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May 02, 2008
Strategy for VMSF
Implementing a successful investment strategy requires more than just good stock picking. I personally divide my money-management process into three core parts:
- Portfolio management.
- Stock selection.
- Trade execution and risk management.
Here is what the long side of my "guideline" portfolio should look like in Strategy Lab:
To sum it up -- my portfolio will generally consist of 16 or 17 long positions, with only one position larger than 10%. All losers -- with an exception of the contrarian bet -- will be eliminated mercilessly once they suffer a 7%-10% loss (depending on stock's volatility), even if that means higher turnover.
Minding the shorts
On the short side, my maximum initial position is 40% of my long side holdings. Smaller average positions of roughly 2% each should be expected. There will be no sector-concentration limit, but losing positions will be mercilessly cut with maximum 10% loss. Picks will be based on the company’s financial numbers using a model that emphasizes high leverage, negative cash flows and high short interest. I will add to the winning positions at the expense of losing but not to exceed the double of the initial position.
My fund should be expected to invest (both long and short) in domestic equities, foreign equities and US-traded ETFs. Tax considerations, while important for individual investors, will not significantly influence my process here. I am running my portfolio with the goal of delivering above-average positive returns, so short-term capital gains are to be expected.
To sum up the principles of my portfolio strategy: 1.4-to-1 expected total leverage, 16 to 17 long positions, 15 to 20 short positions, no single stock with more than 25% of the portfolio, losses cut at 7%-10% depending on individual volatility of the stocks. Significant short-term capital gains and higher-than-average turnover are to be expected.
Stocks I understand
I will only buy stocks with a business model that I can understand, but my approach is somewhat different from what Warren Buffett teaches and believes in.
I don't necessarily have to understand in great detail the underlying product, service or technology that a company provides -- knowing the concept is enough for me. But understanding the fundamentals of how the company makes money is a must.
While customers are the ultimate judges of how good the products/services are, we as owners -- yes, investing means owning a piece of the company -- should be concerned with how the company makes money out of a product or service. Does the company have a recurring revenue stream versus one-time sales? Does it have long-term contracts with customers? Is it responsible for any warranties or liabilities after the sale?
Because of the business-model differences, fundamental investing based purely on ratios like price-to-earnings or price-to-sales seems to me to be absolutely silly. What's more, I think ratios like price-to-sales are almost worthless and can mislead the average investor. Screening for stocks with the lowest sales ratio will probably surface a bunch of stocks that either are retailers or simply have an extremely low profit margin. To a certain degree, the same thing could be said about the absolutely overused and overrated P/E ratio. This ratio is almost worthless without the other fundamental part -- the expected future growth of earnings.
Out of all the fundamental ratios out there, I pay the most attention to the one called PEG – price-to-earnings growth.
It is an estimate of the relative worth of today's earnings based on their expected growth in the future. It is readily available on the Web, and some investors use this simple rule of thumb: Buy any stock with a PEG of less than 1. I don't think it's quite that simple, but if you are going to use any ratios out there, PEG is more valuable than most.
Its most significant drawback is that the "growth" part is based on the average of analysts' expectations, and thus if the stock is not widely covered, it might become difficult to estimate. I usually use my own back-of-the-envelope calculation to do a sanity check to make sure that these analysts are not blowing smoke before I pull the trigger.
So, to sum it up: I like buying stocks that offer growth at a reasonable price and I do not tolerate losing positions for too long.
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