Today's piece is about portfolio strategy and risk management. Every week I spend upwards of fifty hours reading, synthesizing, and thinking about markets. It is both a passion and obsession. Most of this time consists of reading company conference calls, reviewing 10-Ks and 10-Qs, reading SA's excellent and comprehensive news coverage, writing articles, and interacting with Second Wind Capital members. In addition, perhaps ten percent of my time is spent reading free site articles by other authors.
Incidentally, while reading the work of some other authors, I have observed that bold article headlines and assertions like 'Buy The Dip', 'The More It Drops, The More I Buy', and 'I'm Betting Big' seems to be very popular with the readership. As an author with the pen name 'Courage and Conviction' I used to think this way too.
After all, if you loved an idea at $10 and you bet 10% of your portfolio on it, at face value, it seems like a good idea to double down after a 20% or 25% loss. However, upon reflection and after twenty years of accumulating battle scars (I am 40 years old), I have evolved and realized the folly in this misguided thought process. I will explain why I no longer think on this wavelength.
For context, 2020 was an auspicious year for me as an investor. The total return of my portfolio was 93% and this was despite maintaining significant percentages of cash from July 1, 2020 - December 31, 2020. If you have been closely following my work you might recall a pivotal piece that I wrote on April 29, 2020, titled: Taking My Medicine (Losses). For many readers the idea of taking a loss seems crazy and akin to admitting defeat.
Moreover, so many people maintain the notion that they need to get back to even on a losing bet and the best way to accomplish is to double down, sometimes even triple down. I get the sense that their thought process is that they are (conscious or subconsciously) so invested in the ego of being right that this leads to bias, subjectivity, and ultimately bad decisions. And when we lose our objectivity, I can assure you this isn't the best way to generate returns.
Likewise, within the comment threads of many of these 'Buy The Dip' articles I also noticed that some readers tend to blame others, like the evil short-sellers, an analyst downgrade, or even Dr. Seuss. In other words, for far too many people, the possibility that an investor/ speculator would have made a mistake doesn't even cross their minds.
Trust me - I get it!
I too used to fall into this misguided mindset. Lo and behold, last year, at the depths of March 2020 / April 2020 lows, in the face of breathtaking unrealized losses and a big drawdown, my mind moved into hyperdrive and I reflected back on the past twenty years as an investor/ speculator. And when I laid bare my results, I realized that unequivocally I correctly identified dozens would be winners, ideas that would go onto generate exceptional returns (multi-baggers), and yet despite this stock picking, I generated poor returns. It turns out, my poor results were driven by misallocated bandwidth, poor portfolio sizing, and bad risk management. In other words, I fell into the classic trap, the one the great Peter Lynch warned us to stay clear of - Cutting Our Flowers and Watering Our Weeds.
Realizing this reality was hard to accept as the ego doesn't like being wrong. I felt the force of gravity, like Marty McFly, and his famously saying in Back To The Future: "This Is Heavy."
Anyway, let me explain my thought process.
As an investor/ speculator, we only have so much bandwidth and a fixed amount of investment capital. There are upward of 3,000 publicly traded securities available for purchase, and available for purchase five days per week. The choices abound and range from nano-caps to mega-caps, from value to growth. There are a myriad of different sectors, sub sectors, and so many choices that it can be more overwhelming than when Howard Johnson introduced 28 flavors of ice cream.
I don't care if you are a Nobel Laureate, graduated from Princeton, got your MBA at Stanford and you obsessively work at your craft for sixty hours per week, we all have limitations. As humans, we all have our bandwidth constraints. Financial markets and the future are inherently uncertain and unknowable. Exogenous shocks, unforeseen events, and positive and negative surprises occur every day. This is what makes markets so captivating, challenging, rewarding, and worthwhile, all at the same time.
With this introduction out of the way, let me share my current thought process.
Sizing - Never Bet More Than 15%
I run a fairly concentrated portfolio, but I never allocate more than 15% of my investment capital in any single company (cost basis sizing to be clear). In fact, current favorite ideas tend to be sized between 8% and 12% (and generally speaking I don't like going north of 10%). Last year, the only two ideas that I sized at 15% were Macy's (M) and Kirkland's (KIRK). Macy's was a mistake and I covered my faulty thinking in the original Taking My Medicine (Losses) article.
As for Kirkland's, I loved this idea, did a lot of work on this idea, including interviewing CEO Steve 'Woody' Woodward, and fortunately I allocated 15% of my portfolio when the stock was $1.75 per share, back in June 2020. Unfortunately, I sold the last of my shares at $10.85, so I only made 6X my money. That said, I'm totally fine with the fact that Kirkland's traded north of $32, last week. Let's face it, I love it when my readers have the chance to make 18 times their money in less than one year!
Source: Fidelity
Maintain Dry Powder
As individual investors, there are advantages and disadvantages compared to professional money managers. One distinct advantage is that our portfolio, at least for most people, is often less than $1 million dollars, so we can nimbly enter and exit positions without our buying or selling influencing the underlying stock price. Secondly, unlike most mutual fund managers, we don't have to be fully invested (or nearly fully invested, say 95% invested) at all times.
In other words, if we don't like the overall market backdrop or we simply want to defensively raise cash, we have that opportunity whereas mutual fund managers are mandated to be fully or nearly fully invested at all times (imagine what it felt like as a technology mutual fund manager circa March 2000 and you had no choice but to be 95% invested). Personally, I like to have 20% to 40% of my capital sitting in cash. This might be too conservative for most readers, but find the right level of cash that suits you.
Perhaps, it is psychological, but I don't like being fully invested and exposed to a sharp market sell-off and being unable to take full advantage of it. For example, at the depths of last Friday's intraday lows, believe it or not there were many technology stocks that were down 30% to 50% from their February 2021 highs. If you had dry powder (say 20% to 40%) then you could have opportunistically put money to work, even if it was simply to catch a few 10% to 20% mean reversion trading bounces.
Taking 10% Losses
Finally, we have come to the main event, and the most controversial section of this article. This past holiday season, I had a chance to catch up over the phone with a long time investing friend and one of my original investing mentors (I have known him since 2003). We often trade investing idea emails but rarely get the chance to chat for an hour. This person has been in the investment business since college and has exceptional experience.
After college, he started in Putnam's excellent three-year analyst training program, then went off to B School. Post B school, he spent two years as an analyst on the buy side (on the fixed income side), then three years in fast-paced hedge fund world, at two different distressed debt shops, as an analyst, and then permanently moved to equities. To make the transition (or leap) from fixed income to equities, he put in his four or five years as Senior Analyst and then became a portfolio manager, a position he currently holds and has held for upwards of ten years.
At present, I believe co-manages a portfolio with assets north of $500 million. My long-winded point is that this Kool Kat is battle-tested. For perspective, the barriers to entry to become an equity PM are so high and fortressed that it requires a unique combination of talent, work ethic, experience, and luck (frankly) to land there and more importantly stay there.
During our holiday chat, he subtly and gracefully planted the seed that the only thing really holding me back is my risk management. And he said that if you run a portfolio where you take 10% stop losses then you start to spend a lot more time thinking about your entry points. He artfully noted that - think about how quickly a bad bet can go from a 10% loss to a 20%, 30%, or even 50% loss.
When this happens, if you decide to buy more or double down then the sizing of the bet can bump up against your sizing limits and now your bandwidth is consumed trying to soothe your ego by figuring out why this bet isn't working. There is a big opportunity cost.
Suddenly, a 5% idea goes from down 10% to down 25% and the shares that you doubled down are now down 15% and suddenly a modest loss turns into a material loss. This is the fastest way to leak portfolio performance. He said it very gracefully and artfully such that it wasn't offensive and that I would receive the message and objectively evaluate it.
The more I thought about it, the more I realized that he was more or less correct. It is amazing how quickly a 10% loss can spiral into a 20%, 30% or even a 50% loss. The market today moves at lightning speed and if you are on the wrong side of momentum then things can get ugly and fast.
For a real world example, let's take Nautilus, Inc. (NLS). Nautilus is a stock I know reasonably well and that I wrote up (A 2021 Battleground Stock) on SA's free site on January 17, 2021. For context, I bought shares of Nautilus in late December at $17.76 and I eventually sold around $24. Unfortunately, I missed the run-up to $31 (just ahead of earnings). That said, it was a nice 30% win and I wanted to wait for the Q4 FY 2020 earnings print and FY 2021 guidance.
As it turns out, Nautilus posted great Q4 FY 2020 results, but Q1 FY 2021 guidance was murky as revenue was ahead of consensus but there was no formal EPS guidance and commentary was guarded. Despite the guidance uncertainty, I dipped my toe back in the water, at $23.50, the night when NLS posted its Q4 FY 2020 earnings (in after-hours trading and I seized the best modestly at under 4%).
Lo and behold, at least in the short term, I caught a falling knife. On a trading idea side, throughout 2021, I have been super disciplined and methodically taken my 10% losses. I made an exception because I had done a bunch of work on Nautilus and concluded its fundamental results were great. Had I taken my medicine and 10% loss, I would have been stopped out at $21.20. As of yesterday, NLS shares closed at $18.41. See how quickly a 10% loss can spiral into a 22% loss (and NLS traded down to $17, last Friday).
Let me give you one more recent example where I didn't follow my 10% trading stop loss and how quickly you can get yourself into trouble. Most of the names in my portfolio are small caps, value-oriented, under the radar, and have clear catalysts. However, with 10% to 20% of the portfolio, I like to traverse new terrain and learn about new companies. Despite the high valuation and controversy, this too is a battleground stock.
The stock I am referring to is fuboTV (FUBO). Last week, the company posted what I thought were good earnings and signed an agreement with Caesars to bring its sports betting concept closer to reality as they signed agreements giving them access in three states. FUBO's management said that this sports betting concept/ book could be live as soon as Q4 2021. I dipped my toe in the water, and picked up a 3% sized position at $38.81. And then added more shares in the low $30s.
Lo and behold, the second time I broke my rule and strayed from my 10% loss discipline, I got my head handed to me.
Yuck! See how quickly, a 10% loss can turn into a 24% loss and why doubling down is a bad idea.
Here is a snapshot of my ugly unrealized FUBO loss, as of yesterday. Suddenly, what started out as a 3% sized bet turned into an 8% bet (measured by cost basis).
Look at how quickly and severely a high beta stock can move in the wrong direction, especially when the Nasdaq had a big 'risk off' week triggered by swiftly rising interest rates.
Source: Fidelity
Despite these two unforced errors, luckily, I have $64,000 in realized 2021 gains. And marked to market, my portfolio is up north of 30% year to date through March 8, 2021.
However, fuboTV and Nautilus are good reminders that doubling down is more often than not a bad idea. Also, if you have been an investor/ speculator long enough, keep it real and realize how quickly a 10% loss can spiral into a 20%, 30% or even 50% loss. You want your capital to be productively deployed in stocks that are appreciating (or that is the idea anyways).
Putting It All Together
Instead of sharing an in-depth write-up about an obscure small-cap stock that I think can double, I decided it was long overdue for me to write a portfolio strategy piece. As I noted, I have religiously been at this game for twenty years, as an investor and speculator, and I want to share some of the important lessons I acquired along the way. For your sake, it is better to learn vicariously from the mistakes of others, including my own, as opposed to paying the steep tuition at the School of Hard Knocks.
I would argue that sizing, risk management, and taking 10% stop losses are critical items in your investing/ speculating toolkit. Good luck out there to all the intrepid travelers.
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