Portfolio Construction Thoughts 10/28/2014
We are very selective in the opportunities we recommend illustrated by the current portfolio holding only two positions and over 80% in cash. We adhere to the philosophy of waiting for “fat pitches” (odds heavily skewed in our favor) and loading up on these opportunities when they present themselves as these opportunities are rare. There are two key assumptions driving our portfolio construction views.
First, permanent loss of capital is the biggest risk of any investment therefore the riskier the expected return/cash flows from an investment, the smaller the weight.
Second, valuation is the key driver of returns therefore the cheaper the opportunity the larger the weight.
We look for high quality companies with a sustainable competitive advantage, strong growth outlook, and good management trading at a discount to intrinsic value. High quality companies are entered into the portfolio at a 5% position if the expected annual return is 15%. Position size is increased as the expected return increases with a potential of up to 15% if the expected return is large enough.
We also look for companies that may not be as high quality but have a strong growth outlook, quality management trading at a significant discount to intrinsic value. These companies are typically near the top of the industry in terms of profitability. These investments require an expected annual return greater than 20%, and start at a 5% position size that can increase to 15%. PC Jeweller is a perfect example of this type of investment. PC Jeweller is a company that operates in a highly competitive industry where there are no barriers to entry (illustrated by the thousands of competitors), demand is cyclical and there are high fixed costs of operation (rent & salaries). PC Jeweller is one of the best operators in the industry (efficiency/profitability) and the industry is only at the beginning of its life cycle so there is plenty of room for growth easing competitive pressures. At the time of investment, PC Jeweller’s expected annual return was 23% before factoring in any growth so close to 30% assuming a sustainable growth rate. PC Jeweller’s extremely attractive yield, a clear path to doubling its store count and weaker competitors trading at premium valuations, PC Jeweller’s initial position size was 12.5%.
We also look for special situations. The position size of these investments is 5%.
The minimum position size is 5% allowing potential investments to make a meaningful contribution to performance. This is also a function of the depth of our research and the high threshold for inclusion. With a five year investment horizon, 20% of the portfolio is turned over annually. With each position at a 5% position size, four new positions are required per year, which is in-line with our target for one idea per quarter.
We believe the benefits of diversification are overstated evidenced by the best investors tend to be concentrated and focused. Diversification is good strategy for scenarios where the odds are slightly skewed in your favor. When the average investor is turning over his/her portfolio over 100% per year diversification is a requirement as the outcome of the short term holding period is driven by momentum and noise rather than fundamentals. Given we wait for the odds to be heavily skewed in our favor, we get to know our investments and we hold assets for the long term to allow fundamentals to be the driver of the share price, diversification is not significant.