Confidence and Concentration Risk

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In a recent article, "Shortcomings in My Investment Process" ( here ), I mentioned something that's inherent / ingrained in my way of thinking that I believe magnifies concentration risk:

From there, I discussed how I've attempted to mitigate this risk over time - primarily by keeping the time frame of the investment in mind and also recognizing what type of business / situation I was dealing with. While those factors are very important, I thought it would be worth writing a short article that addressed the underlying issue in a bit more detail; it may not be the most insightful conclusion, but it's something I wish I would've thought about more deeply years ago.

As I noted above, I've been quick to add more to my holdings when Mr. Market has disagreed with my research in the past. In a few instances, I essentially backed myself into a corner that could have easily been avoided (luckily, I've largely emerged unscathed).

Looking back, I can see that I felt the need to act this way for a simple reason: I viewed the decision to buy more as a test of my conviction - a test of whether or not I really was the value investor I claimed to be. If a stock declined shortly after my initial purchase, there was a high likelihood that nothing material had changed in the business; the gap between my estimate of intrinsic value and the stock price, by definition, must have widened. If I was unwilling to buy as the price-to-value gap widened, I was essentially admitting that (a) I was letting Mr. Market dictate my actions, and / or (b) that I really didn't have the confidence that I should have required to justify my initial purchase, let alone additional purchases. In other words, failure to act was an affront to everything I stood for. The "right" thing to do was to buy more.

With some experience under my belt I can see that was a bit foolhardy. While I can see the rationale for investing in a company like Yelp ( YELP ) if the price is right, I now recognize that position sizing and patience - in this case, the ability to sit comfortably with unrealized losses without reflexively adding more - must be top of mind at all times. Looking back, I think I erred in this area with Staples ( SPLS ) and JCPenney ( JCP ). Even if both investments had worked perfectly, that would not change the fact that I was too aggressive on short-term moves in the stock price when viewed in light of the investment thesis and the risk / reward tradeoff.

As Walmart ( WMT ) has fallen nearly 30% over the past year, I've felt the urge to buy more numerous times, and in size; if I had done so, my position would obviously be much larger than it is today. I'd be able to beat my chest and tell you - show you - that I'm as confident in my investment as I've ever been; from an emotional perspective, that would feel pretty good.

The problem is that seeking emotional satisfaction may be detrimental to investment results.

In the case of Walmart, there's no denying a material change has taken place since my initial investment: management has come out with guidance for a few years down the road that suggests net margins will be materially lower in the future than they have been in the past. While I'm still of the opinion that the company will ultimately outpace guidance by a wide margin (I'm talking two to three years from now), I don't see any reason to get out of hand betting on that outcome until I have a good reason to back up that conclusion (historical data alone isn't enough at this point, in my opinion). Beyond margins, my assumptions for sales growth are also under pressure; unless management can reaccelerate ecommerce, this will be a problem as well.

While I'm comfortable owning my current stake, it's probably safe to say that I'll be acting timidly for the time being - because if management's margin targets turn out to be the "new normal," it has material implications for the intrinsic value of the business.


A few years ago, I would've probably bought Walmart four or five times as it fell from the mid-$70s to the mid-$50s (assuming I had any money left to do so in the past month); the position, as a percentage of my portfolio, would probably be at least twice as large as it is currently.

The different position sizes are not correlated with research / conviction: I've done a lot of work on Walmart, and I'm still quite confident in the investment. With that said, I'm much happier with my current stake in Walmart than I would be if it was two or three times larger. This is the type of situation where I've accepted that I may miss short-term gains in order to retain the flexibility to act long term (hopefully at much more attractive prices if I end up doing so). With this type of investment, optionality may be worth the risk of missing short term upside.

In the past, I've been too quick to overlook the value of this optionality; in a few cases, I found myself "all in" with a hand that was far from a sure winner. Over time, I've started to recognize that this was a haphazard way to approach position sizing. That's not to say you shouldn't make big bets, or even go all in - just make sure you're comfortable playing out the hand before you do.

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This article first appeared on GuruFocus .

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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