Sunday, April 20, 2014

Fool’s Wisdom #4 : An alternate approach to position sizing

Howard Marks in his classic, The most important thing, divides the investing community into people who think that the future can be foreseen or the ‘I know’ group as against the ‘I don’t know’ group viz those who believe that it is absolutely impossible to tell what tomorrow will bring.

He writes “The question of whether, trying to predict the future, will or will not work isn’t a matter of idle curiosity or academic musing. It has – or should have – significant ramifications for investor behaviour. If you are engaged in an activity that involves decisions with consequences in the future, it seems patently obvious that you’ll act one way if you think the future can be foreseen and a very different way if you think it can’t.

Investors who feel they know what the future holds, will act assertively: making directional bets, concentrating positions, levering holdings and counting on future growth – in other words, doing things that in the absence of foreknowledge would increase risk.

Those who feel they don’t know what the future holds will act quite differently: diversifying, hedging, levering less (or not at all), emphasizing value today over growth tomorrow, staying high in the capital structure and generally girding for a variety of possible outcomes”.

In the above few words, Marks summarizes quite effortlessly, what we have been struggling to communicate in the previous posts (Post 2, Post 3) of Fool’s Wisdom ie we fall in the ‘i don’t know’ group which drives our decision making.

Before discussing the position sizing approach, we think it makes sense to first reiterate the context. Recently in an article we came across a photograph of Rakesh Jhunjhunwala in his office standing next to a poster of what he calls his ‘10 commandments of investing’.  Inspired, we decided to ape him!!

 Our Ten Commandments

 1. Capital Preservation takes precedence over capital maximisation. However, we need to guard against permanent loss and not focus unduly on risk of temporary losses.

2. Investing for us is similar to a amateur marathon runners goals. It is more important to finish the race (reach our goals) as compared to winning (beating the index or others to it). Therefore, building wealth over a period of time through controlled risk taking is more important than identifying the next hot thing.

3. Mr. Market is much more intelligent than he is given credit for and thus deserves respect at most times. It is incredibly difficult to identify truly mispriced opportunities. What appears mispriced is more often than not, cheap for a good reason. A reason which we get to know painfully, mostly in hindsight.

4. There is enough available opportunity within discovered ideas, mispriced or otherwise. While obscure hidden gems and micro caps find favour with many, we are happy to pass up most ideas as we don’t trust our own judgement and fall in the ‘i don’t know’ camp.. While multi baggers happen, we don’t set out to identify them. We believe, multi baggers are known only in hindsight while at the beginning they are at best good investment ideas.

5. You can know only so much, beyond that however intensive the level of research it’s all illusion of control

6. Being lucky is the only 100% sure shot strategy. Improve your process since outcomes will always be influenced by the presence of good luck or the absence of bad luck. While making correct decisions obviously helps, it is harder than it seems. A relatively easier goal is to reduce errors.

7. Conviction is for fools. Scepticism followed by constant questioning of your thesis is a good friend to have. There is absolutely nothing wrong with having to change your opinion even if it means that you fall from a pedestal of respect. Also a change of mind need not necessarily be preceded by a change of facts. Improved insight is enough reason.

8. Diversification is the only insurance against ego as well as misfortune

9. Position Sizing is a larger driver of overall portfolio returns and wealth creation as compared to stock selection. By focusing only on stock selection we tend to ‘miss the woods for the trees’

10. We only have 9. There are no fixed rules. Expect the unexpected. Rules of this game are liable to change without notice!! Constantly question your beliefs and learn from your mistakes!!

The 4 quadrant approach

The above commandments define our ability to assume risk in our allocation decisions. Rather than be guided by our convictions, we like to continuously slot our investments, current & potential, on a simple business quality v/s valuation matrix.

It is said, beauty lies in the eyes of the beholder. Likewise assessment of both business quality and valuation are also subjective and differ from one beholder to another. Also, experience and time generally tends to improve the quality of this judgment.
So which are the businesses which look ugly or ‘bad’ to us?? While there are no fixed measures, some obvious ones are low ROCE, poor pricing power, commodity stocks, manufacturing cyclicals, highly regulated entities, any businesses lacking moats, poor balance sheet plays etc. Sometimes inherent business characteristics might be good but unscrupulous and/or incompetent managers (example some PSU stocks) make us qualify a good business as bad.
While the above is mostly obvious, in line with Commandment 6 (try and reduce errors over trying to hit home runs) we also have a habit of slotting ideas outside our circle of competence as well as complex business, as bad business by default.
We think businesses with these characteristics represent a dominant part of the market. A good 80-90% of the ideas that we look at tend to get slotted into the bad business quadrant. Always better to be safe than sorry!!
Conversely what are ‘good’ businesses?? Companies having characteristics which are the opposite of the above qualify as good businesses. Healthy long term ROCE, unregulated mostly consumer facing businesses having pricing power in relatively low cyclical industries, industries with low rate of change, clean balance sheets. Businesses with moats also run by managements with a trustworthy track record.

So what are we trying to achieve through this demarcation? In line with our 1st commandment, we need to guard against permanent losses of capital. And in our experience, it is our investments in bad businesses which, have been and are most likely to be in the future, the source of losses which are permanent in nature. While we are yet not wired to fully eliminate our investments in bad businesses (we will explain why in a short while), we surely want to KNOWINGLY monitor our exposure so as to closely guard against the risk of permanent losses. Demarcating the bad businesses from the good ones is the first step in this regard.
Conversely, we believe that for genuinely great businesses risk of permanent losses are quite low (while not nil) for the very long term investor, even if he were to have overpaid to some extent to start with. For eg. if you bought Infosys at a PE of 200 at the height of the dotcom boom in 2000, you would still have broken even after 10 odd years, without getting into a debate on time value of money. However we are not sanguine if long term buyers of Suzlon or Kingfisher will EVER break even.

The judge of valuation can be equally subjective and has been the subject matter for many an author. Investors would however recognize that it is at best a probabilistic exercise and concepts like intrinsic value and margin of safety take many expensive lessons from Mr Market to understand in the real world.
This judge of quality and valuation cannot be a one time but needs to be a continuous process. Not only does valuation change with the price, businesses can also lose their mojo due to industry upheavels, management decisions and black swans. Good businesses can slide to the Bad business quadrant or vice versa, thereby calling for an allocation review.
While on the face of it, this slotting looks easy, it can get complex even for highly experienced investors largely due to their personal biases. When we have already jumped to a conclusion based on let us say valuation, our mind will figure out a way of convincing us that the business quality is also good by only selectively paying attention to the positive arguments. Quite often we tend to wrongly confuse ‘growth’ for ‘moat’ and most of the times we simply lie to ourselves because a ‘screaming buy’ is nothing but another word for ‘instant gratification’.
Therefore, when analysing a prospective idea, we have learnt to first conclude on the business quality judgement and then move to the valuation, in that order. The reverse somehow just doesn’t seem to work!!

Good Business, Good Valuation (GG) quadrant – Quality at a discount

This one is easy. There is no logic, not to invest confidently into ideas that fall into this quadrant. We therefore wish to have the highest possible overall exposure as well as concentration into individual ideas that fall in this quadrant.
However, given that we are wary of very high concentration, we tend to limit most individual bets to between 5-7% of the portfolio, but this is strictly a matter of personal choice.
That said, it is ONLY an idea in the GG quadrant which can potentially be worthy of an initial 10% allocation, our maximum comfort level. So what will make us go there? First, the business will need to be great. Simply good will not suffice!! Second, the valuations will need to be doubly attractive. Borderline cheap is not good enough!! But most importantly, the steward of the ship ie the management will need to be of impeccable quality both on competence and ethics.
So for example, VIP Industries, which we have written about in a previous post, fell in the GG quadrant, in our view, at the time of writing. We allocated roughly 5-6% weight. Why did we not go to 10%? Because, we classified the business good not great (discretionary spend based industry prone to some cyclicality) and had no issues with the management (quite different from being in love). Should we have changed our mind and gone to 10% if hypothetically the price fell further by say 30-40%? We don’t think so. We bet big (defined as 10% J for us) only if superb management is an insurance against our possible mistakes of omission and commission and the curved ball that the future is certain to often throw at us.
GG ideas once found need to be exploited to their potential. We try to guard against the mistake of underweighting. A 2-3% weight simply does not do them justice!!
So why not simply put all your eggs in the GG quadrant? Wish we could!! However, truly good businesses don’t always come cheap. Even if you are able to identify a few such ideas, it might be difficult for diversified investors to build an entire portfolio of such names. Though it might be possible if you are willing to concentrate heavily, which brings its own set of risks.
Assuming that you have allocated the maximum possible into GG ideas, while at the same time successfully able to sidestep all BB ideas, the challenge now is to choose between quadrant BG and quadrant GB, for the residual capital. This is where one has to contend with a divide of opinions even amongst the investing greats. While Graham/Schloss/Seth Klarman feel that valuation provides the margin of safety and tend to favour the BG quadrant over GB, Buffet/Munger/Fischer advise the reverse and seek margin of safety in quality and not in price.

Bad Business, Good Valuation (BG) quadrant – Smokers corner

Why invest in a bad business knowingly in the first place? First, because it is cheap and appears to come with a large margin of safety. And second, because it is better than Unknowingly investing in a bad business, which in any case is incredibly tough to avoid.
We think that if slotted without bias, this quadrant is where the bulk of ‘value investors’ portfolios rest. Value investors find it tough to avoid a bargain when they see one since they have are constantly on the lookout for ‘mispriced’ securities. Also since we tend to overestimate ourselves and underestimate Mr Market, we think that there are a large number of dollars available for 50 cents out there.
Reality however could be a bit different. While mispricing is most easily found in businesses without moats, history teaches us that value traps are real and what is cheap is quite likely, because it deserves to be!! What’s more, poor quality businesses are most likely to result in a permanent loss of capital, something we wish to avoid in line with Commandment 1.
So why not avoid the quadrant altogether and put all residual capital after investing in the GG quadrant into the GB quadrant?? This is difficult since we are not wired to pay what is a seemingly high price. Like a smoker who is unable to quit despite prior knowledge of the ill effects of his actions, we are also yet unable to resist the temptation of a mispriced bad businesses altogether, especially when the alternative is to ‘pay up’.
There are two reasons for the same. One practical and the other emotional. The emotional reason is that like most ‘value’ investors we still feel that we are smarter than Mr. Market and while others might get hurt investing here, we wouldn’t due to our superior skills :). Maybe we will learn in time, but it is not yet time!!
The practical reason is that it helps us turn more stones. And as we keep turning more and more stones, we keep learning. If we close our mind and restrict ourselves to delving into only high quality businesses, then the risk is that we stop turning stones and therefore stop learning.
Since we are going to smoke anyways the trick then lies in controlling our extent of smoking!!
In this case, since we are assuming higher risk knowingly, we need to monitor and control our overall exposure as well as reduce risk by practising wide diversification.
For investible ideas with a high margin of safety that we categorize to be in the BG quadrant, our rule is to have no more than 2-3% of the portfolio weight. Why? Because when we fall, as we frequently will, it should hurt but not kill us. And when we sometimes get it right, it moves the needle, otherwise what’s the point?
So when we spoke about Triveni Engineering in an earlier post on sugar, we harboured no illusions. This idea fell squarely in the BG quadrant. Allocations thus capped at 2-3% to protect against risk of permanent loss. Likewise with Polaris.
Over and above a stock level weight, we think it is extremely important to closely monitor the overall BG quadrant level weight. We like to be slightly tactical here. 
In greedy times like today, we wish to be careful by reducing our weight to a minimum in the BG quadrant. When players start compromising on quality in search for ideas that haven’t ‘run up’ and look ‘relatively’ cheap, we prefer reducing risk in favour of quality, moving to investible ideas in the GB quadrant or cash in their absence. As we speak we have less than 15% in BG names with no single name above 3%.
Conversely, when fear grips the street and markets seek refuge in high quality, we hope to draw courage to get out of our holes. At these times GB ideas need to give way first to newly opened opportunities in the GG quadrant and then to increased opportunities in the BG space, now available on even more favourable terms. The underlying principle of high diversification remains at all times, to ensure a basket approach to assuming higher risk. In the worst of times for the market and the best of times for this quadrant, we would not prefer keeping more than say 40% in the BG quadrant, always capped at 3% and floored at 2% for an individual position.
New ideas in the BG quadrant therefore need to make space for themselves within these dynamic quadrant limits.

Bad Business, Bad Valuation (BB) quadrant – Deceptively Easy

If i ask you to pay up for a Bad business, what should you do? Obviously walk away.
While this does not require a lengthy discussion, we think investors are quite commonly guilty of remaining unknowingly invested in this quadrant.
The first reason could be an error of judgement. So for example if you are buying PSU banks thinking that they make good BG investments, it is quite likely that you find out in time that they were infact BB investments, because their book value on which your valuation is premised, simply vanishes. Judgement errors are ofcourse impossible to avoid and can at best be reduced over time.
A more critical error is made when investors fail to sell after a price gain, an originally BG idea but now a BB idea. Sometimes paralyzed with indecision and at other times smug with a feeling of success, investors fail to spot this situation in the absence of a framework for the selling decision.

Good Business, Bad Valuation (GB) quadrant – Pay up for quality, but don’t forget growth

This quadrant is the most difficult to buy into for the price conscious investor. Since you will find enough thoughts on this quadrant including Prof Bakshi’s post and this great talk, we do not wish to add a whole lot of our two bits here.
The market is full of examples of high quality businesses with strong durable moats turning out to be multi year compounders. This has happened even though prima facie they have been far from cheap, in some cases quite expensive at first glance.
So what do we look for before investing in this quadrant?? Quite simply, we look for sufficient headroom for multi year growth and management ability to capture it. Stock prices can move in only two basic ways. First, earnings growth keeps rolling in without compromising the balance sheet and second market rerates a great business from what was earlier average to now premium valuations. Since expensive is the assumption to start with for the GG quadrant, it is unfair to bet on further rerating, and its growth that counts. Should you invest in Cera or Relaxo without counting on future growth? Probably not.
We like to cap ideas in the GG segment at 5% with a floor of 2%. We tend not to go higher because 1) psychologically it is difficult for us to pay up and 2) being in the ‘i don’t know’ camp, we remain wary of looking far out for future growth. We however don’t feel the need to apply a lower cap since we judge low risk of permanent losses.

Applying the framework to the selling/averaging decision

The 4 quadrant approach also guides us when weight changes occur due to price movement. While we have spoken on the initial allocation based on quadrants, an equally important decision investors need to make is whether to keep adjusting the portfolio weight by selling (profit booking) or buying (averaging) when prices rise or fall.
We present our thinking about the scenarios in a tabular format.

Existing Quad


New Quad



Good Bus, Good Val


Good Bus, Good Val

Price higher, valuations still attractive

Let it run. Why cut flowers?

Good Bus, Good Val


Good Bus, Bad Val

Price higher valuations expensive

Let it run. Why cut flowers?

Good Bus, Good Val


Good Bus, Good Val

Price lower, valuations even more attractive

Buy and average. Quality gets cheaper.

Good Bus, Bad Val


Good Bus, Bad Val

Expensive gets more expensive

Let it run. Why cut flowers unless its gets extraordinarily expensive.

Good Bus, Bad Val


Good Bus, Good Val

Quality get cheap

Buy and average. Possible increase in allocation

Bad Bus, Good Val


Bad Bus, Good Val

Price Higher, valuations still attractive

Restore initial weight. Control Risk

Bad Bus, Good Val


Bad Bus, Bad Val

Price higher valuations expensive

Sell entirely. Book Profits

Bad Bus, Good Val


Bad Bus, Good Val

Price lower, valuations even more attractive

Recheck for value traps. Average only selectively.

We sincerely hope we have set you thinking about your portfolio!!

Best of Manufactured Luck!!


  1. Thanks Abhinav/Niren for this excellent post. Though perception of good/bad quality business will differ, still its an excellent practice to place the stock in appropriate quadrant.

    Only if I had learned these two concepts without paying steep fees in term of time & money. 1) "When analysing a prospective idea, we have learnt to first conclude on the business quality judgement and then move to the valuation, in that order". 2) "Poor quality businesses are most likely to result in a permanent loss of capital, something we wish to avoid in line with Commandment 1."

    1. Anil,

      Thanks for your positive feedback and reading through carefully :) We are all forever learning. We fear that we will end up writing a book if we ever attempt to simply list our mistakes!!

  2. Hi,

    I m a trendfollower and spinoff investor.
    I tell u wat, interesting article but with 1 big flaw!!! U can never get rich. Sure u won't go broke, but forget about changing ur strata in single generation. All the blokes and dames I knw who have made it big in any industry have loaded up when the stakes were high and the odds favorable. Unfortunately, there is no other way unless u r starting as a billionairre interested in cap protection.

    1. Hi Manish,

      Thanks for your comment. To each his own :)

    2. BTW, just to add, the focus of the post is the 4 quadrant approach. If you are seeking higher concentration, it should be quite possible to achieve it as well within the above framework. The caps and floors are ours. You should be easily able to change them to suit your own risk appetite. The framework should help nevertheless..

  3. Amazing. Is this your original idea? Else pls point to the book/ resource.

    1. Hi Anon,

      Happy our thoughts made you think!! You wouldn't read this anywhere else :)

  4. Great post Niren and Abhinav !!! ...Always a pleasure reading your post.

    You have talked about making an allocation in the BG quadrant where valuation is of higher importance than the business quality....does an allocation still make sense in a BG when it is run by an iffy management....for all you know the numbers on which the valuation is based might be cooked - and beyond a point it is truly difficult to figure that out from analysis of the financial statements, especially in the midcap companies eg. netting off borrowings against loans and advances....

    Also a clarification needed - u mentioned that in worst times for the market, and the best for BG, the allocation should could be capped at 40% - isn't that too high bad times for the market wouldn't good businesses be available at better valuations (though not cheap) and hence exposure to bad businesses with good valuation be lower?



    1. Hi Abhishek,

      Thanks for the questions..

      We are not suggesting that one invests in any and every BG idea even which you don't like. If nos. are an issue or management is an issue, why like in the first place? Avoid completely without doubt. Invest only if your analysis tells you that you should.

      However, do not fool yourself by thinking that just because you like it, it is a good business. Be aware that you have chosen to buy it in spite of it being a bad business and manage the risk accordingly. We have given examples of Triveni & Polaris. In our judgement 1) accounts have not been written by a fiction writer 2) Management is okish, not great 3) business bad (commodity, low ROCE, lack of moats etc) but valuations provide margin of safety (at the time of writing). If the answer to any of point 1&2 would be in the negative zone (accounts cooked, fraud management) we would not invest, whatever the price. Also, its ok if you don't want to smoke this quadrant. If you want to avoid these kind of mispriced bets, its just fine and depends on your aptitude.

      On the second point, we have mentioned that we would entirely invest in GG ideas if we find sufficient opportunity. Other quadrants come into play only for excess capital.

      On whether 40% is high or not, would suggest not to focus on the number caps/floors. Those are designed keeping in mind our risk appetite. Choose your own caps/floors based on risk appetite. The key thought is to slot ideas into the 4 quadrants.

      Trust that helps, do write back in case of further issues..

  5. Thanks for the reply...makes a lot of sense...

    Just a name that comes to mind - Crompton Greaves - where taking a call at 250 bucks hurt the most....good business with strong brand, decent management (though had issues such as private jet purchase and of course the share sale by Mr. Trehan - obviously he must be having a sense of the operating performance before it unfolded via slump in quarterly earnings) and reasonable valuations - don't know where to categorize it hindsight probably a GB and not a GG....couldn't avoid it at that time with a strong positioning of the company and decent valuations...assessing the management and the numbers was indeed tricky, wasn't it?

    1. Aptly put across Abhishek,
      If you find it a good business then surely your assessment is right. There were enough factors available publicly to recategorise Crompton at various points in time. About the tricky nature of the assessing qualitative factors .. Well just like a lot of other things in life .. It ain't easy for sure !!
      Best of ML !!!

  6. Hi ML (manufactured luck) team, you have explained the concept & the framework very well. Let me add my two cents to it. As mentioned in your post there are two main steps before you invest. (1) Identify a good business (2) value the business. For step (1), my view is that everyone should first calculate a score based on some criteria or mix of criteria (eg ROCE/sales growth/EPS growth/Dividend etc). Then, stratify the co's into four groups (great, good, average, bad). In step (2) take the great/good businesses & value them based on various criteria like DCF etc. The next step would be then to invest in them if market price is at a discount to the value arrived.

  7. Hello Manufactured Luck -

    Good post and am glad I stumbled into this blog! Keep up the good work !

    #1 Capital Preservation....many famous value investors say this, but I am honestly not able to grasp what this _truly_ means. Is it to mean not to invest in BB businesses, or something different? But then no one deliberately invests in bad businesses; they only prove to be bad in hindsight. Or, does capital preservation means to invest in business at below fair value, to ensure a margin of safety? What does this preservation of capital really mean? Also, what does the corollary mean.....destruction of all of the invested capital, or part of invested capital? Even Mohnish Pabrai says..."tails I dont lose much...", but some loss is hence possible, we can attempt to reduce the probability of it occurring, and indeed this is manufactured luck.

    #3: Yes, agree 100%...Mr. Market is very intelligent - and stocks on an average are priced where they ought to be. Mr. Market is also given to wild mood swings and that is when he becomes irrational! 2008-09 is a good example of extreme depression of Mr. Market. Now looking at valuations of some of the companies, I wonder is Mr. Market feeling very exuberant now in May-2014?

    #7: Conviction to me, is not a boolean YES or NO, Absent or Present kind of attribute. I'd like to think of it more as a gradient. Complete absence of Conviction would mean that everyone would need to seek an appointment with the dart-throwing monkey! Its only with change of degree of conviction that one can move on to the next step of individual stock sizing in a portfolio. Stronger the conviction in a stock, higher is the allocation. But you're right, conviction is not forever, any belief needs to be constantly questioned, constantly evaluated for change of circumstances, either within the company, or external environment. You have said it perfectly - a change is not necessarily due to change of environment, just improved insight is enough.

    Arun SG

  8. PS: The 4 quadrant slotting of companies is very good !

    Arun SG

  9. Thanks Abhinav & Niren for developing and sharing this wonderful framework.

    I am a strong believer in having the right processes and this will surely help me improve my investment analysis process.

    What you are essentially saying is that fine you may invest in a bad business but there should not be an illusion of it being a good business, you have to be true to yourself, know the reasons of investing (good valuation) and have a clear exit strategy(when valuation catches up or stays low for extended period of time making it a value-trap)

    Having defined exposure limits of 2-3% in each idea and overall caps for the quadrant is surely an effective way of keeping a check on the overall portfolio risk.

    Also agree its far easier to avoid mistakes then to get hooked on to doing only right things (which actually are clear only later in hindsight)

    Overall a brilliant post. Keep flowing more of such frameworks and wisdom :)

    Jatin Khemani

    1. Hi Jatin,

      Thanks for your appreciation. We recently made a presentation on this topic at FLAME Have a look when you get the time..

  10. I am thankful to have come across this article. But please accept my sincere thanks. This article is loaded with wisdom. Pure gold!

  11. Very insightful and educative for individual investors. This sentence summed it up for me "Unless one pays extraordinarily high price for a high quality businesses, generally one would suffer only opportunity cost and not loss of capital." Thanks for sharing your thoughts.