My investing framework

Goals, Philosophy, Stock Analysis, Portfolio Management

I’ve decided to summarize my investing approach so that you can see what to expect from this newsletter and as a reference for “future” me.

Goals and Philosophy

In general, I follow the value investing approach. I define it as buying companies with a substantial margin of safety - where the price is much lower than the intrinsic value of the company. Big margin of safety (and by definition - lower price) helps me achieve two main goals:

1. Reduce the risk of losing capital, which is my biggest priority

2. Increase potential returns

There are three important points which shape my investment philosophy:

1. Equity investments are always highly volatile in the short-term. Historically, stock market had a correction (10%+ loss) once every 2 years, a bear market - every 4-6 years (20%+) and a crash (30%+) - every 7-10 years. So, it’s possible that my portfolio will also have periods of negative returns. During such periods, it’s very important to keep a cool head and continue investing, because corrections and crashes often create great investment opportunities.

2. On the other hand, in the long-term equity becomes the best investment vehicle thanks to its unlimited upside and limited downside - the stock can go up 5x, 10x, 100x or more, but can lose only 100%.

3. I share the opinion of prominent value investors (Warren Buffet, Charlie Munger, Howard Marks, Peter Lynch, and others) that it’s impossible to predict macroeconomic conditions and therefore not possible to time the market. Although, I will obviously try to position the portfolio so that it performs well under different scenarios.

4. Why do I believe that I can do better than a passive equity index fund?

   • Market is often short-sighted - looking only a few quarters in the future

   • Market periodically hates certain industries or companies and considerably dumps their prices

   • Passive investing makes markets less rational (disproportionate investments in the biggest and most well-known companies) and it became really crowded in the last 20 years

   • Professional money managers (who run institutional funds, like pension funds) have a lot of legal rules and social constraints and often do not have adequate incentives, which also makes markets less rational

Stock analysis process

I am not too rigid in my definition of the value investing and I don’t restrict myself to a certain category of investments, because I believe such inflexibility could only harm investing results. Many great value investors (including Warren Buffet) changed their investment style over time and/or had multiple categories of investments (e.g. Peter Lynch had 6 categories). I also think that specifics of my approach will evolve and change over time.

Therefore, I do not put any explicit restrictions on size, geography, industry or type of the company. Although, there are a few important factors which I look at (besides margin of safety), when I search for a potential investment:

• If I don't understand a company, I don’t own it.

• Minimum quality hurdle: company is profitable, generates free cash flows, has little debt, shows some organic growth and has some competitive advantage (moat)

• Company’s managers are honest and good capital allocators

• Estimated annual return of investment should be higher than 12-15% (the higher the quality of the company, the lower the hurdle rate)

• Ideally, I search for investment theses which should take 12-24 months to play out

I use various sources to search for ideas:

• Quantitative Screens

• Portfolios of value-oriented hedge funds

• Publications of fellow value investors

• Occasional ideas from news, social media, etc.

Here I have written about my stock analysis process in greater detail.

Portfolio Management

I buy common or preferred stock of companies. Occasionally, I may use covered call writing to improve returns, if I expect a certain price in the future, and therefore believe that upside is limited. I do not intend to buy corporate bonds, warrants or any other investment vehicles.

I believe that position sizing is very important to limit the risk of capital loss due to my own mistakes or some unforeseeable events. Therefore, I have a few rules in place:

• The full normal position is 5% on a cost basis, and can be maximum up to 7.5% if I see some great potential

• I do not buy in full position immediately, but rather in chunks of 1-2%

• If position becomes bigger due to the natural price appreciation, I let it grow → “let your winners run”

These rules mean that I normally have 10-20 stocks in the portfolio.

I do not have any other explicit diversification rules, but I expect that due to the bottom-up approach the portfolio will be well diversified across sizes, geographies, industries and types.

I sell a stock, if:

• Market revalues a company according to my expectations

• The story does not play out as expected (e.g. quality deteriorates, management makes wrong decisions, etc.)

• I’ve made a mistake (missed something)

• Better opportunity is found

Since I do not expect any material external cash inflows to the portfolio in the near future (except if I receive dividends within the portfolio), I will keep certain amount of cash available in case some extraordinary opportunity arises. In the meantime, this cash will be invested in money market funds.

I may use some hedging techniques, if I find the price acceptable (e.g. put options or some precious metals).