## March 27, 2006

### portfolio construction - Size of a bet

My earlier tendency when adding a stock to my portfolio was to allocate an arbitrary amount of money to it. The actual bet or the size of the position was initially a fixed amount of money and later it became a fixed percentage of the portfolio (around 5 % usually).

However later I read several articles and charlie munger’s thoughts on investing and have modified my approach. After I have identifed a stock and am willing to commit money to it, I try to evaluate how confident I am about the stock. I try to quantify this confidence level in terms of the margin of safety, which is the discount at which the stock is selling from the intrinsic value of the stock. So if the intrinsic value of the stock (as calculated by me) is 100, and if the stock is selling at 60, then the discount is 40%. So higher the discount or margin of safety, higher my confidence.

In addition, I try to calculate the odds on the stock too. I use the following formulae to calculate the odds

Intrinsic value (under most optimisitic assumptions of growth, profit margins etc) – current price / (current price – intrinsic value (under most pessimistic conditions)

So my cut off in terms of odds is 3:1 and I typically look at stocks selling at a discount of 40% to intrinsic value. The above may seem to be very stringent criteria in terms of selecting stocks, especially under current market conditions. But this criteria has served me well, as I am able to build a huge margin of safety in my purchases. Ofcourse I am using the above criteria for my long term holdings.

My bet or size of the position is generally 2% or 5 % and a max of 10% if my level of confidence is very high. However I am not into portfolio balancing. So if my best idea has done well and is now say 20% of my portfolio and I think is still undervalued, I let it run and remain in the portfolio. The only time I would sell would be if the fundamentals of the company deteriorate or the company becomes highly over valued.

Side note : Just read that capital account convertibility may be introduced in india. That could have major implications for all of us as investors as it is possible that we may be allowed to invest out of india. I think currently we can do that with a limit of 25000 usd, but it is with restrictions. Lets see what kind of freedom the capital account convertibility brings in. I am however optimistic and excited about it.

Prasanth said...

Rohit,
How do you estimate the intrinsic value of a stock ? Do you use DCF method? If so, then what is the risk free rate that you use?

Regards,

Prasanth

Rohit said...

Prashanth

i use DCF for calculating intrinsic value. I acutally use DCF + a probability approach. Basically i create a DCF model for optimistic, pessimistic and current state scenario. Associate probability to each scenario and calculate the expected value (intrinsic value).

I used a hurdle rate instead of cost of capital. Earlier when the interest rates were high, my hurdle rate was 15% , which now i have reduced to 13%.

I have built the above in a valuation template. If you want one, i can mail it to you.

Anonymous said...

Hi Rohit,

I have read about the valuation template you are using for calulating intrincic value. I would be very happy if you could send me the template? At present I am struggling to find list of good stocks in the overheated market. My e mail id is pravinshah74@yahoo.co.in.

Thanks again.

Regards,
Pravin

Anonymous said...

HELLO CAN U TSEND ME HOW THW THE INTRINSIC VALUE IS CALCULATED MY E MAIL ADRESS IS KISHOR.DHUMAL@YAHOO.CO.IN

Vivek Nath said...

Dear Rohit,

Sent you an email on your indiatimes id. Please do find sometime and respond.

Regards,
Vivek Nath