Building a Position and Risk Management

Good Afternoon,

I wanted to let you know that I added to an existing position in the taxable account today (more details about this at the end of this email). I also wanted to share some quick thoughts I had about Building a Position and Risk Management.

Building a Position and Risk Management

I invest in companies that meet my entry criteria.

Before I invest in a company, I decide how much money I am going to risk on that position. I also decide on the factors that would cause me to sell as well.

Other decisions involve monitoring the situation while I build the position. I tend to build my positions slowly, and over time.

Generally speaking, in order for me to invest in a company, it has to have a good valuation and good fundamentals. I would only try to invest in a company that I believe is a good quality one, that also sells at a good valuation.

When I build a position, I usually end up spreading this over a period of time. In some cases, this allows me to monitor how the company is doing relative to my original thesis. This allows me to limit capital allocated to a company that turns out to be a dud quickly.

For example, let’s assume that the target position size is $1,000 per company in a hypothetical portfolio. This is the most I would allocate to said stock.

If I were to build this position, that would mean putting something like $100 or so at a time, over a period of many months.

This exercise provides a few fundamental touch points to evaluate my thesis. Possibly a few quarterly reports, and a couple or so annual reports. Even more importantly one or two annual dividend increase announcements.

If I bought a security, and I saw that management all of a sudden stops raising the dividends at a typical rate of change, I would have red lights going in my head. I would investigate further. A slowdown in dividend growth is definitely a signal that something is going on in the business. This is possibly a good signal to pause new investments.

Losses of major customers, increased competition and stagnation in revenues and profits could also make me question my initial beliefs in the company, and pause investments.

I would continue monitoring the situation, and would consider investing again if fundamentals improve. Every company goes through a temporary lull in performance for various reasons. Only the solid ones tend to recover from those lulls (eventually). If they don’t, then chances are that the previously impregnable moat is pierced, or the industry is now facing some new headwinds. Think newspapers in the old days when the internet came, or sadly my beloved consumer staples as of recently.

If fundamentals go as planned however, I would be interested and build that position until I reach the maximum I could risk per security.

This fundamental exercise is of course going to be only performed if the valuation was attractive as well. However, value and growth are connected at the hip - meaning that valuation is part art, part science. It’s not as simple as stating that a stock with a P/E of 10 is cheap - you have to take into consideration the growth in fundamentals, and how cyclical that earnings stream is as well as the likelihood of a long runway as well. You need to look at the trends at a company level, to ensure you are not overpaying for slowing growth or overpaying for past success as well. Furthermore, you have an opportunity cost to pay, because there may be other securities that fight for your capital attention. You need to rank them, and decide (and that ranking could be further complicated by whether you already have a full position in said security or a partial or none at all).

The upside of course in building out a position slowly is that I stand a chance of allocating as little as possible in a security that surprises to the downside. Hence, protecting valuable capital that could’ve been deployed elsewhere.

The downside of building a position slowly is that many high class world quality companies tend to sell at a cheap valuation very rarely. Hence, buying slowly means that I could end up being too much underallocated to them. Knowing this information to me means that when I invest money every month, I should prioritize the “cheap” securities that are rarely in the attractively valued pile first, and only then should I focus on the companies that are more often attractive. Ironically, the companies that always look attractively valued are quite often the ones that turn out to be value traps.

Today, I presented my framework for building positions for my portfolio. This is the framework I had been using for the past couple of decades or so. You can watch it in action in my newsletter.

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