Recently, fellow GuruFocus contributor Canadian Value posted the transcript from Stanley Druckenmiller’s speech to the Lost Tree Club from earlier in the year (link).
Let’s start with why you should care what he has to say: According to Sam Reeves, who introduced the speaker, Mr. Druckenmiller generated after tax returns for his shareholders of nearly 21% per annum over his 30 years managing outside funds (through 2010); at that rate, each $1,000 managed by Mr. Druckenmiller at Duquesne Capital was worth roughly $300,000 three decades later (fees aren’t mentioned in the transcript). And for the kicker, Mr. Druckenmiller never reported a down year over that period.
In a word –Â exceptional.
In the speech to the Lost Tree Club, Mr. Druckenmiller spent a lot of time answering a question all of us are undoubtedly wondering: How the heck did he manage to do so well for so long?
I won’t waste your time by copying his entire speech, which is a must read; I want to focus on a single factor that he addressed in some detail:
"The third thing I’d say is I developed a very unique risk management system. The first thing I heard when I got in the business – not from my mentor – was bulls make money, bears make money, and pigs get slaughtered. I’m here to tell you I was a pig. And I strongly believe the only way to make long-term returns in our business that are superior is by being a pig. I think diversification and all the stuff they’re teaching at business school today is probably the most misguided concept ever.
"And if you look at all the great investors that are as different as Warren Buffett (Trades, Portfolio), Carl Icahn (Trades, Portfolio), Ken Langone, they tend to be very, very concentrated bets. They see something, they bet it, and they bet the ranch on it. And that’s kind of the way my philosophy evolved… The mistake I’d say 98% of money managers and individuals make is they feel like they’ve got to be playing in a bunch of stuff. And if you really see it, put all your eggs in one basket and then watch the basket carefully."
Later on in the speech, Mr. Druckenmiller tells a story from his early days as a fund manager:
"When I started at Duquesne, Ronald Reagan had become president, and we had a radical man named Paul Volcker running the Federal Reserve. And inflation was 12%. The whole world thought it was going to go through the roof, and Paul Volker had other ideas. And he had raised interest rates to 18 percent on the short end, and I could see that there was no way this man was going to let inflation go. So I had just started Duquesne and had a small amount of capital: I took 50% of the capital and put it in 30-year treasury bonds yielding 14% – and I owned nothing else… And sure enough, the bonds went up despite a bear market in equities.
"It shaped my philosophy: you don’t need 15 stocks or this currency or that. If you see it, you’ve got to go for it because that’s a better bet than 90% of the other stuff you would add onto it."
If you’ve read my writing in the past, you know I agree with that sentiment wholeheartedly; as usual, I think Warren Buffett (Trades, Portfolio) put it best: “Diversification is protection against ignorance. It makes little sense if you know what you are doing.”
With concentration, portfolio construction becomes an increasingly important topic: if the top five holdings in your portfolio account for 75% of your assets, the relative weighting of each individual position will matter greatly. If they’re only 15-20% of your assets, it’s not as important.
That brings us to the focus of this article: in a concentrated portfolio, how do we determine relative weightings for the positions in our portfolio? And how do we determine cash balances?
Let’s put it in the context of the current environment: I’ve found very few positions to add near their present market valuations and am closer to trimming my current holdings (on average) than I am to adding more. How should I balance my portfolio among the individual holdings – and how much should I hold in dry powder? If I trim my most expensive holding, should I automatically reallocate into my next best idea? Or should I let those funds sit idly in cash?
I don’t think I can answer this question without first considering my investment objective: what is my goal as an investor? Am I comparing myself to the index, or am I focused on an absolute hurdle rate? For me, it’s primarily the latter: I target at least 12% annualized returns on new money (with a time horizon for that estimate of at least five years), with the knowledge I’ll likely to beat the S&P 500 over time if I can meet that target.
I think it's worth refining this even further: assuming I believe my holdings are priced to deliver exactly 12% a year, how much should I have in equities? Fully invested would mean that I’ve left myself no room to capitalize on market volatility (without incurring losses); since I’m at the bare minimum on my return target, that doesn’t sound too good to me. I think at a number like 15% a year I’d be happy with being fully invested. At 12% expected returns, I think ~80% invested is more appropriate; at less than 10% a year, I might be at 50% invested or lower.
To be clear, I don’t have an explanation for those percentages; it’s based on my intuition, for lack of a better approach. Exhibit 4 in this paper by James Montier (here) empirically shows what we all intuitively understand: low forecast returns run the risk of deep drawdowns – a bad combo for investors. If I can’t find securities that are near my return requirements, I have a tough time with the argument that I should settle with less (say, 5% a year) if it beats the alternative (like a short- or, in the current environment, even a long-term bond held to maturity).
The drawdown risk is what makes this a tough sell for me: I don’t take comfort in losing less than the market (which is the argument I hear for picking a “safe” name in this situation). That’s different than the majority of market participants, who view risk in terms of tracking error. Their “risk free” asset really isn’t cash / short term treasuries – it’s the index they're compared to.
(Let me make a small side note that seems relevant in today’s environment: when people start worrying about the risk of missing out on gains from not being fully invested more so than the to losses associated with drawdown risk / permanent loss of capital in equity investing, that’s a good indication that we’re closer to greed than fear on the spectrum of emotions…)
With the portfolio ranges set, things get a bit easier: all else equal (most notably the level of confidence in my estimates), positions with higher expected returns deserve higher weightings. The adjustment for risk should have some tie to an investor's risk tolerance. Obviously, both of those factors cannot be precisely quantified; rough estimates will have to do.
I’m of the belief that it’s one of those things that is only refined through practice; take comfort in the fact that even great investors like Mohnish Pabrai (Trades, Portfolio) are still soul searching here (listen to his talk to students at UC Davis here; at the 42-minute mark, he talks about how his approach to position sizing and portfolio construction has developed over time).
To use a personal example from my approach, I think Berkshire Hathaway (BRK.B) in mid-late 2011 was an example where ~15% (or higher) annualized returns over a period of 5+ years were highly likely – along with a very low probability of a hugely disappointing outcome (something well below 15% a year). Following Mr. Druckenmiller’s advice, I moved swiftly to capitalize on this opportunity and decided to “bet the ranch”: in the course of 60 days, I moved more than 20% of my portfolio into BRK.B, ending the year with a weighting north of 25%.
By the way, the window of opportunity in that scenario wasn’t very large (go back and look at the chart for BRK.B in 2011): from March to September, shares fell by more than 20%; the stock got as low as ~$66 per share – but was only under $75 for a period of roughly 90 days.
Conclusion
So what can we take away from this? I’d like to highlight a few noteworthy points.
The first is simply that there’s a strong argument for concentration; knowing intimately about what you own is how you minimize risk. The second point is when you see something worth doing, go big – and move swiftly. That requires being prepared to capitalize. The company you’re looking at today, trading 50% above your estimate of an attractive entry point, should still be researched thoroughly if it’s a potential target down the road; you should do the work now so that you can confidently act later on if you’re given a window to buy the stock at a bargain price.
One company that I’m hoping will eventually fit that description is Hershey (HSY): I’ve followed it for years, even though it has been well above where I would initiate a position. Over the course of the past eighteen months, it’s gone nowhere, with the gap between intrinsic value and the stock price converging. While I still need a fair amount of help, I’m watching closely; I’m ready to act if Mr. Market gives me the chance to do so – even if just for a few days.
All that brings me to my final point: position sizing should not be considered lightly. This is an area where I think I’ve personally struggled. With a company like Staples (SPLS), I jumped in when I spotted opportunity and got too aggressive early on; I added more on a small price decline shortly after initiating my position (something I rarely do anymore), taking it beyond my comfort zone. When the chance came to buy more at a much better price, I was in a position where I wasn’t comfortable doubling down.
Clearly this is a double-edged sword: moving slowly from the start potentially means missing a run on a position you correctly assessed; errors of omission can leave a bad taste in your mouth.
The middle ground, in my mind, comes down to answering the following questions: (1) What’s the absolute cap for this position weighting in my portfolio? (2) How attractive are the returns I’m forecasting from current levels? (3) How confident am I in that forecast?
On its own, 25% sounds like a large position; in reality, I would’ve been comfortable putting 50% or more of my portfolio in Berkshire if the price kept falling. With hindsight, I think there’s an argument for being even more aggressive in 2011 with Berkshire than I was. However, I wouldn’t say the same for Microsoft (MSFT), which was a similarly sized holding with (what I believed were) similar return prospects – but on which I had a much lower level of confidence.
With Staples, I came out too strong; even though the position turned out okay, I failed to consider just how comfortable I would be in adding to the holding as I was sitting on a pretty sizable unrealized loss. If I had sized it properly, I could’ve effectively capitalized on market volatility and generated a much better return on the investment.
I don’t like being in a position where I wouldn’t buy more of a current holding if it was suddenly 25% cheaper without any change in the current fundamentals. By the way, when I get the feeling that a 25% decline on its own would make me question the fundamentals, that’s a bad sign, too.
I think a fair name for this is the “then what?” approach to investing: it’s viewing each decision / investment with consideration for what will happen over time. Initiating a position or adding to a current holding should not be viewed as the end of the decision. I think this thought process (which I need to work on) can help with position sizing and portfolio construction.
How do you approach equity weightings in your portfolio? As always, I’m interested in reader’s thoughts.
