As any investor knows, finding stocks you want to buy is just the first step in building a robust investment portfolio. Determining the size of each position is the next critical step. Today’s blog is the final part in our series explaining how we size the positions in our managed funds. In the previous blogs we examined the factors and tools necessary to determine an appropriate position size for each individual stock idea. However, until now we have been working in a portfolio construction vacuum of sorts, treating each stock in isolation from the others. This final blog considers the broader context of the portfolio, including interactions between stocks and overall portfolio risk management practices.
To begin the discussion, it is important to recognize that we adhere to certain structural risk management limits in both the Montgomery Global and Montaka funds. These limits can be hard – that is they are mandated limits that we will never breach – or soft – limits which we typically will not exceed, but allow for flexibility in certain circumstances.
At an individual stock level, long positions have a hard limit of 10% of the value of the net assets of the fund, and short positions have a hard limit of 5% of net assets. These limits are self-imposed and were designed to allow us to express strong conviction in an investment idea, while at the same time acknowledging that things can and do play out differently to the way we might expect. Think of it as an act of humility in a business where over-confidence has a way of being harshly punished by the markets and preservation of capital is our first priority. These limits represent the maximum possible conviction level that will be used when developing the position size roadmap we talked about in the second part of the series. Immediately this means a long stock position will always be trimmed to the extent it appreciates above the 10% threshold, and similarly for a short that rises above its 5% threshold. *
Beyond the individual stock limits, we seek to “selectively diversify” the portfolio by industry and geography. In other words, we are not interested in diversifying the portfolio for the sake of it, or trying to match the industry and geography weightings of the broader equity market or any other party. Rather we want to choose the best risk/reward opportunities for our clients even if they happen to be stacked in a certain segment. Again as an act of humility and to protect against the unexpected occurring in any one sector, we have introduced a soft industry exposure limit.
Typically, the sum of the long positions in any one sector of the economy will be less than 30%, and the same holds for the short positions. A corollary to this statement is that once we have reached the soft limit in a sector, any new attractive investment opportunities in the same sector will typically have to take the place of existing positions. It also means that we would be more interested in allocating our time and efforts as a research team to other sectors where we are more readily able to add exposure when we find good opportunities rather than substitute them.
As an example, the information technology sector in aggregate accounts for around 35% of long exposure in the Montaka fund today. This includes our position in Apple, itself around 6% and a few other IT stocks around the world. Hypothetically if we were deliberating between researching Cisco Systems, a large enterprise networking company, or Estee Lauder, a cosmetics company, as our next long investment, we would probably be more keen on the latter. Now imagine if we decided early on that Cisco may actually be a much better prospect than Estee Lauder. We then ran our research process to ground on Cisco, discovered it was undervalued and used our roadmap to determine that a 5% positon would be appropriate. It is highly likely that we would fund this new holding by selling down one or more existing holdings in the IT sector so that we are not adding to the exposure beyond the soft limit.
Naturally, our astute clients will be asking at this point, how can IT be 35% of the Montaka fund’s long exposure when the soft limit is 30%? This is a great question and highlights the flexibility of the portfolio construction process and our focus on identifying underlying risk factors and return drivers. One part of the answer is that given the number and quality of opportunities we have found in this particular space we have judged it appropriate to go beyond the soft limit at this time. Another part of the answer is more nuanced and worth exploring further.
Sector definitions are broad and often not an actual reflection of the risks we have assumed or the earnings drivers of the business. Take the information technology segment again. Montaka’s holding in Apple contributes about six percentage points to the fund’s long exposure to the IT sector. Apple is certainly a technology business. It develops and sells smartphones with proprietary software. But it certainly isn’t the same style of business as other constituents of the IT sector classification. For instance, the aforementioned Cisco also appears under the IT banner. There are not many, if any common risks or return drivers between Apple and Cisco yet they appear in the same sector classification. It would be remiss to exclude Cisco from the Montaka portfolio just because we already hold a positon in Apple and the long IT exposure is prima-facie above the 30% soft limit. **
To punctuate the point, consider Apple from another perspective. Apple sells its devices to well-off consumers who pay a little extra for the sleek design and smooth experience. From this perspective, we could easily argue that Apple should be in the “consumer discretionary” sector. In fact, Apple’s risks probably align more closely with the discretionary retailers than they do with enterprise network businesses that sell routers and switches.
We have developed a more sophisticated method of analysing the concentration of risks in the funds we manage. We define specific risk factors at both the micro and macroeconomic levels. These factors might include “Chinese policy accommodation” or “platform company” or “sensitivity to US interest rate rises” or “European full-service airlines” or “US off-price retail growth,” and we monitor our aggregate exposure and potential for loss to each of these factors. In this way, we can easily become comfortable with our sector exposures exceeding the soft limit as long as we are not compounding any particular specific risk factor to an unacceptable level.
Conversely, when we identify attractive stocks that have meaningful overlap of specific risks and return drivers, we often group these issues together and view the stocks as a consolidated position. This helps to avoid unexpectedly “doubling up” on the same risk. As an example, we identified TJX and Ross Stores as excellent investment opportunities around the launch of the global funds last year. While the individual position sizing roadmap suggested we take positions of say 6% or more in both stocks, our actual ownership of these stocks has been much lower. TJX and Ross operate the number one and number two off-price retail chains in the United States. While there are differences between the companies, there is significant overlap given the exposure to the US consumer, tailwind from growth in off-price shopping in the US, and the ability for both businesses to take share of US consumer spend by growing sales at existing stores as well as adding new stores. This was enough for us to consider the two stocks as effectively one positon and limit our combined exposure to not much more than 8%. ***
The roadmap we developed in this series combining valuation outcomes with conviction levels has helped establish an appropriate position size for a stock in isolation. However, this process must be complemented by a nuanced understanding and aggregation of the specific risks underlying the holdings to further augment position sizes and achieve an optimum risk/reward balance across the entire portfolio.
*It is also important to note that at a portfolio level the Montaka fund has a hard limit on gross exposure (the sum of the long positions and the short positions) of 250%. On an aggregate basis if the size of the portfolio began to exceed this limit we would take immediate action to reduce the size of some or all of the holdings.
**Cisco has been used as an example only. Montaka does not hold a position (long or short) in Cisco.
***The position sizes of each of TJX and Ross have changed from time to time as the value proposition and share prices have changed, per the roadmap discussed in part two of the series.