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No. of Recommendations: 3
Hello All:

Interesting discussion. I completely agree with the assertion that position sizing based on confidence is of the utmost importance. While, I don't have much more analysis to provide, I think I can communicate the learning process that brought me where I am today; 35 stocks with none under a 1% allocation, and none over 15%.

When I first started investing, I threw equal amounts of money at any idea that sounded good to me. This resulted in a long index-like list of stocks. As I learned basic valuation and ratios, the journey took a turn into creating a GARP, ratio-based fundamental index, so a number of these original positions were sold.

The idea was to create a weighted average "bottom line" that looked like the ideal stock. The problem was that it got me into stocks that only looked good at a specific moment in time. Over longer periods, this approach revealed businesses with truly crappy financials, and very lumpy or cyclical earnings. I finally got religion when the "Great Recession" reared it's ugly head, and I noticed that my "fundamental indexing" was adding the very same risk to my portfolio that I hoped this approach would minimize.

With my invested capital cut in half, I upped my education, and looked backwards 10 years for businesses with a moat, and historically consistent financial results. Survival instinct kicked in, and I pulled money out of busnisses with high debt and historically cyclical results, and put all of that money into businesses that I understood very well, like AAPL at $90. I weighted them not just on valuation, growth, and other factors, but on my ability to understand and monitor their prospects. I even drew up a weighted scoring system that looked like this:

30% Value to Growth: 1-5
25% Balance Sheet: 1-5
20% Consistency: 1-5
15% Moat Value: 1-5
10% Management: 1-5

Familiarity Multiplier 1-5

Actual scoring looked like this:

AAPL $90

30% Value to Growth 4
25% Balance Sheet 5
20% Consistency 5
15% Moat Value 4
10% Management 5

Familiarity Multiplier 5

4.55 x 5 = 22.75

Because of the Familiarity Multiplier, Apple scored higher than any other idea; I had owned it since 2006, my mother had owned it since 1999, and I had been using it's products since 1990. Subsequently, I allocated 10% of my portfolio by adding to Apple at 90$ and $120.

The somewhat mechanical nature of this scoring system belies the subjective, yet informed, choices that make up the inputs. To make choices, you need to have a clear image of every facet of your ideal business. You also need to study, to determine how the business you are analyzing compares to your ideal. Before my final tally, I'd often bump up my familiarity score, after all the studying I had engaged in. In bull markets or minor sell-offs, this scoring system is less important. In bear markets, when it's harder to make rational decisions, and every stock you own seems to be a toxic asset, it really shines.

One more thought on position size. It's one thing to size a position based on the percentage deployment of investable cash, but it's another to decide what you want an ongoing position size to look like after many of your stocks have moved. One idea is to let your winners run and to cut your losers. There is some value to this idea, but doesn't take into account the various complexities of this decision. This is why I have a 1% minimum allocation. If a stock drops far enough below 1% of my invested portfolio, I have to decide if I want to buy it or sell it. If I want to keep it, I will have to buy it back up to 1%, and this requires a fairly rigorous process. Three questions have to be answered;

1) Is it at or below fair value?
2) Is my thesis still intact?
3) Are there better opportunities inside or outside my portfolio?

If the stock passes, I buy it back up to at least a minimum position. If it fails, I reallocate to a better idea, but not to cash.

As for winning positions that have moved into overvalued territory, I tend to leave them alone unless I determine that they have developed a speculative premium. In this case, I estimate how much of the stock price is speculative overvaluation, and lop that percentage off my position. So let's say CMG is fairly valued at $150, but it trades for $250. Because CMG is a good company with bright prospects, I'm okay with some premium valuation up to $200, but not with a speculative valuation above $200. Since it trades at $250, I want to cut the $50 speculative premium off the price, or 20% of my total position. These proceeds will get rotated back into the portfolio at better value points.

Other than trimming speculative valuation off a position, I don't think it's wise to put limits on how large a percentage of my portfolio a stock can grow. If one of my stocks grows to be 95% of my portfolio, I'd be thrilled.

Investing within your circle of competence and weighting your ideas based on your familiarity with a company or industry, may lead to a fair amount of industry concentration, which will occasionally lead to underperformance. It is my belief that these short-term blips will be outweighed by long-term outperformance, as long as you keep learning and building new circles of competence.

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