I look for investments in companies where my understanding of operations is very different to the prevailing view and where their current valuation is at a steep discount to their future value. I'm not dogmatic about the 'investment style' associated with these companies e.g. I'll as happily own an early stage Amazon as a deep value, cyclical oil refiner. I also don't mind the industry as long as I have experience in understanding these types of companies.
Selecting Investments
In selecting for investments, my approach is based on:
Contrarian: look for opportunities among misunderstood, neglected and sometimes hated companies
Fundamental: build a deep, bottom up understanding of the company and its industry. My valuation is generally based on normalised cashflows or earnings. Sometimes tangible book for deep value situations
Asymmetric payoff structures: small downside vs upside payoff structures. I also include look for hard to value, long tail free options as part of the skew
Compound growth: with the exception of deep value, mean reversion plays, I want companies which can compound earnings over many years. The industry structure and company management are often important aspects to achieving this
Portfolio structure
The characteristics here are:
Concentrated: hold only ~20 investments/ideas
High conviction: sizing of positions and ideas depends primarily on their upside. The strongest ideas can become a large portion of the portfolio
Market condition appropriate: defensive vs offensive
My portfolio structure can seem aggressive. To manage the downside of being wrong, the risk control measures are essential. I aim to put new positions in at between 2-3% of the portfolio. Then I scale up from there depending on the events which leads to either a price rise or fall. If the original thesis is intact I will be a buyer in a falling price environment. If the investment falls significantly from the initial entry point e.g. -20%, I may trim aggressively to wait and reassess. It is also best practice to have a fresh, second analysis on the idea in downturns.
Portfolio winners may run to become large positions with the portfolio. Depending on the quality of the compounding company, I will let it run even if it extends beyond 'fair value'. These investments which prove their quality and revalue upwards with their growth usually gain a loyal following which makes them more resilient on the downside. Therefore putting stop limit orders on them is often a good way to balance their growth momentum with sizing.
For mean reversion plays I will size and cut the position purely on expected return. I try to size bigger and cut more aggressively on these and binomial bets. However I have learned to be less aggressive in the initial position sizing as the trough can be much lower and the recovery take much longer than you initially expect.
Risk
My view on Risk is a unique defining aspect which affects all parts of my Investment Approach. I see Risk as "the Risk of Absolute Loss" NOT the standard Market definition of "Volatility". The Market hates Volatility and Uncertainty and will usually offer huge discounts to avoid it. To me these are often opportunities if I can form an alternative view on the downside or the duration.
My integration of Risk at the Portfolio level is very important. Rather than starting with correlation, I work on thinking about Risk in structuring the portfolio based on the state of the current Market and as an active source of alpha (e.g. I think holding a certain exposure to US/China/Trump risk today is correct). To me Risk at a Portfolio or thematic level is more important than at the stock level.
Currently I'm working on understanding of Risk via the Kelly Criterion (bet size optimisation for logarithmic growth). I may write in more detail on this in a later post but I'm excited by a preliminary study of the maths which suggests that with more bets, an asymmetric upside payoff structure with lower odds of 'Win' is more rewarding than a normal payoff structure with higher 'Win' odds even when the Expected Value of the two is the same. Interestingly the only Kelly Criterion variables are win/loss probability and upside/downside results (no volatility variable).
Time Horizon
I'm willing to hold for the long term (but not dogmatic about it) - it all depends on the investment play and how events unfold. I don't have any particular advantage in timing my investments so being prepared to hold long term is necessary for most portfolio candidates. A long term investment perspective and preparation is an advantage in this industry.
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