Thoughts on allocating new capital, business performance, and FICO's valuation
Response to a question
In response to this year’s annual letter, Alex from The Science of Hitting Investment Research Service posed the following:
would love to hear you explore thoughts on holding cash vs allocating to current positions, particularly in light of the FICO comments / weighting. Think that might be an interesting road to go down.
Alex’s prompt has resulted in some introspection, which I welcome.
I’ll admit from the outset that my orientation here has evolved significantly over the years. When I first began actively investing, I resonated with the idea of allocating a large percentage of the portfolio to a single position at the point when I decided to buy the stock. This had some good results, but also some fairly disastrous results.
This approach was largely inspired by what Buffett and Munger have said about portfolio concentration. Exhibit A:
Once you are in the business of evaluating businesses, and you decide that you are going to bring the effort and the intensity, and the time involved to get that job done, then I think that diversification to any degree is a terrible mistake… if you really know businesses you probably shouldn’t own more than six of them. If you can identify six wonderful businesses that is all the diversification you’re ever going to need.
Warren Buffett
The truth about concentration, however, is that it works fabulously well if you are a great investor and, inversely, although not unsurprisingly, it works decidedly less well if aren’t an investing legend. For the novice investor it is simply almost always a mistake. While I can still feel the nimbus of my 20 year old ego lash out, I am not now, nor have I ever been, an investor of comparable ability to a Buffett or Munger.
The novice investor experiences the same kind of difficulties with trying to remain perfectly rational that the seasoned investor does. What they do lack is simply the ability to contrast between mediocre opportunities and great ones. They simply don’t know what they don’t know.
Consequently, most of what I am trying to do now is minimise my own remarkable capacity for misjudgement. Unfortunately for us (although on occasion this works to our benefit) the opportunities for misjudgements in investments are virtually limitless. This understanding, both of markets, and of my own psychology, has inspired me to approach markets in a way that requires the absolute minimum amount of decision making on a day-to-day basis.
I would like to qualify the above statement by saying that this can’t possibly be the most optimal approach to markets generally. However, it is the most optimal approach for me.
The reason why this is relevant to the question at hand is that I tend to find myself buying stocks at very particular moments in time. Quite often this is years after a catalysing event has taken place. I’m not looking to take chances - I would like for the business to be seriously de-risked before committing capital to it. Consequently, I tend to find myself owning a company for as long as it continues to perform well at the business level, and for as long as I feel comfortable that I understand the business well.
I’ll also admit that I’m one of those eccentrics that only likes revenue growth when it translates disproportionally into earnings per share (EPS), and I only like disproportionately strong EPS growth when it is mostly translated into shareholder value.
An unfortunate consequence of clearly demonstrable business (as well as financial) success, coupled with great capital allocation by a management team, is that the equity gets priced accordingly. Whenever I have made a successful investment, I have found that the attractiveness of the equity on a purely valuation basis is a short lived state of affairs. Unsuccessful investments tend to have a knack for remaining cheap indefinitely.
To go off on a slight tangent, valuations matter, however valuations are much better framed in terms of expectations. After all the prices of securities are merely a reflection of the market’s expectations for their future prospects at any given moment in time. This is one of those few areas where I think Buffett’s folksy, oversimplified wisdom seems to lead investors astray. There’s a public perception that his practice is to disambiguate the complexity of the investment question by simply describing a stock as cheap or not. There is relatively little public material on what inputs he uses to come to this conclusion. For example, the Oracle’s Apple investment is commonly lauded for it’s optical cheapness at the time that the investment was made - relatively little information is shared as to what Apple earned in the subsequent years, or what was driving the quality of those earnings.
In any event “cheap” is a relative term. Adding additional capital to an existing position doesn’t differ that greatly from beginning a new one. There still needs to be a value realisation event (or a series of them) between the moment when the shares are purchased and at future point in time. These events need to be inadequately priced in and that is are rare. Alternatively, the eternally cheap stocks generally lack any value realisation event or are being subjected, in one way or another, to value destruction (lack of proper capital allocation, declining business lines, lack of shareholder returns etc etc).
I have generally been reticent to add capital to existing portfolio positions unless I feel confident that I have some insight that the market is not pricing in. For new positions I am generally starting off with a 5-10% initial allocation (although 10% these days would be a little unusual for me), and then following the business story closely. If I am right that the intrinsic value of the company is going to compound at an acceptable rate for a long period of time, I should get a couple of opportunities to add to that position over time. If I am wrong about any part of the thesis, I should be taking capital away from that position quickly.
On a personal portfolio basis, I have experienced a few happy issues. Firstly, I have had the good fortune of being able to add significant new capital to the portfolio. This has prompted the eternal investment question: what happens when plentiful new capital meets a dearth of high quality opportunities? I have no good answer to that question except to say that both short term US governments and the S&P 500 seem to be both reasonable saving s vehicles in the interim. Secondly, as I have become more aware of my own competencies, I have sold significantly sized portfolio holdings as they have no longer met my criteria. This has also freed up additional capital that I have no immediate use for. As I find more opportunities - which would include adding capital to current portfolio holdings - this should be less of an issue.
With regards to the FICO question/valuation, a few things are important to note:
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