Mental Models discussed in this podcast:
- Operational Leverage
- Risk Management
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Show Outline
Business Risks
- Stock specific
- Acceptable:
- Price – I’m willing to compromise on my price target of less than 10x earnings in recent days. Now I’m willing to accept up to 15x earnings per share for high-quality businesses
- Growth Rate Estimates – I’m willing to accept being wrong on my estimate of growth. I’m usually targeting businesses that grow revenue/earnings at double-digit rates. If my pricing is right, I can be wrong on my growth rate assumption and still do fine.
- Operational Leverage – I’m willing to bet on and be wrong about operating leverage
- Unacceptable:
- Balance Sheet Liquidity – I want a liquid cash-filling balance sheet
- Self Funded – I don’t want to buy a company that has to be funded by debt
- Bankruptcy Risk – No bankruptcy risk of any kind, which means I am unwilling to accept highly leveraged companies.
- Commodity Risk – I’m not willing to accept exposure to commodity prices.
Portfolio Risks
- Related to your overall strategy or investment portfolio
- Non-stock or business-specific
- Acceptable:
- Illiquid stocks – I’m willing to accept lower liquidity in my stocks than other investors. I’m willing to spend months building my positions instead of just days or hours.
- Concentration Risk – I’m willing to hold fewer stocks than other investors. (3-5 companies)
- Tracking Error Risk – I’m willing for my results to be dramatically different from the results of an index like the S&P 500 or the Russell 2000.
- Unacceptable:
- Unwilling to underperform inflation for long periods of time. (5-10+ years)
- Unwilling to underperform a 10% baseline absolute return over time
- Brings in decisions like how to address cash drag
- I have realized while preparing for this show that I don’t really know what my “unacceptable risks” should e on a portfolio-wide basis. So let me know what I’m missing. You can send me an email or DM me on Twitter.
Summary:
As an investor, the risks you take can be categorized as either business risks or portfolio risks. In order to earn a return, you must take some risks from each type. In other words, how are you willing to fail?
