I was recently reading through some old investor interviews from the excellent Graham and Doddsville newsletter from Columbia Business School, and I came across an interview from Glenn Greenberg of Brave Warrior (formerly Chieftain Capital). A couple years ago I commented on a talk that Glenn Greenberg did at Columbia, where he discussed his investment approach. My own investment approach tends to fall in line with Greenberg’s investment philosophy as well as his portfolio management approach. Despite a few misses here and there (notably Greenberg’s investment in Valeant, a company I discussed last year in this post), his overall performance has been outstanding over the past 3 decades.

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Photo by skys the limit2
Photo by skys the limit2

But putting Greenberg’s individual investment ideas aside, I’ve always like his general approach, specifically the following two points:

  • Focus on the quality businesses (he lived through the stock market crash of 1987, where the market tumbled over 20% in one day, and he wanted to ensure that if that ever happened again, he would feel comfortable with the businesses he owned)
  • Position Sizing: If it’s not worth putting 5% of your portfolio in the stock, then it’s probably either too risky, outside your circle of competence, or doesn’t have enough upside

Focus on the Quality Businesses

Greenberg lived through the stock market crash of 1987, where the market tumbled over 20% in one day. He wanted to make sure that if/when that type of crash ever happened again, he’d be perfectly comfortable owning the businesses in his portfolio. In other words, he thought of his stocks as businesses that he owned for the long-term, and looked for durable companies that could withstand a variety of economic downturns, macro shocks, and stock market crashes.

I’ve talked about how I’ve moved away from long, specific checklists (not that I’m against them, but I prefer simple, more general checklists. This frees me up to think about each individual business and all of its own unique nuances and set of risk factors, competitive dynamics, etc…). But despite not having a 100 point checklist for each stock I look at, I do have a few general tenets that I think about with all of my investments. One of these tenets is very simple: I ask myself if I’d feel comfortable with this company if the stock dropped 50% due to either a market crash or an economic downturn.

In other words, a recession can cause many businesses permanent damage that they often cannot recover from (some go out of business, others are forced to restructure in bankruptcy). I consider these types of events (bear markets, macroeconomic crises, recessions) to be a completely normal and a regular occurring part of the business cycle, yet I also consider them to be completely unpredictable. I know with certainty that they are going to happen; I just don’t have any idea when they are going to happen. So I want to own stock in durable companies that can withstand these inevitable economic headwinds.

Position Sizing

Another key “general checklist item” is another question to reflect on: Would you be willing to put 5% of your portfolio (minimum) into this investment? If not, then there usually is a higher than ideal amount of risk associated with the investment, or you just don’t know the investment as well as you should.

Some investors will say that there is always a place for small investments (1-3% “bets” that will return multiples of the initial investment if they work out well, but will suffer large losses if they don’t work out, possibly even going to $0).

The math of these long-shot bets can be configured to be very compelling. A “bet” that pays 10 to 1 with 25% odds of success should be taken every time. The problem with these types of bets is that assigning probabilities (and payoffs) with any sort of precision is extremely hard—much more difficult and error-prone than most investors realize in my opinion. I see a lot of write-ups that seem to slap arbitrary probabilities to justify the long-shot investment, but when I do the math on some of these, the investment looks like a bad bet if the probability of success goes from say 25% to 10%. While I think I’m good at judging which “bets” are high probability vs. low probability, I don’t seem to be very good at being able to accurately pinpoint whether a low probability event has a 25% chance of success or a 10% chance of success, and sometimes that is the difference between a great bet and a terrible bet. I think many people overestimate the odds of success and/or the payoff potential on these types of ideas in order to improve their estimate of the expectancy of the investment and to justify buying the stock.

There are some investors who succeed at placing these long-shot, low-probability but high-payoff bets. But I think the vast majority of investors who attempt these types of investments are overestimating the potential of these ideas. And for me, I’m just more comfortable focusing on higher probability ideas, thinking of my investments as long-term stakes in real operating businesses rather than chips at the poker table.

I’ve found that most of my mistakes tend to be with smaller positions—stocks of companies that I knew weren’t good businesses but I was more attracted to the security, the special situation, or the opportunity to make sizable gains relative to the amount I was risking. These long-shot investments by definition fail more often than they succeed, but I think even when they work, they work out in both lower frequency (the probability is lower than expected) and lower severity (they don’t have as much upside as people initially expected).

The 5% rule forces you to think about the business the way an owner would think. I try to think about each individual stock investment as if it were a private business that I was buying a minority stake in and couldn’t sell for a period of time. Of course, the stock market allows us to sell our position whenever we’d like, but I’d rather take advantage of this liquidity than have it take advantage of me. By imagining that you are buying into the business and partnering with management, you are forced to think more about things that impact the competitive position of the business and the long-term value of the enterprise, and less about things that will impact the short-term nature of the stock price.

I think both of these “rules” are worth considering:

  • Ask yourself if you’d be okay holding (owning) this stock during an economic or stock market collapse.
  • Ask yourself if you’d be okay investing a minimum of 5% of your capital in the stock.

I think staying focused on the durable businesses that you are willing to put 5% of your capital into is an initial hurdle that will certainly limit some of the investments you can make (and thereby possibly limit certain profitable opportunities), but I think more importantly, this general rule of thumb will help reduce many mistakes and focus your attention on the high-probability (and usually higher quality) investment opportunities.

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John Huber

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