As managers of Montaka, finding great individual investment ideas is only part of the battle. Once we have identified a stock with attractive future returns for the risks being assumed we must then determine an appropriate position size. We believe there are three key variables which should guide this decision. Today’s blog is the first in a three-part series that will address each variable in turn.
The first input into the sizing algorithm is a judgement on the value of the business, to determine what the stock is worth compared to the price at which it is trading in the market. Many financial commentators, brokers, and even investment managers, will often quote target prices or point estimates for the value of a stock. This is insufficient. Rather, we believe investors should view the worth of a business (and its shares) as a range of values, each with a certain likelihood, and size portfolio positions according to where the current stock price falls along this spectrum.
By way of simple example, we may believe that REA Group – owner of the realestate.com.au property portal – is a fantastic business. Although its shares are trading at around $56 today we might think that it is most likely worth over $70 per share, or 25% more than the current share price, should our expectations for earnings growth eventuate. Of course the future is always uncertain and unpredictable, and valuation is an imprecise science*, so REA’s shares may actually be worth more or less than our $70 estimate.
There’s a chance things turn out worse than we expect, in which case the stock might be worth say $40, 29% below the current share price. And if the future is brighter than we expect REA shares could be worth up to $100, 79% above the current share price. On balance REA’s shares look like a good bargain today and we might allocate 5%** of the portfolio to a position in REA, or half of the mandated maximum position size of 10%.
Even more interesting are the actions we would take if the price of REA shares changed. Perhaps counterintuitively (though not surprisingly to our astute clients) if REA’s stock price fell, all else equal we would look to increase our position size, and conversely if REA’s stock price appreciated we would look to decrease our position size. Let me illustrate by way of example again.
If the REA share price fell to say $45, our base case valuation would remain unchanged at $70, but this now represents about 56% upside. Similarly, the upside value of $100 per share remains unchanged, but now represents more than a “double”. Clearly we stand to gain a lot more at $45 than at $56. Our upside potential is higher. But this only tells half the story. At the lower share price the downside to our low case valuation of $40 is just 11%. Our downside risk is now lower too. Greater upside and lower downside means a better bargain and justifies a bigger position. We may increase the portfolio weighting of REA to say 8%. Further, as the share price was sliding toward our low case value of $40 we would be increasing our positon size towards a maximum allocation (capped by the 10% mandate of course). In fact in this example a $40 share price would imply no downside in REA stock at all – the best kind of investment!***
Conversely, if the REA share price appreciated to say $80 the upside available to investors would be lower and the downside risk would be higher, so a smaller position would be appropriate (I will leave it to the reader to calculate the upside and downside potential at this higher share price). We may decrease our REA holding to say 2% of the value of the total portfolio value. Moreover, if the share price was climbing above our base case value of $70 towards our high case value of $100 we would be reducing our position size towards zero. At $100 (and most likely well before) we would have exited the position in REA completely.
We view our assessment of the distribution, or range, of a stock’s value as the first critical determinant of position sizing. In part 2 of the series next week we will look at how the level of conviction or confidence in our investment ideas helps with position sizing.
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*To illustrate this concept, think of your very own car. How much is it worth? You might choose to search carsales.com to ascertain a reasonable valuation. I did this for a 2014 Toyota Corolla. There were 477 such cars ranging in price from $11,990 to $26,500. If it is this difficult to pin down the exact value of a standard car with plenty of units available for sale, then imagine the difficulty in being precise about the value of a multi billion dollar corporation.
**More on how we might arrive at the 5% figure in part 2 of this series.
***Of course in the short term the stock price may trade below $40, but the fundamental value of the business would still be $40 at a minimum.
Montaka owns shares in REA Group.
Christopher Demasi is a Portfolio Manager with Montgomery Global Investment Management. To learn more about Montaka, please call +612 7202 0100.
