As a fund manager many people ask me to share the secret about how professional investor size up their portfolio. I thought let us not keep this secret anymore and share with you on how we size stocks in our portfolio. Finding great investment idea is only part of the battle in investing. In this first part of this series we will discuss about how we process and approach sizing of our position.

The most important part in this activity is to know what the intrinsic value spectrum of company is. What price its shares are trading in the stock market and where are they placed in the valuation spectrum. Many commentators, brokers and even investment managers will quote target price or value of the stock. But this information is insufficient. We think investors should view the worth of business as a range of value and see where the stock price is currently trading within that spectrum to take decision on its sizing.

Let me give you real example, we believe Kitex Garments is fantastic business to own. It is in our wish list today and will explain why we haven’t bought them. Its share price today are trading around Rs 480. We think most it is worth for Rs 468 per share on its 2017 valuation spectrum. Which is 2.5% below current market price. Kitex Garment is expensive in our opinion and is trading outside our 2017 intrinsic value spectrum. Of course the future is always uncertain and unpredictable and valuation is imprecise science. So there is a good chance that Kitex Garments may be worth less than Rs 468 per share or even more than Rs 468.

There is also chance of things turn out worse than what we expect. In which case shares of Kitex might be worth least of Rs 317, below 34% of its current price. And if the future is brighter than we could expect its intrinsic value to climb to Rs 565 (2018 valuations), 18% above its current price. On balance Kitex Garments shares look expensive today and we might just wait to allocate any sensible size or just take 1% of our portfolio position or 10% of maximum mandated position of 10% of our fund(Why we have allocated 1% of our portfolio will be explained in part 2 of this series).

Now the interesting part is what actions we will take with its price movement. If Kitex Garments share price fell, all else equal we would look to increase our position size, and conversely if Kitex Garments share price appreciate we would look to decrease our position size. Let me explain this again with example.

If Kitex Garments shares price fell to say Rs 400, our base case valuations will remain unchanged at Rs 468, but this represents about 17% upside. Similarly the upside valuations of 2018 remains unchanged to Rs 565 represents 41% of upside. Clearly we stand to gain more by buying more at Rs 400 then at Rs 480 per share. Our upside potential is higher then what it is today. But this is only the half story said. At lower share price of our valuation of Rs 317 is still 21%. But if we buy them at Rs 375 then our upside is 25% and our downside risk is only 16%. Greater upside and lower downside means a better bargain and justifies a bigger position. We may increase our portfolio weighting of Kitex Garments to 5% if its share price falls down to Rs 375. As lower its share price keeps falling down we would keep increasing our allocation to our maximum limit of 10% when it reaches to Rs 317. In this example there will be no risk of downside if it reaches to Rs 317.

Conversely, Kitex Garments share price today are above our 2017 intrinsic value spectrum and there is a big risk for share price to fall down from these levels. The upside available to investors is lower and downside risk is higher, so smaller or no position (keeping the stock in watchlist) would be appreciated. And today if it climbs to Rs 565, then we will reduce our position to zero.

For us stock value spectrum plays critical role in assessment of position sizing. In our next part of this series we will look at how conviction or confidence in our investment ideas help with position sizing.

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Aziz Dodhiya is the chief investment officer for the Valueoperations funds which operates in the Indian market as an FPI (Foreign Portfolio Investor). We do not offer any personal advice to buy or sell any stocks and the views that are shared by Aziz might not incline to your personal investment strategy and this is the reason we advise you to take professional advice before going ahead with our views.