Investing strategy

My investing strategy has two stages. The first, more resource intensive, stage is to construct a watchlist of the highest quality shares I can find, by making an assessment of their quality entirely independently of their share prices. Momentum and value are determined by the share price and as these prices fluctuate a lot I believe better used to time purchases rather than identify which shares to buy.

The aim is to maintain a watchlist of 100 of the best quality businesses I can find.  This list shouldn’t change much but I update it periodically when I come across new candidates. My method to identify potential candidates is predominately to use quantitative screens based a small set of quality criteria. This doesn’t pick up everything I might want to invest in so I also keep a watchful eye for ideas on the news, other columns and what other investors I follow are buying.

How to decide whether to put a new share on the watchlist? The key underlying problem is to compare the likely extent, certainty and consistency of future growth in profits of a business relative to the others already on my shortlist. Before making an overall judgment, I first go through a list of smaller questions to break it down a bit:

  1. Does the business have ‘good economics’? Does it have little debt? Does it convert profits into cash? Does it have a high return on capital?
  2. Does the business have a good track record? Consistent and stable growth in profits and cash over time; steadily growing share price over the long term.
  3. Does it have a competitive advantage or ‘moat’ that allows it to persistently earn high margins? Is it increasing its market share?
  4. What scope is there for more growth? Is it in a growing market? Is it non-cyclical? What is the prospect for geographic expansion?

I have written a post with more detail about identifying quality.

I would be quite happy to buy most of the shares on my watchlist immediately and a viable and sensible strategy for the long term might be to just hold all of them. However, I believe I should be able to do better than this by holding a portfolio of just a subset of those stocks with the best relative valuations and momentum, and by rapidly eliminating any mistakes that might have occurred in my initial shortlisting.

My way of thinking about my portfolio is much more top down rather than bottom up. I don’t think I gain much of an advantage in carrying out very detailed analysis of specific businesses. In fact I think this type of approach can create or exacerbate mental biases: in particular you may unintentionally artificially limit yourself to a very narrow universe of shares that you have looked at in detail, or may become attached to your own research or give undue weight to specific original elements of it.

Detailed research is also a rather time consuming and often ineffective way of managing risk. My approach aims to eliminate a lot of risk by restricting my universe to the very best businesses I can find on the stock market and by following sensible disciplined trading rules that limit the cost of mistakes.

I like to be fully invested most of the time but am not averse to holding a small proportion of cash in the portfolio to more readily take advantage of opportunities as they arise. I’m also happy to raise more cash in a bear market when there aren’t buying opportunities in my watchlist.

I believe there is a trade off between diversification and conviction. I believe diversification across shares with idiosyncratic risks IS a free lunch in that it can reduce risk without compromising expected returns. I think it is foolish for any investor not to acknowledge uncertainty about the future or the possibility of mistakes. However, it is also true that I have greater conviction in some shares than others and it can be a tricky balance to weigh up how concentrated I should be in a particular position. More recently, I have started to think my portfolio would benefit from being more concentrated and have started to reduce to 10-15 holdings and am raising the maximum size of an individual holding to 20%.

I will generally start a holding with a smaller position and then let it grow over time as the price rises and add to it as I get to understand it better and grow more confident in the business.

What shares to buy from the shortlist? I will consider overall portfolio diversification when choosing what to buy but mostly I will be guided by:

  1. Whether a share has strong momentum – in particular from recent good news (as this momentum tends to suggest the price has underreacted). Otherwise shares with steadily increasing prices or breakouts to new highs tend to look attractive to me. I also sometimes like bounces off ‘support’ where there is still a long term upward trend.
  2. Where valuation is cheaper – I will typically consider the relative valuations of potential candidates using a simple DCF approximation (like the Graham rule of thumb). I will be careful to try to weigh up the quality of the business when making this assessment. I also sometimes use stockranks as another shorthand metric to think about valuation, quality and momentum but I am tending to rely on them less and less and go straight to the underlying metrics.

When to sell? I think the key is unequivocally to run winners and sell losers as ruthlessly as possible!

  1. I always sell immediately on a profit warning. The research I’ve seen on this suggests that selling on the day of a profit warning is the best thing to do the vast majority of the time. I’ve found for most of the profit warnings I have had in the last 2 years (e.g. AMO and IGG) I saved a good 20% by selling in the first 10 seconds after the market opened. An advantage of having a small portfolio!
  2. I sell if there is a loss of momentum (particularly if I have less conviction or if the valuation very high) – when to sell in these situations can be a tricky judgment if I have a lot of conviction in the share. I sometimes have to remind myself that I have plenty of other potential candidates to invest in with rising prices that look almost as good.
  3. If an individual position grows to more than 20% of the portfolio (or sometimes a bit lower for a lower conviction holding) I’ll trim it back to preserve diversification.
  4. I might sell my lowest conviction holding if I see a better opportunity or if I have changed my view.
  5. Otherwise never. I try to never sell solely based on valuation. In principle I would be prepared to if I felt a share was sufficiently overvalued but I think this is unlikely to occur much in practice for the sort of high quality shares I try to invest in.

You will have noticed that my investing strategy, while allowing some judgment, has clearly defined rules. This is because I believe trading discipline is very important – our natural instincts are more often than not to do exactly the wrong thing. Sometimes this is to stare like a rabbit in the headlights at a plummeting share price when you have made a mistake but are unwilling to admit it. Sometimes this is to avoid buying something because the price is annoyingly higher than when you first spotted it. Using momentum based rules allows me to avoid these behavioural biases and instead exploit those of other investors.

From a behavioural perspective, humans are emotionally programmed to want to avoid errors and to seek wins, but are less good at taking account of the difference in magnitude of these wins and losses. Consequently many of the best investment (or gambling) strategies will try to exploit this by allowing for lots of small losses and a smaller number of huge wins. Running winners and cutting losers is a variant of this.