Concentration, risks and portfolio sizing

First, a small portfolio update. Until Q2 the portfolio is -9 percent, and YTD it is -9,5 percent, both measured in SEK. Currency movements, a stronger SEK, have hurt the result a lot, but it's at least a stable result. I have sold Uni-Charm Indonesia, since I now consider them to be of too low quality (they aren't profitable enough, Q2 took a turn for the worse). I also decided that I only want to own independent companies. This was not a good investment at all, as you can guess, but I hope I have learned some lessons.

Increases have been made in Argent Industrial, Primeserv and RFM. The money comes primarily from Uni-Charm, but I have reduced my holding in AS a little bit, just for the sake of increasing in those three. They have P/E:s of 6-9, EV/EBITDA of 2,9 to 3,8 and the FCF-yields range between 15-18%. I have also increased my holding in Karooooo a little bit (reinvested dividends). Perhaps too many changes going on this year, but the theme of them is consistent, so lets move on to the subject of today: concentration!

The reasons for concentration
This year, I have become much more focused. I have reduced my portfolio from 14 stocks to 10. There are reasons for that, hopefully good ones! One simple reason is that the really fat pitches, unique opportunities on a global scale, are rare. If you find one of these, you should go for it! Bold words, but when the upside is significant and the downside is low, and you think you understand the business well, you should size big! Time and opportunities are both limited.

The large holdings have significant long-term potential, of course. But, more importantly, there are no major risks. They have net cash or very low debt, business and competition risks are low, and the valuation risks are not high (very important). Hopefully, the worst-case scenario will not be that bad (although unknown risks always exist). To summarize my thinking: Exceptional opportunities are rare, and my high-conviction holdings are low-risk stocks. Taking "high risks" with low-risk stocks is OK!

Three buckets and limits
As I see things now, the number of stocks in my portfolio should be about 8–14, most probably 10-12. The actual number depend on what I find and if I chose to invest in more markets (thinking of Japan). In theory, a normal share is almost 10%, but in practice it's smaller, since I prefer to invest heavily in my high-conviction holdings.

I usually categorize my holdings into three buckets:

• Small: 4–5%
• Core: 7–8%
• High conviction: 12–20% (reduce at 25%)*.
  
  

The bar is set at 4%. If I'm not comfortable owning that percentage in a company, I shouldn't own it at all. I want to be able to keep track of what I own, not have too many stocks to follow and be as updated and sure as I can be about them. Is the thesis intact? Is there any new information? Is the weighting OK? I want to make fewer, better-informed decisions. As for the small or core holdings, some things are holding me back. I like the companies a lot, but they are somewhat riskier, have more uncertainties or just don't offer as good growth or low valuations.

*The limits are for buying. If a small holding decreases to 3%, I should either increase it or sell it. But if a high-conviction holding increases to 21%, I will not automatically reduce it. However, if it increases to 26%, I will automatically reduce it to 25%. I hope this will reduce my risk of confirmation bias, no buying when I already have 20%.

The maximum limit? Why stop so "early"?

I mentioned rare opportunities at the beginning, so why not invest 30% or 40% of your portfolio in one of these? Well:

• Confirmation bias. I have to limit myself. If I allowed myself to invest more, I would be influenced by the time, money, and effort I put into these stocks. I am already affected, but the effects would be more severe. Put simply, I might be more and more wrong without being able to see it.
• The unknown is still there. Even if I quit my daytime job and devoted all my time and effort to following just three companies (the so called best ones), I still wouldn't be safe. Anything can happen in any company. There are things I don't know, I can't know, or anyone can know. The only way to protect yourself against catastrophic events is to diversify a bit more. I want to sleep well.
• The last one isn't about risks, but I look at many markets and ideas. That way, I will certainly come up with several ideas worthy of being high-conviction holdings. If I only invested in one or two markets, I might run out of ideas, but when the pool is 10,000 companies, there will be more than 4 worthy of 10+ percent in your portfolio. But perhaps not if the pool is just 500–1,000 stocks. (I also strongly believe that owning stocks in different stable countries is safer than just one).

These three reasons explain why 25% is my maximum limit, even if the company is the cheapest and most exceptional stock opportunity that I can find in the world. Again, these are big words, and I talk about best in the world according to my strategy (the chance that the stocks really are, is very slim).

What worst case are we talking about? 

A common way of thinking is that a stock might lose 50% in a bad year. This could happen to your largest holding. Let's say it does. If you have 20% of it, you will lose 10% overnight. If you have 40%, you would lose 20%. It's a really bad year, but it's something you can recover from. So why am I afraid? Well, two things.

• A bad year is one thing, but permanent loss of capital keeps me awake at night. What makes me afraid is if the 20% holding goes to zero. Or if the 40% one does. It's very uncommon, especially if we are talking about well researched high quality companies. But it could happen if you're really, really unlucky. The issue is that I invest in small, rare often little-known stocks that on the surface almost seem too good to be true. The research is thorough, and the quality is definitively high but it's still impossible to be 100% certain.
• Losses are harder to recover from. If you lose 20%, you have to regain 25% to break even, but if you lose 40%, you have to regain 67%. Mathematically, it is important to limit your losses.

Opinions?

I think it is logical and it might suit me to be a bit more concentrated. It is also highly individual. However, there could be some problems with my thinking. Having fewer stocks is less fun. You could become narrow-minded. And ten to twelve is a really small number if you invest in many markets. There are often almost equally good opportunities, and choosing one and rejecting the other could be too drastic.

What is your opinion on the portfolio sizing? Is a portfolio of 10-12 stocks a good middle ground, where you bet big on your "best ideas" but still are diversified? Are there effective ways to minimise the risks of confirmation bias and unknown events besides diversification? I guess a clear selling discipline and a critical mindset could be important. Do you have any thoughts on the matter?