing out that our performance in 1965 was overwhelmingly the product of five investment situations.
  9. A quote not in the 1966 letter: “With each investment you make, you should have the courage and the conviction to place at least 10 per cent of your net worth in that stock”

Note that those are Buffett’s thoughts in 1966. We know from the more recent comments by Buffett/Munger that the variance of the portfolio is no longer a concern once they have moved to the Berkshire Hathaway holding company structure as opposed to a hedge fund / partnership structure. Hence adding in a large number of stocks to lower the variance, and incurring a performance hit in the returns, does not make sense any more.

Another thing to note is the explicit use of calculating mathematical expectations for the potential returns of each investment, and also looking that the probability of a really poor performance despite having a high expectation.

One thing that I thought should not be done is to try to calculate the outperformance relative to the Dow. To do that will require you to project how the Dow will do, and that is difficult. It also does not serve the point as it is the absolute return that matters. There might be some debate here as many value mangers (including Buffett in his letter) that if the index went down 30% but your portfolio went down 15%, then it is a good year. I would say that what needs to be evaluated is the execution, whether or not you monitored closely and moved swiftly to protect capital, as opposed to saying that the timing is too hard so ignore it. Firstly you need to determine whether the event would lead to a market-wide downturn (e.g. the credit crisis yes, but not the dot-com boom-bust where staple stocks like JNJ maintained their value) If there is an event that will lead to a market-wide downturn, I would say that a good manager would have known of that possibility early on, just that the timing of which is hard to predict. The manager should be watching the appropriate indicators and to get the hell out when the crumbling starts (e.g. for the housing crisis, when the delinquencies hits, margin calls start, etc., and for trading exuberance like the dot-com boom, and you are in tech stocks, could be if a stock dropped under its 20-day MA for 4 days, etc.)

Sir John Templeton

  1. No more than 50% in a single country.
  2. No more than 25% in a single industry.
  3. Source: here.

Anthony Bolton (Fidelity)

  1. Based on following factors
    1. Conviction level for the stock
    2. How risky it is
    3. How marketable these shares are
    4. Percentage of equity you hold in the company (absolute limit of 15% as the maximum exposure)
  2. Position size changes over time as the conviction level changes.
  3. For large portfolios, start with a 25bp (0.25% of your portfolio) holding. As conviction level increases, increase the holding to 50bp, then 100bp, then 200bp, and finally 400bp. With a smaller portfolio, can start with 50bp.
  4. May go above 400bp in a mega-cap share. Company would need to be FTSE 100 company to go over 200bp.
  5. Make incremental moves and not large adjustments to the position size.
  6. Source: His book titled “Investing Against The Tide: Lessons from a Life Running Money”

Michael Price

  1. Say he has $100M.
  2. Top 5 names to be each 3-5% of assets.
  3. Next 10 names to be each 2% of assets.
  4. Want 20-30  positions at 1% each.
  5. Every day, look at those 1% positions, and say I bought them cheap, should I be adding to them, should they be 2 or 3%? For the 5% positions, are they good enough to stay at 5% or should I bring them down to 1%.
  6. Usually enters the position cheap, the stock moves up, sells off some at a high price, the stock pulls back, and it ends up in a position where you don’t want to buy and you don’t want to sell. If you did a good job in your research, these positions will do okay. Constantly evaluate whether you still want to hold the positions, can be impacted by industry news, general economy, level of interest rates, commodity prices, etc.

Lee Ainslie (Maverick Capital)

  1. Each position top out at around 5-8% of the overall portfolio.
  2. Average position size of 2.1%.
  3. Diversifies also by industries, have 6 sector heads (consumer, health care, cyclical, retail, financial, technology) each with 7 analysts.
  4. Source: here.

Jim Chanos (Kynikos Associates)

  1. Short positions limited to between 0.5% and 5% (max) of capital. If positions start to get too big, they’ll trim them back down to the intended allocation. Stop loss orders are used to limit risk.
  2. Source: here.

Richard Pzena

  1. Takes into account the volatility of the stock (trailing 12 months) when determining the position size.
  2. His research showed that by eliminating the 20% most volatile stocks from his portfolio, returns improved and volatility dropped.
  3. Source: here.

Peter Lupoff (Tiburon Capital)

  1. 40-50 positions, maximum position size of 10%.
  2. Calculates the Kelly formula recommended size for all positions including the new position. Then scale it down such that they sum to 100% without changing their relative weights, subject to a maximum of 10% for a position.
  3. To calculate the odds, create base, best, and worst case scenarios, then probability weight them.
  4. Remove correlation among investments by hedging to remove risk exogenous to the thesis of each investment.
  5. Source: here.
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Discussion

2 thoughts on “Position Sizing in Value Investing

  1. it’s simply amazing to stumble into this blog by accident with all the links on right hand side and all the review of other great investors —— really love reading your blog and hope you can continue writing!!

    btw any chance of putting everything into a pdf so admirers like me could print it out ?

    Posted by jacky | July 13, 2011, 4:07 am
  2. Thanks for your comment, glad that you like reading my posts. I hope to continue writing too, but have been pretty busy lately so have not been posting new materials for some time.

    I have no idea how everything can be printed into a pdf, if there is a quick way (i.e. takes 1 minute) to do that, do share. Many of my posts also comes with hyperlinks, which makes it even more difficult to put into a pdf file.

    If you want to PDF a post yourself, you can install a free PDF printer driver like PrimoPDF, and print the posts you are interested in into PDF files. Hope this helps.

    Posted by whatheheckaboom | July 18, 2011, 2:21 pm

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