Why Position Sizing is Underrated
Plus earnings reports from serial acquirers, growing profits when invested capital declines
Stay informed with our latest portfolio and quality growth news digest, designed to keep you up-to-date on what matters most!
Today’s Topics
In this digest, we’ll address:
position sizing and why it’s underrated;
our reflections on recent earnings reports from four serial acquirers: Indutrade, Lifco, Addtech, and Diploma;
a premium member’s question on profit growth on a flat or declining invested capital figure. A negative ROIC isn’t necessarily bad, just have to consider what’s driving it (negative NOPAT growth is problematic, while negative growth in invested capital frees up cash);
consumer discretionary companies in Europe
Coming up next: the key lessons from Chris Hohn’s investment strategy. His insights are also related to the first topic: position sizing.
Position Sizing
Our good friend and premium member Toby has been sharing incredibly insightful blogs on investment strategies, mindset, and his personal philosophy on The Intellectual Edge Substack. It's all completely free, and we highly recommend you subscribe to gain access to his valuable content.
Toby recently published a comprehensive piece on position sizing, a topic he argues is the most underrated skill in investing. While diversification's effectiveness has been thoroughly explored by Markowitz and others, position sizing and portfolio construction often don't receive the attention they deserve.
As legendary investor Stanley Druckenmiller stated:
“It’s not whether you're right or wrong that's important, but how much you make when you're right and how much you lose when you're wrong.”
We've previously discussed portfolio concentration, and we'll revisit our perspective in an upcoming blog about Chris Hohn. Ultimately, our goal is to find great companies led by exceptional individuals who consistently make strong capital allocation decisions.
Consistency is paramount. While everyone faces setbacks, a high degree of consistency helps us focus on long-term outcomes. Consistently high returns on incremental invested capital (ROIIC), high Internal Rates of Return (IRRs), and solid reinvestment rates create asymmetric risk/reward opportunities. When building a concentrated portfolio around a few top ideas, the aim is to hold them for as long as possible, as compounding requires time. We must strive to pick excellent, steady winners, not settle for average companies.
As Toby mentioned in his article:
Chris Hohn’s happy putting large allocations into positions because the businesses he invests in are highly predictable, allowing him to confidently put big bets on them.
Predictable businesses are also more valuable when forecast over longer time horizons; and with shortening investor time horizons, these businesses end up being undervalued since their compounding ability is never fully appreciated.
It's important to recognize that position sizing in equity portfolios is very similar to a company's own capital allocation. If a company pursues the wrong acquisition (betting too big on a low-ROIIC opportunity and leveraging up) or misjudges a cycle (e.g., over-investing at the peak), it will take significantly longer for these investments to yield solid returns, if any. Companies must allocate capital based on expected IRRs, dispersion, and individual project risk. It's all about target-based probabilities.
Consistency, time, and ROIIC are often underestimated and difficult to fully grasp over longer periods. Therefore, effective position sizing in a concentrated portfolio begins with a deep understanding of our companies' reinvestment and growth profiles, and most importantly, who is in charge. The better the metrics, the lower the probability of permanent loss (absolute risk) and opportunity cost (betting big on something that underperformed other alternatives).
This aligns with what we discussed in last weekend's presentation: reverse-thinking helps us understand why running a concentrated portfolio should focus on unique, multi-decade winners. Crucially, these companies should be led by very rational managers who comprehend the ROIIC and growth game. Position sizing isn't solely about financial track records; it's about trusting the right people and observing them effectively lead the company for many years, preferably over a decade.
The Compounding Tortoise
If the metrics don't add up, the investment case becomes heavily reliant on external factors. We prefer companies that control their own destiny rather than those riding unpredictable macro tailwinds.
Four Industrial Serial Acquirers
This week, four leading industrial serial acquirers posted their Q2 (or fiscal Q3) results. We’ve already covered Lifco’s, but wanted to touch on Indutrade, Addtech, and Diploma too.
To us, it seems one trend’s emerging: industrial serial acquirers that have been struggling with organic growth for several quarters continue to struggle. Organic growth is quite relevant at a time of increased macro uncertainty and M&A transactions being postponed; where should the profit growth come from otherwise? It also tends to lead to operating leverage, and thus increased profitability (excluding any mix effects from M&A).