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(All props first to Salt-n-Pepa).

In early-Feb, I published my first write-up on Richland Resources (RLD:LN), flagging an Upside Potential of 137%. Three weeks later, I was looking at a 65% gain on the share price. This presented an interesting dilemma (would that we could all enjoy more of these..!). But it seemed strange to be contemplating a sale so soon after diving in. Aren’t I a long-term holder, like most value investors..?! Well, ideally…but I use price, technicals and risk management to scale in and out of my positions.

For example, picture a GBP 100p stock I recommend/hold, and which I believe has a 125% Upside Potential. Sweet! With this kind of upside, I might have something like a 5% portfolio allocation. Shortly after, the stock shoots up 75%so what do I do?! Well, in value investing world this is entirely expected (value will out, etc…) and I should definitely just sit tight. And sure I’ve got another 50% of value to realize…buy and hold, baby! Of course, in the real world, the answer may be a little different…

In the market, there are always buyers and sellers with v different objectives and/or perspectives. If a stock jumps so quickly you’re almost bound to see some (significant) consolidation and/or retracement after. Also, I don’t have another 50% upside to go in the stock, I’ve only got another 29%sorry, I’m sure you noticed that, but you get my point..?! My portfolio allocation’s also blown out to something like 8.4% (depending on relative portfolio performance).

Think about it, do I really want 8% of my portfolio in a stock with a much reduced upside of 29%? Especially when I think profit-takers are just about to strike after its recent/welcome rally? (Remember, lots of people appear to have absolutely NO idea of fair value when they buy/sell a stock!) Absolutely not, it’s far too risky, and I’m sure I can re-allocate to other stocks with much better potential upside. In some cases, I might cut back to my original % allocation – in this particular example (with 29% upside remaining), I’d likely cut back a lot more aggressively.

Oh God, this sounds something like ‘when a stock doubles, sell half‘’ – it’s not meant to be! Too many investors, and commentators, have an unhealthy focus on their entry prices. I actually try my best to ignore these… After all, the market doesn’t give a flying f**k what your entry price was! I prefer to focus instead on looking at all my positions afresh every day/week, and asking what % holding (if any) should I now own based on the company’s business/financial risk, its share price action, its potential fair value upside, the changing micro and macro risk environment, and the relative value of other holdings/buy list stocks.

Obviously, most of the time my conclusion is ‘no change’, but then a gradual/sudden shift in my overall macro/risk view, and/or my micro view on the stock and its price, will prompt a (sometimes significant) change in my portfolio allocation.

You’ll notice I’m not shy about throwing out v specific price targets on stocks. This is essential to my own investing approach, and I see no reason not to share these targets, and my % portfolio allocation, with readers. In fact, while a good stock write-up’s always interesting and informative, I think a price target and % allocation are often the most informative (and revealing) facts a writer can tell a reader. But how often do I expect to buy, hold and then sell at my price target, thereby realizing the upside potential I’ve originally identified?

Well, the risk approach I describe above has some important implications. It’s certainly not as clean and simple as the ideal value investing model would suggest. First, I generally layer into positions. I also don’t like to increase a position on the back of a falling price, unless I’ve some fresh news/info to reinforce my view. This implies my average entry price is usually higher than, or at best equal to, my original buy-in price. Then, if a share price is consistently rising, in due course I’ll progressively sell down my position. This addresses those two key risks you face as the price takes off: i) an increasing portfolio allocation, and ii) a decreasing upside potential.

I won’t necessarily have sold off a stock completely if it reaches my fair value target. After all, the more excitable message boarders might finally be getting interested in the stock at that point..! This can sometimes offer substantial additional gains, as long as you’re monitoring price risk closely, but overall I’ll admit my risk approach can limit/reduce the gains I can extract from successful stock picks. Often, only a core portion of my position in a successful stock has a chance to realize anything like my full upside potential.

Oddly enough, this sometimes leads me to wish for slow & steady price appreciation in my favourite stocks. What?! Who on earth doesn’t want to see their stocks shoot higher?! Well, we can all dream (and babble about it on message boards…), but when you become an experienced investor realism tends to set in… The beauty of a slow and steady performer is the chance to compound at excellent long term returns with a stock you know well. It also offers a chance to regularly add to your position, on an opportunistic basis, based upon a regularly increasing price target (as newsflow/results prompt you to re-evaluate and upgrade the stock).

So, why the hell would I stick with an approach that promises to reduce my potential gains?! It all comes down to risk management, of course. I believe that continually re-allocating your portfolio towards your highest potential/lowest risk stocks, and away from stock stakes that have grown too large and/or offer a much-reduced upside potential, actually reduces risk and improves your overall return.

Sounds like classic value investing, really – but there’s an important distinction to make here. Yes, a value investing approach is an excellent way to identify and value good stock opportunities but can sometimes hurt you from a risk management perspective. You need to adopt a trader’s mind-set (plus some technical analysis) to properly manage and to scale in/out of your stock positions.

To sum up:   My risk management approach does limit my gains but, much more importantly, this is more than paid for by a reduction, or even an elimination, in my significant portfolio losses.

 

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