Most value investors recommend holding a concentrated portfolio of stocks in which we have high convictions. Any number higher than 10 or 15 stocks is considered 'diworsification'. Once, Warren Buffett invested 50% of his net worth in GEICO stock. However, I want to avoid such concentrations. I currently hold 75 shares in my portfolio. This is a lot more than most private investors. Starting this blog is an excellent moment to explain why I diversify that widely. I will also detail how I size a stock position.
Reason #1 : I am not Warren Buffett
I have been investing for almost 20 years. My stock picks did reasonably well, but I also observed that my highest conviction buys did not yield the highest returns. I concluded that I shouldn't take my own convictions overly seriously. I am not as experienced as Warren Buffett or Charlie Munger, who make large, concentrated investments.
Reason #2 : I invest in emerging markets
When Asian value investing pioneer Dato' Seri Cheah Cheng Hye started Value Partners Group in 1993 in Hong Kong, he still believed in having a concentrated portfolio. He told everybody they would not find more than 40 companies in his fund. As the years went by, he realised that the Asian market differed from the US. There were a lot of company managers that did not do what they told you they were going to do. There were a lot of crooks. Cheah Cheng Hye told this anecdote at the Graham and Dodd Breakfast Keynote Speech, at Columbia University, New York City in October 2010. Around that time, I started investing in Asian stocks myself. I decided to heed the warning.
There is a lot of company-specific risk in Asia related to fraud and mismanagement. It seems that Cheah considers 40 companies already too concentrated. Therefore, I decided never to invest more than 1% of my portfolio in any company incorporated in an emerging economy country. In that case, even if a company turns out to be a complete fraud, despite my checking all the red flags before investing, I am bound to lose 1% at most.
My position sizing system
2% + 2% position for a company incorporated in a developed market
0.5% + 0.5% position for a company incorporated in an emerging market
Let me remind you that, as I wrote earlier, I don't trust my own conviction and excitement for a particular stock too much. That's why I made a strict system with fixed, equal allocations per share: 2% extendable to 4% for companies in developed markets and 0.5% extendable to 1% for emerging markets.
For example, a new buy of a UK-incorporated company share initially gets a 2% allocation within my portfolio. I hold this position for at least a few weeks to get a better feel for the company. If it is again the best possible buy after this probationary period and I have cash available, I double down to a 4% holding. It also happens that something feels amiss during the probationary period, or I actually discover some worrying detail. I noticed that I look more critically at a stock once I own it. So, if my conviction decreases, I just sell the 2% position off again and make a note to never repurchase it.
For emerging markets, such as China, Malaysia, Indonesia and Thailand, I use the same system but 0.5% plus potentially another 0.5% at a double-down occasion, leading to a maximum of 1%. An 0.5% position hardly impacts the total portfolio performance, so I prefer to double down on these positions at some point. This contrasts the 2% positions, which I usually double down on if they genuinely become a deep-value bargain.
With most stocks at 1% or 2% positions, I leave the portfolio alone. Remember, this is a Coffee Can portfolio for the long term. The fundamental principle is not to mess with it. I have a small list of valid reasons to sell a stock, for example, when management changes dramatically, or the things they do are hard to understand. In such cases, I always sell the entire position.
Just to resume. If you see a 3% position in my portfolio and its headquarters are in a developed country, then it was initially a 2% position that went up. It could also be a 4% position that went down. It is also possible that the currency of that stock went up or down against the USD. The positions in my portfolio overview are sorted on their value in USD. Also, events like dividends in specie and spin-offs over time diffuse my system away from the initial 0.5%, 1%, 2% and 4% positions. These movements are not really a problem because the goal of this system is to force discipline upon the purchase process and not on the holding phase.
Final note: You may argue that 'emerging economy' definition is unclear and debatable. Several organisations keep track of national economies, and their categorisations are summarised in the Wikipedia entry for emerging market. I follow these, in particular the IMF categorisation. Note further that many companies have their headquarters in a jurisdiction where they have none or few operations. For example, many Chinese companies have a registered office in Hong Kong, while their activities are mostly within China. In such cases, I usually assume the risks to be associated with the country where most of the company's operations occur.
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