How do you optimally allocate your portfolio concentration?

[yudeng2004]

You guys are hilarious.

 

The Kelly Criterion--where do I begin? When applied to investing, as opposed to cards, it has all of the drawbacks of qualitative reasoning combined with the arrogance of quantitative reasoning. It's the worst of all worlds.

 

As Templeton said, if you think you have all of the answers, you're not even asking the right questions.

 

How about a nuclear attack? I don't care how good a stock picker you are--you're screwed--end of story. The risks that end up killing you are the risks you don't even consider.

 

If you think rationally, you will realize that you can apply the Kelly Criterion to closed loop systems--cards--not the probability of exogenous events, such as some guy in a saloon pulling a gun on you if you win too much. And please, don't give me a lecture on your confidence level of getting shot. In other words, you can apply the system to things that can be definitely measured--cards--not the risks outside things that can be definitely measured, because those must be estimated, and the estimates are what throw a wrench in your calculations. It's a fun theory, but if you think you can blindly apply it--or even apply it to stocks at all in its original or 1/2 Kelly form, I have a great ice pond in Florida to sell you.

 

If you have a good way to handle the situation outlined I am all ears.

 

The risks you don't consider would end up killing you even if you do not use a model to do allocation, since you are subject to them as long as you bought stock. For every security you buy, you are implicitly making a statement about the downside, upside, and expressing some form of confidence in it.  The question is when you have multiple choices, what are good techniques you would use to decide how much to put into each choice?  It would be immensely helpful to know how you approached this.

 

For example with Buffett and Korean stocks - he got a basket of them trading at PE of 2-5 and didn't know much about them individually, but that basket did well overall for him.  Just because North Korea might attack South Korea(a risk Buffett acknowledged) it still didn't stop him from committing some money.

 

The situation with the Korean stocks was that if North attacked, they would all tank pretty much close to 0.  If North did not attack, then they would no longer remain cheap and probably can go up 100-200%. I doubt anyone can really know the chance that North Korea will attack South Korea, but I guess Buffett assumed it was small.

 

The main question is how many % of your portfolio would you put into the Korean stocks if you were in Buffett's shoes?  The answer would be a combination of:

1) depends on how comfortable you feel about the Korean situation

2) depends on what your other choices are, and their respective upside/downside/confidence level

 

That's what I am curious about - how people handle allocation so I can do it better.

 

 

The Kelly Criterion comes into play for us, but it's the last thing we do.  It's far more important to understand all aspects of risk.  Some risks can be ignored if you like because they may have little relevance to asset allocation, for example, asteroid strike.  However, nuclear war is one thing we take into consideration.  We have a moderate position in a New Zealand company mainly to help provide a new start if we should flee there if a big war looms.  New Zealand would probably be about the safest place to be in that unfortunate event.

 

First degree relatives in our core family have unmortgaged houses.  That gives a lot of comfort, especially to the members of the gentler sex.  We have zero debt.  That's a good way to be, less worry, better sleep.  So we build a base of prudent security first, and then it doesn't seem quite so risky to put a third or half of one's investable assets into a really good idea if one thoroughly understands it and the idea is much better than anything else that's well understood.  

 

When we have an investment, there is a continual process of calculating and recalculating the estimated weighted probabilities of how the investment will do. This is a Bayesian analysis.  It's not perfect, but the ongoing process helps keep the evaluation objective as new information appears and is evaluated.  It's much easier to do this with a concentrated portfolio than with a widely diversified portfolio, and the returns will be much better if well executed than with a large portfolio that will be subject to "diworseification".  :)

 

You are right, a model cannot substitute good research and stock selection.  I mentioned using a model because allocation was the part I struggled with after I had already done my research.  Even without paying much attention to allocation, I have already done very well the past few years, and that's from research and calculating risks.  But understanding the problem of allocation can improve upon that performance.  An allocation model can never be the primary driver of an investment strategy and definitely cannot replace research or even diminish its role - but I think it has its place in an investment strategy.  It is a facilitator. 

 

Allocation also forces you to re-balance your portfolio after certain positions get very very large - and this is consistent with margin of safety because once the price increases, your margin of safety decreases, so you should be lightening up at some point.  Of course with market momentums you should "let a stock run" to get the best results, but I am sure a good allocation model can account for this.

 

Essentially, something has to be in place that forces you to switch a portion or all of your 20% undervalued stock  into your 50% undervalued stock after tax considerations, momentum, risk factors, and whatever other factors u wish to consider.  And this model also forces you to examine all of your positions simultaneously with rigor.

 

But I suppose this entire exercise is a reflection of my doubt that "buy undervalued security, hold it, and sell it at 80-90% intrinsic value" is really the best one can do.  And I have always had trouble dealing with these things just by reacting to them - there has to be a plan.

[jasonw1]

This is really good discussion. Even without a systematic approach, we're all making implicit decisions for selling/buying in our portofolio, based on our research and the factors mentioned. I would be really interested to know if a statistically proven allocation approach can help improve results.

 

To have an optimized allocation for the ideas you have, I think you need to factor in the criteria for the overall portofolio:

1) What's an acceptable % of loss and its confidence level, for the portofolio as a whole?

2) What's the targetted % of gain and its confidence level, for the portofolio as a whole? This is not arbitrary but based on the initial input and research ideas

 

And one more input factor: Cost of tax and trading

 

Intuitively the problem looks like a tradeoff between criteria 1) & 2), with all the factors mentioned earlier as input. Is there any math wizard to be able to come up with a fomula?

 

 

[twacowfca]

This is really good discussion. Even without a systematic approach, we're all making implicit decisions for selling/buying in our portofolio, based on our research and the factors mentioned. I would be really interested to know if a statistically proven allocation approach can help improve results.

 

To have an optimized allocation for the ideas you have, I think you need to factor in the criteria for the overall portofolio:

1) What's an acceptable % of loss and its confidence level, for the portofolio as a whole?

2) What's the targetted % of gain and its confidence level, for the portofolio as a whole? This is not arbitrary but based on the initial input and research ideas

 

And one more input factor: Cost of tax and trading

 

Intuitively the problem looks like a tradeoff between criteria 1) & 2), with all the factors mentioned earlier as input. Is there any math wizard to be able to come up with a fomula?

 

 

 

 

Formulas may be useful for providing a framework for evaluating investments.  But formulaic investing has huge blind spots, especially about changing conditions.  These formulas may be oblivious to dark clouds on the macro scene or they may command selling the rare great company too soon.  Most allocation formulas are intended more to reduce volatility than to produce exceptional absolute returns or guard against permanent loss of capital.

 

When I find a truly great company, selling at a bargain price, put as much as one third or half of my funds into it, and let it run for years, there is a bonus because the eventual large gains are taxed at a low long term capital gains rate.  This would be disallowed under the diversification and rebalancing required by almost all allocation formulas, but this is how Warren and many other superinvestors have made their fortunes.  :)

[Phoenix01]

<<But I suppose this entire exercise is a reflection of my doubt that "buy undervalued security, hold it, and sell it at 80-90% intrinsic value" is really the best one can do.  And I have always had trouble dealing with these things just by reacting to them - there has to be a plan.>>

 

If your company is a good one, the full intrinsic value should keep increasing over time.  You are therefore chasing a moving target.

 

If you can project the earnings growth into the future (which you should based on your analysis) and the company is tracking to those expectations, then the there is no real need to sell.  Each new company brings with it new risks and opportunities.  The opportunity for the new company needs to be much greater to account for the new risks that are not as familiar.

 

[Myth465]

If you can project the earnings growth into the future (which you should based on your analysis) and the company is tracking to those expectations, then the there is no real need to sell.  Each new company brings with it new risks and opportunities.  The opportunity for the new company needs to be much greater to account for the new risks that are not as familiar.

 

 

I think this sounds good but doesn't work too well for most investments. Guys typically end up giving back the gains over a certain time, after trying in vain to justify holding an overvalued / fairly valued stock.

 

Monish and Younger Buffett - had it quite right inmo.

 

Monish Pabrai - "Plan A is always to buy the Coke and Moody's of the world at 50% off. If you buy these type of businesses at that discount and it takes 2-3 years to trade at intrinsic value, you'll do very well. Intrinsic value will be much higher in 2 to 3 years. So 50 cents may be worth $1.30 or $1.40. This is always Plan A. But plan A is virtually impossible to execute across the entire portfolio because they are so very very rare. (Work Horse Positions)

 

When plan A fails, we go to plan B. Plan B is to buy at half off, regardless of business quality (as long as you're pretty sure intrinsic value is very unlikely to decline). Most of Pabrai Funds investments over the years have been Plan B.

 

----

 

Parsad is even pithier. Buy cheap, sell dear. The trouble is whats cheap and whats dear. Thats where the expertise comes into play.

 

ATSG was bought due to stress, and I ended up liking the business. At $2-$3, I said it was worth $10 conservatively. Once it hits $10 I will reassess and take some gains. I feel you run into problems when you start moving things around. You start with 8x CF, then 10x CF, then 12x due to the business being stable and annuity like, then 15x CF due to QE2. .....

 

Its tough to say whats the right multiple, but its easy to say whats cheap and dear.

[Phoenix01]

 

I think this sounds good but doesn't work too well for most investments. Guys typically end up giving back the gains over a certain time, after trying in vain to justify holding an overvalued / fairly valued stock.

 

Monish and Younger Buffett - had it quite right inmo.

 

Monish Pabrai - "Plan A is always to buy the Coke and Moody's of the world at 50% off. If you buy these type of businesses at that discount and it takes 2-3 years to trade at intrinsic value, you'll do very well. Intrinsic value will be much higher in 2 to 3 years. So 50 cents may be worth $1.30 or $1.40. This is always Plan A. But plan A is virtually impossible to execute across the entire portfolio because they are so very very rare. (Work Horse Positions)

 

When plan A fails, we go to plan B. Plan B is to buy at half off, regardless of business quality (as long as you're pretty sure intrinsic value is very unlikely to decline). Most of Pabrai Funds investments over the years have been Plan B.

 

 

I agree that these types of "Plan A" stocks are hard to find.  Right now there are several of these available.  I would not consider this a plan B type of market.

[PLynchJr]

Several "Plan A" stocks selling at 50% of IV?  Please share. 

[Guest Bronco]

I am also struggling finding the A's now - but not too long ago (2009) Apple was trading for under $100 (no typo).  Maybe technology isn't durable, but if you look back at the cash on hand at the time, it was a bit of a no brainer. 

 

This was as clear cut an A as I could find.  You had other businesses trading dirt cheap during the crash, but there aren't too many balance sheets + earnings potential companies like AAPL.

[Phoenix01]

Several "Plan A" stocks selling at 50% of IV?  Please share. 

 

As mentioned earlier, ESI & NE are really cheap right now.  Both of their industries have been battered, but they are both still solid and will be able to take advantage of the fallout.  ESI is discussed under a separate thread titled "Education Stocks Once Again Get Slammed on Apollo Report".

 

Noble is a deep sea driller with an impeccable safety record and management team.  Peak oil and the huge Brazilian off shore initiative will give this company all of the opportunities to grow into the future.  In the short term, I think the Q3 will disappoint and may offer an even better entry point, however, it may already have been priced in.

 

[Myth465]

While interesting I wouldnt call those Plan A stocks. They are growing in IV but arent in the same league of Coke, Moodys (prior to the crash), or other world class stocks. Many would call Noble a plan B because its business is based on a commodity and it has no pricing power what so ever. If oil goes to $40 they are screwed, and this is coming from a guy with 25% of his port in oil and gas moratorium related stuff / a holder of ESV.

 

Plan A companies are High ROIC, low capex requirements, growing, and pricing power. PVD would be a type A company. Having a portfolio of them at 50% off has only happened 1 time in recent history - 2009.

[Phoenix01]

There is a tremendous need for the products that both are producing and this need will go on for decades.

 

NE has the best margins in the industry and can be differentiated by its safety record and cautious management and the relationships they have in place.  Post GOM spill, there will be a premium for this.  You are definitely correct that oil dropping to $40 is a huge problem.  I personally think that all indications are that the price will continue to rise because of the lower $US and the increase in demand with more and more people rising out of poverty.  You can also protect the position with an oil hedge if you are not comfortable with the risk exposure.

 

Education is going to be the battle ground of the future.  The US has dropped the ball on this front and will have to invest heavily in order to remain competitive.  ESI appears to be one of the better run for-profit schools, but I have not investigated many of them.  They seem to have the management aligned with the interest of the students and the shareholders.