I have been lucky to guest lecture at the University of Sydney over the last 12 months, and it has made me realise there are few “practitioner guides” for students or less experienced investors. I hope to shine a light on how we think about some of the more esoteric aspects of the investment process. This is not only for the students and newer investors but also for those who are interested in what happens behind our four walls at TDM Growth Partners.
At TDM we operate a business which partners with management teams for the long term. We invest capital on behalf of a small number of clients as if it were our own. For us, this means having high levels of alignment between ourselves and our clients. When we invest our clients’ money, we are also investing ours and our family’s money in the same companies and in the same proportion. Our “true north” of ensuring we are 100% aligned with our clients is a key building block of everything we do, including portfolio construction as I explore below.
Often we get asked, “so, what stocks do you like at the moment?”. This is usually an easy question to answer. We spend our working hours looking for new opportunities and new businesses in which to invest. However, the question we never get asked is “well, how much do you like it?”. This question gets to the heart of what we spend a lot of our time thinking about: portfolio construction.
Often we get asked, “so, what stocks do you like at the moment?”. This is usually an easy question to answer. We spend our working hours looking for new opportunities and new businesses in which to invest. However, the question we never get asked is “well, how much do you like it?”. This question gets to the heart of what we spend a lot of our time thinking about: portfolio construction.
We invest in public and private businesses but unlike private equity or venture capital, we do not operate a fixed-life, fund structure. Some investment firms take capital from institutional clients and once they are “fully deployed” go and raise more capital to invest into new opportunities. This makes sense for institutional investors. Unfortunately, my own capital doesn’t work like that. Once I’ve invested it all, I’ve got to trust I’ve made the right decisions. If new and better opportunities come along that I want to invest in, I must sell some of my existing holdings.
That’s what we mean by managing money as if it were our own: being diligent and thoughtful about our capital allocation decisions within our portfolio because once we’ve deployed it, we won’t go and ask for more.
The purpose of the post is to describe how we approach portfolio construction. We have found few explanations online about how investors make these decisions. This post will cover how I think about this decision-making process and how we determine whether one Company deserves 1% of our portfolio or 25%.
Firstly, a disclaimer: I do not believe there is only one “right” answer to portfolio construction. You will get the answer to whether you’ve made the right decisions in 25 years’ time when you can look back on your investing track record and see whether you “beat” the market. Given this caveat, this is my perspective working in an investment company which emphasizes being a “business owner” in a small number of companies and believes in partnering with management teams to help them build outstanding businesses over the long term.
This discussion will consist of two posts. The first post looks at constructing a portfolio based on each investment opportunity, or a “bottom-up” approach. The second post will address overlaying “market” considerations and the importance of the cash balance.
The principle vantage point we take when making these decisions starts with our unit of analysis: the company we are looking to invest in. In particular, does the investment opportunity provide sufficient “risk adjusted returns” to warrant being one of the very few companies (typically 10–12) we hold in our portfolio at any one time? To put another way, are we investing our capital with a sufficient margin of safety (loosely defined as the likelihood of capital preservation)?
A simplified explanation of how we determine “risk adjusted return” is as follows:
1) Undertake a significant amount of research on the company’s competitive position, future growth prospects and quality of the management team.
2) Estimate the likely 3 to 5 investment outcomes for this business which could play out over the next 5 years.
3) Based on an assessment of the various risks which the company is exposed to, including its business model or the market structure in which it operates, estimate the likelihood that each of these scenarios plays out.
The aggregate of these returns and the probability of each of these scenarios playing out is what I refer to as our “risk adjusted return”. If our risk adjusted return compensates us for the risks we are taking and meets our investment return hurdle, then it likely warrants a position in the portfolio.
A comment on the investment scenarios mentioned in point 2 above. A heightened focus should be given to the “downside case”. This will determine your view on your margin of safety. As Warren Buffet famously quipped, “Rule №1 in investing: Never lose money. Rule №2: Never forget rule №1”. The slimmer the chance of losing money in an investment, the more money you should be willing to allocate to it.
The next step is to determine how much of the portfolio is allocated to each investment.
One way that investors could do this would be to equally weight your exposure to those businesses. The argument would go: “they all meet our minimum return requirement, and we’ve done a sufficient amount of work to invest in them. What’s key is what is in your portfolio, rather than how much of it.” However, for us, that logic breaks down given different investments have different risk adjusted returns. One investment opportunity may have a preposterously low chance of losing money and a decent chance to make many multiples of your initial investment. Compared this to another opportunity which has a small but decent chance of losing 5–10% of your capital and lower, but still attractive upside potential. I’d much prefer to own more of the former than the latter, despite both of them having an attractive risk adjusted return.
On this basis, we try to remove some level of false precision around position sizing and instead use a simple nomenclature to decide position size: small, medium, large, XL or XXL. This typically equates to position sizes from 3% (small) to around 15% (XXL) with the rest stepping up by three percentage points. That is not to say at any one point in time we have positions which run the gambit from small to XXL, rather each investment on its absolute merits determines the appropriate position size.
Why is a small position 3% rather than say 2% or 5%? That is a fair question and I don’t have a quantitative answer to it. My best response would be, we only own 12 businesses or so, there needs to be a minimum amount of capital deployed to make the time dedicated to each business worthwhile.
The table below gives a crude and overly simplified rule of thumb regarding how each position size gets determined:
The final row in the table, “Current valuation relative to fair value” provides a blunt assessment of one aspect of margin of safety. This crude measure represents the idea that the fewer pennies we are buying dollars for, the more capital we will be willing to deploy into that opportunity.
Once we go through the process of determining the suggested position size of each company in the portfolio, we have a “bottom-up” constructed portfolio.
To be clear, position sizes evolve and change. When share prices move, so do prospective returns. Changes in prospective returns impact our margin of safety and our risk adjusted return, which impacts how much of our capital we may be willing to allocate to that investment.
In the next post, I will cover off how we think about it when our portfolio allocation doesn’t equal 100% and we’re left with cash still to deploy. This is a perfectly acceptable outcome, and typically the norm for us. I will also discuss how we think about positioning the portfolio based on “market considerations”, which is especially relevant in the current Covid-19 related investing environment.
Article published by Julian Reddick, TDM Growth Partners Investment Team Member.
