Saturday, March 21, 2015

The science behind capital allocation & how to make sense of concentrated positions

“Diversification may preserve wealth, but concentration builds wealth.”
- Warren Buffet

Position sizing is the biggest determinant of overall portfolio return. At a 10000 foot level the following table summarizes the allocation concept:

Conviction Level
Discount to fair value
Position size
Low
Low
Zero
Low
High
Very small or zero
High
Low
Small
High
High
Large



In practice conviction level and discount to fair value are both grey areas as this is not an exact science. In order to estimate this, the ValuePickr (Donald Francis) team has a wonderful framework that I would like to tell you about. They break down the conviction level into 5 factors:

1.    Business Quality
2.    Management Quality
3.    Fundamentals
4.    Industry, position within industry & track record
5.    Growth prospects


My take on these factors is that I further split them up into sub factors and take an average score on each factor to come to a conviction level. I use the moat grading system, described in a previous article, as a tool to judge the business quality. I will be describing the remaining factors in the following articles. This is also a good time to point out that the conviction level that you have in a company is something a computer cannot do because there are many a soft factor to be judged. You might find that you are adjusting your conviction factor scores to reflect your biases - which is normal. But the idea is to slowly get to a point where your biases are minimized.

You might also notice that a low conviction level with high discount to fair value leads to a smaller bet than higher conviction with low discount to fair value. This is another place where the concept of buying a wonderful business at a fair price is better than a mediocre or fair business at a wonderful price.