Divestor

Today’s trade execution report from Interactive Brokers showed that I bought 3 shares of a company, and since the share price is in the single digits, at this rate of accumulation I will more likely die of old age than getting my desired allocation level. The slap in the face is that the stock closed at around 3.7% above that level. My total portfolio allocation in this particular stock is currently 1% and my sense of the tape suggests that somebody else is out there very slowly gobbling up shares as well as myself, while the sellers are just dumping them with market orders here and there. This probably means the stock price has bottomed out for now.

Since the stock is relatively thinly traded (daily average volume is around $100,000 traded), I have an algorithm running that breaks my order into relatively small pieces. A market order to get my desired allocation would be suicidally inefficient – I’d probably spike the stock price a good 20% by doing so, which requires breaking down the order and being patient. As each piece is sold into, the price of the order declines by about two percent immediately, but over the course of a day, the bid price notches up slightly every time increment. This is incredibly easy to do in Interactive Brokers and is the simplest type of algorithm to employ when not dealing with million dollar trade sizes. It saves so much money on trade execution it is unbelievable.

The market is going through its usual manic cycles, with Greece voters purportedly saving the EU by voting in a pro-austerity government (which will kick the can further down 6 months), today’s downturn revolved around the release of not-so-good economic data and Moody’s downgrading various major financial institutions. I also note that the EU’s problems are nowhere close to being solved, with Spain and eventually Italy should be on the debt crosshairs unless if they can get their fiscal act together (quickly).

I note that the S&P 500 volatility index is still hovering around 20%, which is not exactly a big sign of panic.

My focus has been far away from the broad markets and on lesser capitalized issues (anything less than $1 billion and preferably under $500 million). I have also been purposefully avoiding anything commodity-related since it is fairly evident that most of the sentiment out there is still relatively bullish even though the charts have been indicating otherwise. I’m not too heavily into technical analysis, but clearly something is going on with WTIC crude oil being pushed below US$80. Measuring sentiment and expectation is about as good as reading tea leaves or the horoscope, but the tea leaves that I read still indicate that sentiment for oil is still high. When I start seeing analysts and news commentators shunning oil because of huge supply gluts and expanded production, that’s when I will start getting interested again.

Ironically this is what natural gas producers have had to face and I would be more inclined toward natural gas than crude oil at present. Encana (TSX: ECA) would be the prototypical large cap stock that a buy-and-hold-and-forget type investor would probably do okay with, but again, it depends on whether there will be this purported recovery in gas prices since Encana has been living off of its hedges.

I’ve taken the opportunity to put more capital to work and am hoping for more funds liquidating these smaller capitalized companies since the underlying companies will make for a better risk/reward ratio.

Finally, I’ve been trying to look over companies with high insider purchasing or high management ownership of shares (but not companies with dual-class voting shares where they maintain voting control but not economic control) and have been trying to sort through a stack of them, both in the USA and Canadian markets. I quickly scanned the Canadian debenture market and really didn’t like anything there – most of the energy-related companies continue to trade as if there is nothing wrong. As a result, I am not that interested in that asset class at present.

I do have one company that is outside my normal screens (is larger than $1 billion market cap, gives out a healthy dividend, is majority-owned by another entity) that I have been accumulating a stake, but there is a fairly good reason why I believe the market is significantly mispricing the company (i.e. factoring in more risk than actually exists) and why I think the market is materially incorrect. I am purchasing shares at a level that I think is about 30% under what my fair value is for the firm. My estimated “floor price” for the company, however, is quite close to current trading levels, so the risk/reward ratio is fairly handsome at present – risking around 10-15% for a potential gain of 50% is a decent ratio, especially since the probability of the positive side occurring is better than 50/50.

This post is still relatively abstract since I don’t really want to give away too much of my research.

The government announced today some changes to the minimum criteria required in order for mortgage insurance to be offered on housing. The details are here.

This is fourth in a series of changes that the government has taken (the others being in October 2008, February 2010 and January 2011).

The more stringent requirement for retail people on the street will be the amortization requirement – from 30 years to 25 years. Plugging some sample numbers on a calculator, using a 3.00% rate, a 25-year amortization requires $473.25 in monthly payments per $100,000 mortgaged. A 30-year amortization would require $420.60 in monthly payments per $100,000 mortgaged, or about a 12.5% increase in the monthly outlay between 30 years and 25 years.

More relevantly for mortgage insurance, after a 5-year fixed period, at a 25-year amortization, approximately 14.5% of the loan would be paid off. At a 30-year amortization, about 11.1% of the mortgage is paid off. Presumably this would significantly reduce the risk of mortgage default after the typical 5-year fixed term.

Notably, the minimum down payment for a new owner-occupied residential purchase in Canada that will still qualify for mortgage insurance is still 5%. As a result, a residence purchased at 5% down, with a 3%, 5-year fixed mortgage at 25 year amortization will have about 18.8% amortized at the end of the 5-year term.

The tightening of mortgage credit will undoubtedly have a marginal economic effect of taking out higher-risk clients out of the housing market, which will have a marginal suppression on housing prices. I do not believe this will have a strong effect – that will be reserved for an increase in interest rates.

The question of how large a position to take in various securities has generated a lot of literature in financial academia. I won’t bother repeating it here, but specifically, the analysis deals with how to mitigate systemic and non-systemic risk, and diversification is one method to reducing non-systemic risk.

The concept is pretty simple – if all your eggs are in one basket, if you drop that basket then you are hooped. But if you have two baskets then you at least still have half your eggs left in case if you trip.

I noted on Gannon on Investing (somebody that writes very well and comes from a similar background as mine in Finance, mainly through self-teaching) that he believes in big concentration. Specifically, he wrote the following:

My Most Controversial Investing Belief: Extreme Concentration Works

I buy very few stocks. Again, this comes from personal experience. By far, the worst losses to my portfolio came in years where I held the most stocks. The best performance came from 25% or bigger positions in my portfolio that I chose to hold longer term.

I’ve made a lot of money by:

Sticking around for the buyout
And having more than 25% of my portfolio in the stock when that buyout came

Today, I would never buy a stock that makes up less than 10% of my portfolio. I prefer not to start a new position unless it is expected to eventually be 25% of my portfolio. I am not interested in owning more than 5 stocks at a time. I’ve done it – like with Japanese net-nets. I may do it again in similar basket type situations. But I’m a lot less likely to. So, basically I own 4-5 Warren Buffett type stocks (in terms of competitive position) bought at Ben Graham type P/E ratios.

Right now, I’m looking for a European stock to put 25% of my portfolio into. It won’t be 5 European stocks at 5% each. It’ll be one at 25%.

I will distill this principle in another manner: an individual investor can only spend so much time researching securities. Very frequently this process can be as laborious as going through a hundred companies and then throwing all of them on the watchlist and not do anything because they are trading at incorrect valuations. When you do finally have a “hit” that reaches your hurdle rate with an appropriate margin of error, why should you take something that you’ve deemed to have a good risk-reward ratio and dilute your own investment research with a small position size? Good opportunities don’t come often, so why not pounce on it with two feet when they occur?

Personally, my own position sizes are determined by my own perception of risk and a slight modification of the Kelly Criterion. If the risk is high (which would require the reward component to be extraordinarily high), then you keep your bet size small. If the risk is low, then you can afford to concentrate without incurring a blow-up. Probably the best example in my own investment history was putting a large position on Rogers Sugar (TSX: RSI) back during the middle of the economic crisis. It was a classic example of a low risk, medium reward type situation where you can afford to put capital to work.

Ultimately estimating the risk is quite an art because you also have to factor in risk that you never would have conceived of. For all publicly traded companies, such risks include management fraud, accounting misstatements, an earthquake ripping through the corporate headquarters, a plane crash with the executives on board, etc. This alone is probably a good enough reason why I wouldn’t go far above a 20% position size.

That said, if that starting 20% position doubled in your portfolio, it would become 33% of your portfolio. Learning how to pare concentrated positions that have grown due to appreciation is a skill. While I have tended to have decent skills on my entries, I still haven’t mastered the art of selling profitable positions – I typically am one to leave the party early.

Finally, the academic rules concerning position sizes tends to revolve around the management of large portfolios rather than individual investors applying their niches on the markets. The rules of diversification change when running a billion dollar hedge fund versus a relatively smaller portfolio.

Given the high amount of cash in my portfolio, it is always tempting to allocate more cash than usual into new positions, but that is a sure-fire way of losing money.