Investing strategy

My investing strategy is focussed primarily on exploiting two factors in combination: a) the tendency for high quality defensive compounders to outperform over time and b) the tendency of shares with momentum to continue to do well.

My 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 price based factors and as prices fluctuate a lot I believe better used to time purchases rather than identify which shares to buy.

The aim is to maintain a shortlist of 50-100 of the best quality businesses on the UK stock market.  At the time of writing, I have 77 shares on this list including my portfolio. This list doesn’t change much but I update it periodically when I come across new candidates. My method to first 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. What does the business do? How (uniquely) valuable will this be to its customers in the future?
  4. Does it have a competitive advantage or ‘moat’ that allows it to persistently earn high margins? Is it increasing its market share?
  5. 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 shortlist 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 if those with the best relative valuations and momentum and to rapidly eliminate 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 and I think this type of approach can create mental biases: in particular you may unintentionally artificially limit yourself to a very narrow universe of shares that you have looked at in detail and may become attached to your own research or give undue weight to specific original elements of it.

To start with I think it is much more important as an investor to develop a good overall process rather than to invest your efforts in researching unknown shares in detail. Much of my analysis is fairly high level but I believe this is appropriate given 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 to maximise my returns from them by following sensible disciplined trading rules that limit the cost of mistakes.

I am pretty much always fully invested as I do not have confidence in my ability to time the market.

I believe there is a trade off between diversification and conviction. Make no mistake: 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. I think this is particularly true for me who follows quite a top down approach. 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.

My approach has been to simplify this decision by following the principle that my portfolio should always have 20-30 stocks, minimising common risks, but with positions more or less evenly graded in size according to conviction (so actual concentration is considerably greater than if equal weighted). I also restrict the possible size of any holding to no more than 10% and will topslice when necessary. I will generally start a holding with a smaller position and then let it grow over time as the price rises and by adding to it as I get to understand it better and grow more confident in the business.

What shares to buy from the shortlist? As I am always fully invested and have a shortlist of eager replacements, I generally buy immediately after a sale. I will generally spread proceeds from a sale across both existing holdings and new holdings that are smaller in size. 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 (or incorporate into assumptions) 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 couple of 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 sometimes 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 a load of other candidates to invest in with rising prices that look almost as good.
  3. If an individual position grows to more than 10% 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 ‘buy and hold’ shares I try to invest in

You will have noticed that my investing strategy while allowing some judgment has a lot of clearly defined rules. This is because I believe trading discipline is very important – our natural instincts (which lead to market mispricing in the first place) are more often than not to do exactly the wrong thing. Often 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 or 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 others. Fundamentally from a behavioural perspective humans are programmed to avoid errors and seek wins but are less good at taking account of the difference in magnitude of different results. Consequently many of the best investment strategies (which exploit this) will involve lots of small losses and a small number of huge wins.

The other thing I think every investor should plan for is how to deal with the ‘market crash’. A lack of plan can lead to panic and then costly mistakes. My plan is mostly just to be prepared by monitoring the overall proportion of cyclical shares in my portfolio and always keeping it as low as possible (unless opportunities seem too good to miss) so I can ride out market gyrations. However, if there was a big market crash like in 2008 I might keep an eye out for the opportunity to shift a substantial proportion of the portfolio into cyclicals if and when valuations looked really good.