100 bagger sizing
They tend to be below $1b market cap - so when choosing your 20 assets to hold, don’t buy assets >$5b market cap as a rule of thumb
How to do Portfolio Sizing (f)
f = edge/odds
Edge = Expected value
(Odds * probability of winning) – (Amount lost per bet * probability of losing)Odds = Expected return if you are right
Example
In general, let’s say you have a 10% chance of being right on a 10x multibagger
Odds = 10x = (10 - 1) = 9
Edge = 10% * 10 - 90% * 0.5 = 0.55
f = 0.45 / 9 = 5%
It’s better to do half Kelly portfolio bets - because it drastically reduces volatility without sacrificing much returns
In conclusion,
No more than 12.5% in any stock, no matter how confident
5-12% is a fair allocation (which gives you somewhere between 8 to 20 asset holdings)
Buying a great business at a fair price vs a good business at a cheap price
“Over the long term, it is hard for a stock to earn more than the actual business performance. Hence, if the business performance is only growing at 6% per year, that is what you should expect on your investment performance, even if you buy it at a good discount to fair value. On the contrary, if you find a business that can earn ROIC or grow earnings at 18-20% over 20-30 years, even if you pay an expensive looking price, you will end up with a fine result.” - Charlie Munger
One way to look at this is to use the PEG Ratio. Anything too far above 1x is too expensive and must have a good justification why you are buying it.
PEG Ratio = P/E / EPS Growth %
Business Quality: Gross profit margin vs Operating Margins
It is more important that a company has strong and sticky gross margins - it is easier to fix lower operating margins as once it scales, it is easier to find efficiencies to trim SG&A that small companies cannot
Every $1 growth in sale, how much did the company have to pay for this $1 in sales growth!!! If it is growing sales through cutting its price down and eroding margins, this is terrible.
Keep in mind that SBC falls under SG&A and R&D which are hidden cost that don’t show in FCF. Always check how dilutive the management are to shareholders as these cannot be shown from Gross Profit Margins alone….
When to sell?
When ROE can no longer sustain above 15% due to declining business excellence. Give it time to fail though - if it’s still wrong after 3-5 years then sell
When valuation gets stupid such that it is already priced as a 100 bagger based on current multiple vs terminal multiple. eg. 1000 P/E vs 10 P/E