Managing downside risk in a downturn!

As value investors, a lot of us are starting to find the environment to be idea rich after a long time. Finally, the valuations are compelling, the companies we have researched are cheap, the war chest is ready to crack open, ready to be used. During such times, there are new risks that needs to be actively managed. While I watched the 2009 recession hunting for a job in the U.S, I did not live through the panic in the securities market during the recession of 2008/9. This is my first real test. There have been drawdowns in the past which have been sharp and never so deep.

One of the risks is through concentrated positions. A ton of wealth has been made through concentrated positions. 2-3 years from now, when the markets are back up (hopefully) there will be stories about investors who bought by the truckloads during the downturn and made a killing on some of the ideas. What won’t get said, are the ton of the people who got crushed during the downturn by investing in concentrated positions (2/3/4 positions) and the companies going to zero. Survivorship bias will exist in this regard. People recall Mike Burry a lot more than Bill Miller. It is highly preferable to give up some upside in order to reduce the chances of going back to Go on the board.

Here is where capital allocation and portfolio management go hand in hand. As much as tempting it is to back the truck into a certain securities and concentrate, a dose of diversification will prevent complete blow ups from happening. There are multiple ways this can be achieved. Buying a basket of stocks in a similar category, allocating a certain % to index funds, looking at preferred stocks, closed end funds, special situations etc. can provide other opportunities even in the securities space. Of course, this conversation here is limited to the securities space where we are finding bargains at this point. Other asset classes are not considered here.

Some of the steps that I am taking while managing through this downturn :

  1. Kept aside cash required to manage next 2-3 years + emergency cash even I were to lose my job.
  2. Had a clear plan written down on how portfolio management would happen in a 30-40% down market when I was clear and lucid.
  3. Diversifying more than usual while adding new bargains
  4. Baskets of stock in a similar story. Everything might not go to zero (unless my stock picking skills are similar to the CDO’s constructed by US banks a decade ago)
  5. Index funds / quasi index like Berkshire get a certain allocated % of the capital allotted
  6. The rules make is tougher and tougher to double down into the same ideas

I am very interested to see how this will pan out. While the ride has been painful, I am far from panicking yet. Just a pit in the stomach once in a while so far.

Current Portfolio of Allan Mecham (Dataroma)

The current portfolio of Allan Mecham as of 31st March, 2015 (From DataRoma)

Stock
% of portfolio Shares Recent activity
hist BAC – Bank of America Corp. 14.35 6,453,725 Add 9.00% $15.39
hist CMPR – Cimpress N.V. 14.02 1,150,329 Add 5.39% $84.38
hist DNOW – NOW Inc. 12.70 4,061,596 Add 123.99% $21.64
hist SNE – Sony Corp. 11.64 3,009,375 Add 2.68% $26.78
hist OUTR – Outerwall Inc. 9.88 1,034,260 Add 5.68% $66.12
hist LUK – Leucadia National Corp. 8.39 2,604,158 Add 8.44% $22.29
hist IBKR – Interactive Brokers Group Inc. 8.30 1,688,495 Add 32.42% $34.02
hist Y – Alleghany Corp. 6.40 91,001 Add 8.83% $486.99
hist MSM – MSC Industrial Direct 4.83 462,853 Buy $72.20
hist CHEF – The Chefs’ Warehouse 4.13 1,274,374 Reduce 6.17% $22.43
hist BRK.B – Berkshire Hathaway CL B 3.43 164,318 Add 13.50% $144.32
hist BRK.A – Berkshire Hathaway CL A 1.35 43 Reduce 2.27% $217511.63
hist CPRT – Copart Inc. 0.51 93,357 Add 9.52% $37.57
hist HEI – HEICO Corp. 0.05 6,611 Buy $49.61
hist DSWL – Deswell Industries 0.03 100,981 $1.84

Talking one’s book

There are two schools of thought among value investors who choose to talk or not to talk about the current portfolio that they hold.

Theory A: Don’t talk about the book

  • Talking about the investments in the portfolio forms a stronger bias in the investor’s mind. Also reversing the position becomes tougher as it contradicts the public position taken on the stock.
  • Public starts forming opinions on the investors based on the performance of the stock that the investor is talking about. It is similar to hedge fund managers facing pressure from the public on short term performance.
  • Ideas are considered as proprietary material. No good reason to share them with the public. It is the product of the firm and it must protect it.
  • When you recommend a stock and change your position, you might not have the time to clarify on the changed thinking and might be selling while others might be buying based on your earlier position. But few investors have the ability to sway the market’s opinion based on their stock ideas

Theory B: Talk about the book

  • It actually makes you a better investor as it crowd sources  opinion into your thought process and you are not under any obligation to be influenced by the thought process of others. Might also bring into consideration perspectives not considered by you in the original thought process.
  • If you are in a position to influence the general market’s opinion based on your thought, it becomes a self fulfilling prophecy. I am not saying going ra-ra and marketing the stock; I am talking about showing the market the catalyst for undervaluation and add to the market’s knowledge on why they need to change their opinion collectively on the stock (Easier said than done)
  • Biggest advantage in my opinion is, if you are confident about your thesis and you are a value investor who can stand out in the crowd, one must not be afraid to talk about one’s book with the right disclaimers. All perspectives can be filtered appropriately and can only enhance one as an investor.

There are investors who believe in both sides of the theories but the important thing is to be consistent about it. In between the two, there are a swathe of investors who talk about stocks at their convenience. I have seen investors who talk about only the stocks that might have gone up multi-fold in their portfolio with hardly any mention about the ones that have not. The public then bids up the securities even more making them even more successful. There are a couple of managers that I track who have disclosed ideas that have only gone up over the years and make it sound that they have never have lost money which is highly questionable as well.