3 Keys to Portfolio Management

The Motley Fool will soon unveil Motley Fool Alpha, a new investment service that seeks to bridge the gap between traditional stock newsletters and the real world of hedge fund investing. John Del Vecchio and I will be heading up this venture, drawing upon our years of market-beating experience in the hedge-fund world. Motley Fool Alpha will opportunistically invest both long and short, with the goal of compounding our capital at 15%-plus over time, while defending against significant drawdowns.

This is the final installment of our four-part series on Motley Fool Alpha investing. In part one, we introduced the Motley Fool Alpha investing philosophy. Part two explained how we optimize risk versus reward with an "active value" strategy. In part three, we looked at the essentials of security analysis -- valuation and risk. And here in part four, we turn to the topic of portfolio management, where we have three guiding principles.

Maintain portfolio boundaries
For our Motley Fool Alpha portfolio, we've established limits for how big we'll go on individual positions, sector exposure, and overall long/short exposure. These rules for our portfolio function like guardrails and speed limits on the highway – both are designed to keep us on a safe path and to prevent us from falling prey to overconfidence. However, unlike the posted speed limits which we have the habit of occasionally ignoring, we will be vigilant in maintaining our portfolio boundaries at all times. Here are the limits we've settled upon:

  • Maximum individual long position of 12.5%, and short position of 6% -- measured at cost.
  • Maximum sector long exposure of 25%, and sector short exposure of 12% -- measured at cost.
  • Maximum overall long exposure of 125%, and overall short exposure of 60% -- measured at market.

What led us to these specific parameters? Quite simply, it was a combination of common-sense diversification and years of experience running money. These limits allow us to get a big payoff if we're right, but won't kill us if we're wrong.

Some may wonder why the first two rules are measured at cost, while the third is calculated at market. The rationale for measuring our individual and sector exposure at cost is to put a definitive limit on how much of our initial capital can be put at risk. If we make a long position the max of 12.5% at cost, it's clear that we cannot add further to that position; whereas if our position limit were based on the size at market, every decline in the stock could justify further adds. In contrast, when it comes to our overall portfolio long/short exposure, we want to stay within market-based limits, because our market-level exposure reflects our active level of risk each market day.

Be rationally opportunistic
We're all familiar with Buffett's famous quip to "be greedy when others are fearful, and be very fearful when others are greedy." It's one of my favorite Buffett-isms. But sometimes this quote is misunderstood as an endorsement of mere contrarianism – i.e., taking the opposite view of the market in knee-jerk fashion – when in fact Buffett's message is to be contrarian when it's rational to be so. Or to rephrase Buffett, we might say: Be rationally greedy when others are irrationally fearful, and be rationally very fearful when others are irrationally greedy.

Markets swing from fear to greed and back again, and this cycle creates a constantly changing mix of risks and opportunities. A large part of being a successful investor is not getting swept away by the market's moods, but instead always striving to be rational. Abingdon Capital's Bryan Jacoboski said it best:

The very reason price and value diverge in predictable and exploitable ways is because people are emotional beings. That's why the distinguishing attribute among successful investors is temperament rather than brainpower, experience or classroom training. They have the ability to be rational when others are not.

This is precisely our aim in Motley Fool Alpha – to be wholly rational in how we size up the market's opportunities and risks, and then be bold in standing against the crowd when the crowd's thinking is faulty. (Or absent!)

Embrace intelligent speculation
The term "speculation" tends to be closely associated with gambling, and therefore is often considered a distinct no-no for those committed to a disciplined investment strategy. If you've read the first three parts of this series, you know the Motley Fool Alpha approach is all about being rational and avoiding unnecessary risks. Thus, you're probably wondering why we would ever go out on a limb like that.

First, let's clarify what we mean by "speculation." For our purposes, a security is a speculation if we haven't done our full due diligence, whereby we reach an informed view of the potential downside versus the upside. That kind of work typically takes at least a few days, and sometimes longer. There are occasions, however, when the first few hours of work on a name reveals a compelling opportunity – perhaps not fully defined, but enough to see much more potential reward than risk. It then becomes a judgment call: Do we patiently push forward in finishing the research, or take a position right away? If the market is moving fast, or if there's a company-specific catalyst looming in the near future, we may decide to take an immediate position.

Many have marveled that Buffett has said he's able to reach an investment decision within five minutes of being presented an opportunity. In 2009, Buffett elaborated on this ability: "Well, it is basically 50 years of preparation and five minutes of investment decision." It's a pretty straightforward concept -- the longer you invest, and the more opportunities you analyze, the quicker your ability to reach correct decisions. John and I have each been at this business for more than 10 years, so our pattern-recognition skills are pretty well honed; they're by no means to Buffett's level, but they're sharp enough to justify making some of our decisions on more limited research.

Now clearly, the drawback to operating on less extensive research is that we run a much greater risk of missing important facts. There are a couple of ways we can compensate for this added risk. First and most obviously, we can keep any speculative position to a smaller size -- probably not more than 3% of the portfolio. The second method would be to utilize a stop-loss whereby we would automatically liquidate the position if it crosses a certain price or if the idea hasn't worked out after a certain period of time. (Stop-losses have many weaknesses, so don't expect us to fall back on that method very often – but we do consider it a tool appropriate for certain circumstances.)

In sum, the market sometimes presents fleeting opportunities that don't allow for comprehensive research, but where basic analysis reveals a trade worth making. By sizing our speculative positions with appropriate conservatism, we transform these into intelligent speculations.

Parting thoughts
I hope this series on Motley Fool Alpha investing has stimulated your own thinking on how to build the foundation for a successful investment approach. And we hope you'll consider joining us when Motley Fool Alpha launches. As a summary of what to expect, Motley Fool Alpha will help you:

  • Benefit from our "conservatively aggressive" style of long investing, where we seek to play defense first while also shooting for 20% annualized returns.
  • Protect against market downside, by shorting vulnerable stocks that face some combination of low earnings quality, declining business momentum, and excessive valuation, with a goal of 2,000 basis points of outperformance (alpha) on each short position.
  • Sleep well at night with a well-diversified portfolio, where we pay close attention to correctly sizing each position relative to its risk versus reward.

If you would like to learn more about Motley Fool Alpha as soon as details are available, click here.

Matthew Richey is excited to be back at The Motley Fool, teaming up with John Del Vecchio on Motley Fool Alpha. True to its name, The Fool is made up of a motley assortment of writers and analysts, each with a unique perspective; sometimes we agree, sometimes we disagree, but we all believe in the power of learning from each other through our Foolish community. The Fool has a disclosure policy.


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