This was my first article published at RealMoney, in October 2003, I think on the 17th.

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As investors go, I am a ?singles hitter.?? I don?t get many investments where I more than double my money.? But I bat a high average when I invest.? One of the keys to this is insisting that the companies that I invest in possess ?financial slack.?? Financial slack means that a company can make a few mistakes, and not get killed.? This is the equivalent of Ben Graham?s margin of safety.

 

If you run a portfolio with a small number of stocks, it is important to avoid companies that destroy your capital.? It is difficult to recover when your capital has been impaired.? A good defense allows the offense to play aggressively, without losing sleep at night.

 

The market is a cyclical beast, with cycles inside cycles.? The market has a cycle of its own, but industries have their cycles within the cycle of the market.? This is where I find my advantage in the market ? analyzing industry cycles.? Industries go in and out of favor.? The time to buy a company in any industry is when it is out of favor; as a matter of risk control (and humility) the companies to buy when an industry is out of favor are those with financial slack.? If you are wrong about the industry, you won?t lose much; if you are right, the gains will be significant.

 

My example for today is the steel industry.? The steel industry is economically necessary for our world, but is in decline in the US.? The older integrated steel mills are inefficient compared to the mini-mills, and foreign competition.? The foreign firms have varying advantages ? cheaper labor, and governmental subsidies, both implicit and explicit.

 

Understanding Cyclicals

 

Steel is a cyclical business that follows the pricing of steel.? This may sound obvious, but the finance textbooks teach us to look at companies in a mode that assumes constant earnings growth.? This is a rare condition in the real world, and non-existent with cyclical companies.? With a cyclical company, watching the pricing trends of the commodity produced is the most critical factor in short-run stock performance.? Longer-term, it comes down to:

 

1. Buying industry leaders with impeccable balance sheets.
2. Reasonable operating leverage ? they should be profitable at the cycle trough
3. Buying them when the industry is hated.? Buy them cheap.
4. Only buy firms that use free cash flow at cycle peak in a way that prepares for the trough.

 

Point 1 comes down to size and financial leverage.? Points 2 and 4 suggest a corporate humility that arises from restraining the increase of productive capacity when times are good, and a willingness to invest when times are bad.

 

Point 3 is the hardest point.? In growth industries, P/E ratios are a reasonable measure for valuation.? In cyclical industries, P/B [price-to-book] and P/S [price-to-sales] ratios are more reasonable, because earnings are less stable and reliable.? With cyclical companies, P/E ratios are typically lowest at the cycle peak, when companies have peak earnings, and high-to-nonexistent P/E ratios at the cycle trough.

 

Other issues around steel

 

There are a number of structural problems around the steel industry.? Tariffs to protect US production prevent inefficient capacity from exiting the industry.? The hint of removal or increase of tariffs can move steel stocks markedly.? Second, labor unions have not figured out how deeply uncompetitive the US steel industry is.? Between total compensation costs and work rules, the unions help make many US steel uncompetitive.? Finally, pension liabilities are often large relative to the total capitalization of many steel companies.? It is no surprise that one of the key issues regarding emergence from bankruptcy in the steel industry involves reduction of pension benefits.

 

Conservative investors investing in the steel industry will look for companies that do not have large pension deficits, and companies that are non-union, or where the unions have made peace with management.? They will also look for companies that can exist without tariff protection.? (Perhaps politicians will realize one day that more jobs hinge on the use of steel, rather than its production, and eliminate tariffs because it preserves more jobs, but I doubt it.)

 

Companies

 

In my investing, in the past, I have made money on AK Steel [AKS], Algoma Steel (insolvent), and Nucor [NUE].? When steel prices were higher, low cost producers (at that time) like AK and Algoma did well.? Their main problem was their debt loads; a company that is operationally efficient still has to service its debts.? EBITDA is all very good if you are a bondholder, but stockholders need free cash flow ? AK and Algoma had none of that as steel prices fell.

 

In this uncertain environment, I am invested in Nucor.? With little debt, a non-union workforce, and relatively low cost production, Nucor is an acceptable stock for conservative investors.? Nucor has been a consolidator of steel assets on the cheap amid the many bankruptcies that have plagued the sector.? When steel industry conditions normalize, they will earn a good return.? It has a strong focus on return on equity.? It should earn a about $1/share in the trough, and perhaps as much as $5/share at the peak.

 

But is it the right time to own Nucor?? Is it cheap enough?? I made my last purchase in the high 30s, and would purchase more there.? In the high 40s, I am a little more indifferent, because I would sell Nucor in the low 60s.? Given the normal level of profitability for Nucor, I view it as a buy below 1.3x book, and a sell at over 2x book.

 

An alternative

 

I do not have a position in POSCO [PKX], but am considering it for my portfolio at present.? POSCO, formerly Pohang Iron and Steel, is the third largest steel producer in the world.? It is based in South Korea, and is presently the lowest cost producer in the world.? Debt is low, and if you can trust Korean GAAP, it has earned consistent money for nine out of the last ten years.? It trades around its book value, and 7x 2004 earnings ? very cheap, unless we get a new war on the Korean peninsula.

 

As with any investment, the risks must be weighed against the likely returns.? I have one Korean company in my portfolio.? Do I want to double my risk?? That is my main question on POSCO.? Absent that, I would rate it a buy for those who can tolerate the risks involved.

The following was published at RealMoney, but I don’t know the date.

?I can always find good stocks to buy, but figuring out when to sell is harder.?? (My Mom, when I was much younger.)

 

In some ways, my career in investing has been a happy accident.? Much of my career has been in the insurance industry, working as an actuary.? Being a generalist, with a focus on investments, this helped me to learn a great deal about institutional investing, before doing it myself.

 

At Provident Mutual, now a part of Nationwide Financial Services [NFS], I was the one financial analyst on a committee that chose the managers for a series of multiple manager funds for our pension clients.? I ended up interviewing 30-40 top money managers over a three-year period.? The similarities and differences were interesting.? Two areas that we would always ask about would be their buy and sell disciplines.

 

On buy disciplines, the answers varied considerably.? But sell disciplines were usually pretty similar, falling into three groups:

 

• Price target met
• Failure of momentum
• Fundamentals deteriorate

 

The last of these is squishy, and I would usually ask, ?How can you detect fundamentals deteriorating ahead of everyone else??? This would usually elicit the intelligent equivalent of a mumble.

 

There were a few of the better managers who used what I later called ?The Economic Sell Rule.?? The economic sell rule says that if a manager finds an asset that he likes better than one that he presently holds, he should swap.? That means the manager either intuitively knows what he likes better, or estimates the anticipated rate of return (adjusted for risk tolerance) over the time horizon that he manages, to appraise the desirability of new assets.

 

I ended up calling it the economic sell rule, because each of three rules listed above had problems of their own.? In a market where valuations are crazy, like the late 90s, many price targets get hit.? If the manager is a ?long only? manager, and has to stay fully invested, he can begin to run out of ideas on where to put money to work.? For managers that can go both long and short, there is the problem that as price targets get hit on the long and short side in a sustained market rally, the portfolio gets shorter and shorter.? And in a sustained decline, the portfolio gets longer and longer.

 

This is an implicit bet on mean-reversion, which no doubt happens, but often not soon enough for the clients of the manager, who can lose assets under management as underperformance persists.

 

Failure of momentum could take two forms: valuation-driven managers with price declines below original cost, and momentum-driven managers that would sell when relative strength weakened.? Some valuation-driven managers would often sell any stock that declined more than a threshold percentage, whereas others would do a review at such times to check their investment thesis.? After all, if a manager liked the company before, certainly he should like to buy it cheaper, no?? Unfortunately, the pressure for instant results, measured on a monthly or quarterly basis, can force decisions that are less than fully rational.

 

As one manager said to me, ?If it goes down more than 20% from where we bought it, we obviously didn?t get the story right, so we sell it and move on.?? This is a recipe for turnover and underperformance.? It is normal for stocks that are good long run performers to have 20% drawdowns once a year or so.? Even with good research analysts, the odds of a 20% drawdown are decent, even immediately after a recommendation.? In my own portfolio, after reviewing my thesis, I view 20% drops as buying opportunities.

 

Because I don?t manage money that way, I can?t comment as competently on the momentum-driven managers.? I will only note that they have high turnover rates, and that their trading tends to demand liquidity, rather than supply it.? In future articles, I will comment on the tendency for those who supply liquidity to be rewarded for it.

 

Though I never heard a good explanation for having a competitive edge in detecting deteriorating fundamentals, following the fundamentals is the most useful way for developing a sell discipline.? Absent surprises, companies and industries perform better or worse as investors change their estimates.? As the forward-looking estimate of future returns for a company falls below that of prospective purchase candidates, it is time to swap out.? As the forward-looking estimate of future returns for a company rises compared to other companies in a manager?s portfolio, it is time to buy more.

 

Consider when a ?surprise? happens to a company.? Surprises can be positive (e.g., possible takeover, good earnings), or negative (e.g., bad earnings).? After a surprise, is it time to sell, buy more, or wait?? It boils down to how much the surprise affects the manager?s estimate of value for the stock.? (And to some degree, how much it has affected the estimates of others.)? How much has the long-run earning power been affected?? For how much could the company be sold off?

 

Answering questions like these will lead to the estimates of value that can properly inform sell decisions in volatile times.? Using a discipline like this forces a manager to re-estimate a forward-looking estimate of return, rather than let greed or regret drive decision-making.

 

In my next article, I will show how this process has worked in practice for me, together with another technique that some managers use to pick up some incremental return, and reduce risk.

The following was published at RealMoney on April 20th, 2007:

The Changing Business Environment

What do you think is the most important change happening in the competitive environment at present?

This query can highlight emerging issues and demonstrate how the company is adjusting to the changes. Again, you need to compare the answers of various managers against each other; an odd answer could either be ahead of the pack or out of touch. If you think the answer makes sense, it can open up new questions that further enhance your understanding of the industry and the role that the company you are interviewing plays in it.

After Hurricane Katrina and other storms in 2005, ratings agencies toughened up their risk models, and catastrophe modeling companies increased their frequency and severity estimates. This created an even greater squeeze in the 2006 property reinsurance markets than what the losses of capital alone would have caused, as happened to the 2005 property reinsurance market from losses suffered in 2004. New entrants in the reinsuring property risk space found that they could write only half of the premium that their more seasoned competitors from the class of 2001 could. Further, property-centric writers found the capital required went up more for them than for their more diversified competitors.

There was less effective capital in property reinsurance at the end of 2005 than at the end of 2004, even though surplus levels were higher on net. Those who recognized the change in the rules of the game caught the rally in the stock prices as the price for reinsurance went up more rapidly than most expected for the 2006 renewal season.

What laws, regulations, or pseudo-regulations (such as debt ratings criteria) would you most like to see changed?

This is another attempt to understand what most constrains the growth of the enterprise (see Part 1 for a different angle on the question). The answer should be something that is reasonably probable, or else the management is just dreaming.

For an investment bank like Goldman Sachs (GS), an answer could be, “We want the ratings agencies to agree with our view of our risk management models, so that we can get a ratings upgrade and lower our funding costs.”

For a steel company in the early 2000s, the answer could have been, “The government needs to enforce the antidumping duties better.”

A media or branded goods company today might say, “Better efforts by the government to reduce piracy both here and abroad.”

For companies under cost pressure, such as General Motors (GM) and Ford (F), the answer could be, “A better labor agreement that includes changes in the union rules, so that we can improve productivity.”

What technological changes are most driving your business now?

Technology often benefits its users more than its creators. Prior to computers, it took a lot more people to run banks and insurance companies. Now financial companies are a lot more efficient and hire fewer people than they used to as a result of the change. You as the analyst want to know about the next technological change that will lower costs or create new products in order to forecast increases in growth of profitability.

There are other technological changes, but the biggest one recently in business terms is the Internet. The creation of the Internet has changed the way people search for information. World Book Encyclopedia was owned by Berkshire Hathaway (BRK.A), which thought it had a pretty good franchise until Microsoft (MSFT) and others came out with their own cheaper encyclopedias on a CD-ROM. Now even these are getting competed away by Wikipedia.

Who else is being harmed by the Internet? Newspapers are under threat from all sides. Classified ads have been marginalized by eBay (EBAY), Craigslist, Monster (MNST), etc. Regular advertising has been siphoned off by Google (GOOG), Yahoo! (YHOO) and others.

What cultural changes are most driving your business now?

Cultural changes affect demand for products. As more and more women entered the workforce, demand increased for prepared foods and dining out options. Demand decreased for Tupperware parties and things sold door-to-door.

Cultural changes can also lower the costs of an operation. Outsourcing has lowered costs and improved time coverage for call centers, computer programming and many other service functions. The willingness of nations to embrace the cultural change of capitalism creates new markets that previously did not exist.

One more example, again from insurance: Insurance became a growth product when extended family ties weakened and nuclear families became the standard. Now as nuclear families break down and are replaced by a greater proportion of singles without children, some insurance markets are weakening (life) and others are strengthening (annuities, personal lines, individual heath and disability).

What regulatory changes are most driving your business now?

Before you talk to management, you should know the answer to this one. But what matters here is that you know that they know, too, and more importantly, are building that into the plans for the business.

To get you started, consider the possible impacts of some changes on a few industries. For a pharmaceutical company such as Merck (MRK) or Pfizer (PFE), this could be a change in the way that drugs get approved. It might be a larger political change, such as the recent election of the Democrats, which is expected to produce a change in Medicare reimbursement rates.

Increases in environmental regulation can affect the profits of extraction businesses significantly, whether agriculture, mining, silviculture, energy exploration and production and more. If it becomes easier to unionize, that can affect wage rates and productivity even more as work rules bite into effectiveness and flexibility of work; both of these can lower profits in labor-intensive businesses.

Now, these are pretty obvious examples, and most examples here will be obvious, because most regulation is done openly. The answers that a management gives can be a test as to whether they themselves know what is going on.

Sometimes the answers get a little more subtle. In personal lines insurance, it took analysts a long time to catch up with the safety trends that were bringing down the frequency and severity of losses, particularly graduated licensing for young drivers. Internally, the companies had figured it out long before they told the analyst community. The analysts who asked why severity and frequency of loss were so good and got an answer that allowed them to “connect the dots” to the regulatory change realized that there was a secular, not cyclical, change going on. Thus they were able to make money buying personal auto insurers, because the trend was likely to extend to more states.

Mergers and Acquisitions

Without naming names, what types of business alliances do you think could be most valuable in the future?

This helps flesh out competitive strategy. Managements will be reluctant to part with details, but usually are willing to explain their approach to supplier agreements, joint ventures and so on.

The answer to this question can also highlight the “missing pieces” for the current business, and how the management team is trying to source them. It can also shine a light on new products and services that management is considering.

Is it cheaper at present to grow organically or through acquisitions?

The right answer is almost always organic growth. Acquirers usually overpay, particularly in acquiring scale. Intelligent acquisitions are usually small and often private firms, where the sale is negotiated and not an auction. The goal is to gain new core competencies or markets that can grow profits in concert with the capital and other resources that the company can add to their new acquisition.

If a company answers “through acquisitions,” there had better be a reason it has an advantage in acquiring companies that its competitors don’t, which is rare. If it’s the only public company rolling up a sector (again rare), there should be some logic as to what discipline the company exercises in not overpaying for acquisitions.

In the early phase of a roll-up, prices are typically reasonable for the small firms being purchased. As the roll-up proceeds, the acquisitions that are easy, logical and cheap get done first. In later phases, if there is a mania, the hard, illogical and more expensive acquisitions get done.

It’s rare to have a roll-up in which some party doesn’t start overpaying badly at the end. Sometimes that signals the end of the roll-up phase, with a decline in the share price of the overpayer, destroying the value of the currency that it is using to acquire small entities; namely, its stock price.

How important is scale when you consider acquisitions?

Again, acquirers usually overpay for scale. The right answer is usually that it is not important, unless it is a commodity business and the acquirer is the low-cost competitor, and will wrench expenses out of the target company to make the target as efficient as the acquirer.

Summary

The difference between my approach and the approach of most analysts is that I think about the business and its strategy rather than the next quarter or year’s earnings. My methods probably won’t help you make money in the short run but will help you make money in the long run as you identify intelligent management teams that understand how to compete for the long term, rather than those that can manage only next quarter’s GAAP earnings.

Two additional side benefits to doing it my way: First, the management teams will like talking with you. I can’t tell you how many times managers have said they appreciated my businesslike approach to analyzing their companies. Second, it will translate back into an improved understanding of the business you presently work in, as you think about strategic issues there.

This was originally published on RealMoney on April 16, 2007:

“I am a better investor because I am a businessman, and a better businessman because I am an investor.” — Warren Buffett

One of the things I try to do in my investing is analyze the quality of a management team. Though this is a squishy discipline, if I can be approximately right in this endeavor, I can add a lot of value.

I want to share with you the questions I ask management and the reasons I ask them because I believe they’re useful even if you never come face-to-face with a real live C-suite dweller. They cover six major areas:

• general topics
• financial
• competition
• pricing and products
• changing environment
• mergers and acquisitions

I try to analyze sustainable competitive advantage and the ability of managements to generate and use free cash flow, among other factors. (As an aside, in the insurance industry, I can kind of tell management quality by “feel.” I have worked for good and bad managements, and I know their characteristics intuitively.) I try to see if managements are economically rational, are focused on building long-term profitability and act in the interests of the outside passive minority investors who own their shares.

Personally, I am in favor of small-shareholder capitalism. By this, I mean that small investors should have the same access to management, not least of all through quarterly (and other) conference calls held. This view is partly driven by the inadequate questions asked by sell-side analysts.

Too often, sell-side analysts focus on the short run and qualitative variables in their models. The short term is overanalyzed, so I try to look to the longer term. That means most of my questions are about strategy. I try to figure out if the managements in question are — again — economically rational, focused on building long-term profitability and acting in the interests of the outside passive minority investors who own their shares. Or do they act for reasons other than maximizing value for mom and pop, a.k.a. you and me?

Though most of us are outside passive minority investors, pretend for a moment that you are a private-equity investor. There’s value to be had in understanding how an investor in the business would benefit in the absence of a secondary market for ownership interests. The value derived by a private-equity investor feeds slowly to the public equity investor in the short run but directly in the long run.

Then sit back and read through these questions. Prepare to ask them of the managements of the companies in which you are currently a shareholder. Imagine the answers, or even try to get them.

And adjust your holdings accordingly.

General Questions

What sustainable competitive advantages do you have vs. your competitors?

As with most of my questions, I usually have a reasonable idea of what the answer is likely to be. Part of my question is to test the competence and veracity of management. If it trots out some answer that is nonsense, that is a big red flag to me.

Given that most of the time I invest in mature industries, I want to hear answers that tell me the company has an expense advantage over competitors. That can be easily verified. Other possible answers include exclusive distribution agreements, patents, technological advantages and company culture.

Once I hear the answer, I try to analyze how much it makes sense. Has the company really created a “moat” that protects its profits from competition, or is it trying to fool me? I don’t always get a sharp answer, but the exercise is always valuable. Uncertainty leads to doing nothing or to a smaller position, which is always appropriate when you don’t have a big edge.

For instance, longtime readers know that I am a long-term bull on the diversified insurance company Assurant (AIZ). In most of Assurant’s business lines, it is the No. 1 or No. 2 provider in the businesses in which it chooses to compete. Part of that stems from locking up exclusive distribution arrangements, some from proprietary technology that would be difficult and prohibitively expensive to reverse-engineer.

To give another example, Allstate (ALL) and Progressive (PGR) are leaders in customer segmentation, leading to individualized pricing of personal lines coverage. Other major personal lines companies are playing catch-up, and the smaller mutual companies are losing many of their most profitable customers.

So these companies have a clear advantage, which management should be able to communicate quickly.

What single constraint on the profitable growth of your enterprise would you eliminate if you could?

Companies tend to grow very rapidly until they run into something that constrains their growth. Common constraints are:

• insufficient demand at current prices
• insufficient talent for some critical labor resource at current prices
• insufficient supply from some critical resource supplier at current prices (the “commodity” in question could be iron ore, unionized labor contracts, etc.)
• insufficient fixed capital (e.g., “We would refine more oil if we could, but our refineries are already running at 102% of rated capacity. We would build another refinery if we could, but we’re just not sure we could get the permits. Even if we could get the permits, we wonder if long-term pricing would make it profitable.”)
• insufficient financial capital (e.g., “We’re opening new stores as fast as we can, but we don’t feel that it is prudent to borrow more at present, and raising equity would dilute current shareholders.”)

There are more, but you get the idea.

Again, the intelligent analyst has a reasonable idea of the answer before he asks the question. Part of the exercise is testing how businesslike management is, with the opportunity to learn something new in terms of the difficulties that a management team faces in raising profits.

How are you planning on growing the top line?

This can be a trick question, particularly for industries in which pricing power is nonexistent. When there is no pricing power, the right answer is to focus on the bottom line and not sell underpriced business. The answer here can reveal whether the executive is a rational competitor and whether he has the courage to be honest with the analyst.

The sell side has a bias toward top-line growth, which is wrong in my opinion. Actions that improve the expense structure are just as important as new sales. Good managements have a consistent focus on the bottom line, whether it grows the top line or not.

Particularly in financial businesses, there is a tradeoff between quality, quantity and price. In good markets, you can get two out of three. In bad markets, you can only get one out of three, and if that one is growth in sales or origination, watch out. That business is a candidate for profit shrinkage, and possibly insolvency.

Good managements know when to step back from their markets when competition is irrational. In the short run, that may hurt the stock price, but in the intermediate term, it will keep them in the game. In the long run, it will help the stock price when the pricing cycle finally turns and a few stupid competitors are weakened or bankrupt from their past mispricing of business.

Full Disclosure: long AIZ

I wrote the following at RealMoney on 4/10/2007

I’ve written two columns already about “spring cleaning” a portfolio, walking you first through the criteria I use when reshaping my holdings and then through the stocks and decisions those criteria pointed to. But there’s one aspect I didn’t cover: What’s the best way to size positions for a long-only equity portfolio?

In order to answer this question, I use the Kelly criterion (popularized in the excellent book Fortune’s Formula), which says that a position size should be equal to (edge/odds). Edge is the excess return that you expect to earn on average. Odds describes the likelihood of winning. A 50/50 bet makes odds equal to 1.

There is added complexity in applying this to stocks, because in gambling, each game is (mostly) uncorrelated with the last one. In investing, if you have a number of investments going at the same time, they are to some degree correlated with one another.

That’s particularly true for me, because I concentrate sectors. I believe that my portfolio acts more like a portfolio with half the number of positions because of the correlatedness of the various names in the portfolio. Thus, the 35 names in my portfolio behave more like 18 uncorrelated names.

The Kelly criterion applied to stock investing would recommend a fixed-weight portfolio. Optimally, you would rebalance daily to those fixed weights. But two factors interfere: First, there are costs to trading, and second, momentum tends to persist in the short run.

To me, those realities mean that you can have fixed weights, but that you set a band around those fixed weights for rebalancing. I use a 20% band, but the more I think about it, the band should be smaller, maybe 10%. My portfolio has gotten bigger over the past few years, and trading costs are a smaller-percentage cost factor. I’ll stick with 20% for now. It has served me well, but I will re-evaluate this.

I firmly believe that my eight rules tilt the odds in my favor. What are they?

1. Industries are under-analyzed relative to the market on the whole and relative to individual companies. Spend time trying to find good companies with strong balance sheets in industries with lousy pricing power, and cheap companies in good industries where the trends are not fully discounted.
2. Purchase equities that are cheap relative to other names in the industry. Depending on the industry, this can mean a low price-to-earnings ratio, low price-to-book value ratio, low price-to-sales ratio, low price-to-cash flow from operating activities, low price-to-free cash flow or low enterprise value-to-EBITDA.
3. Stick with higher-quality companies for a given industry.
4. Purchase companies appropriately sized to serve their market niches.
5. Analyze financial statements to avoid companies that misuse generally accepted accounting principles and overstate earnings.
6. Analyze the use of cash flow by management to avoid companies that invest or buy back their stock when it dilutes value, and purchase those that enhance value through intelligent buybacks and investment.
7. Rebalance the portfolio whenever a stock gets more than 20% away from its target weight. Run a largely equal-weighted portfolio because it is genuinely difficult to tell what idea is the best. Keep about 30-40 names for diversification purposes.
8. Make changes to the portfolio three or four times per year. Evaluate the replacement candidates as a group against the current portfolio. New additions must be better than the median idea currently in the portfolio. Companies leaving the portfolio must be below the median idea currently in the portfolio.

I need to calculate what I think my edge is. My procedure will be messy and somewhat ad hoc, but I would rather be approximately right than precisely wrong. How much is each rule worth?

The offensive rules are 1, 2, 7 and 8. Each of those generates roughly 2% of alpha annually. The defensive rules are 3, 4, 5 and 6. Each of those generates roughly 0.5% of alpha annually. Now, that would be an alpha of 10% annually for a portfolio that followed all those rules perfectly. My alpha over the last six years and seven months has been greater than that, but I will chalk up the overage to happenstance. Maybe more should go to happenstance, but I will discuss that below.

If my edge is 10% per year, what are my odds? I have long maintained that the idea I believe is best probably is as good as my 35th idea. Too many portfolio managers naively believe that they can identify their best ideas, when there are so many unknowns to an outside, passive, minority investor. My methods work on average, over the intermediate term. Most of my investments work if I give them two to three years to develop. Time is usually on my side with my methods. That would imply that my odds might be 50/50, or 1:1. That’s a coin flip, but one that, repeated often enough, leads to an extra 10% per year. Using the straight Kelly formula, that would mean I should have 10 positions; 10% divided by 1 is 10%, and for each position to be 10% of my portfolio, that would mean 10 positions. But I own 35 positions. What do I do?

As I mentioned above, because I concentrate industries, my 35 stocks behave more like 18. An equal-weight 18-stock portfolio has weights of 5.5%, and that’s still not 10%. Again, what do I do?

Good investing is based on humility, a willingness to accept that there are many things that you don’t know and that many successes may not be due to skill. Many who use the Kelly criterion decide to go “half Kelly” and cut position size in half because it also cuts volatility in half — but it also diminishes the expected returns by 25%. It’s a humble way to go.

Another way to think about it is that with quantitative investing, when you find a good strategy and have vetted it though back-testing, typically the alpha achieved when the strategy goes live is half of what the model would have predicted.? Though I have already given my edge a haircut, perhaps more of the success needs to be attributed to happenstance.

Whether due to happenstance or conservatism on my part, cutting the 5.5% in half leads to positions of 2.8% in size. How many equal-weighted positions is that? 36. That’s about what I have, and when conditions are bullish, I contract the number down to 30. When conditions are bearish, I hold up to 40 positions. Most of the time, I keep it at 35. That keeps me disciplined, which is a virtue that yields dividends in its own right.

That’s what I do. But what should you, my reader, do?

I encourage you to calculate your edge.

Look at your annualized returns over the past few years, and compare them with the index that you want to beat. Take the? excess (assuming there is one), and cut it in half. Some things went well for you that are not attributable to your skill.

I encourage you to calculate yours odds.

Look at your trading. Divide it into two categories, winners and losers. How often do you win (relative to the index)? When you win (vs. the index), how much do you win on average? When you lose (vs. the index), how much do you lose on average? (Make sure you use your annualized results for this exercise.)

If you consistently lose vs. the index, I’d buy the index instead of continuing to lose capital trying to do it myself. If you beat the index, then work out the calculation that I went through for my portfolio. Take into account your conservatism, but even if you are aggressive, I strongly discourage you from using portfolio weights higher than the full Kelly criterion; it’s too dangerous.

In general, I believe skilled investors with moderately sized portfolios are best served by diversification equal to what I use.? On the raw Kelly criterion, it’s equivalent to saying that one has an alpha between 2.5% and 3.3%. Hey, that’s hot stuff!? Most mutual fund managers would kill for those returns.

In summary, size your positions inversely to your expected alpha. To the extent that you are less certain of your skills, expand the number of your positions.