Thoughts on Risk Management and a Strong Sell Discipline

As portfolio managers, we are often asked how we think about risk management at both the portfolio level and the individual stock level. From a bottom-up stock analysis standpoint, we believe the way we view risk is quite different than most investors.

People tend to buy a stock and say, “If everything goes right, this is how much we could make.” We tend to look at companies and say, “If everything goes wrong, how much could we lose?” Assessing downside risk is always at the core of our analyses. We will not purchase a name unless we feel the upside versus the downside has a ratio of at least 2 to 1. Obviously, these are moving targets and we’re constantly evaluating our companies, but we spend a lot of time looking at what the potential downside is, and we don’t tend to buy companies where we feel like the downside risk is greater than 20 or 25%.

Chain link

At the portfolio level, we also tend to spend a lot of time on position sizing. In our long only portfolios, we typically own 50 - 75 positions (along with a small number of fixed-income securities).  We tend to own many positions that we like as opposed to owning very substantial positions in a smaller number of stocks.

Sell Discipline

When it comes to exiting a position, we do not have hard and fast price targets. There could be a number of different reasons for a sale. The best reason to sell would be that the name gets “crowded out for a better idea.”

A second reason we might sell a position is related to our constant analysis of the upside in a given name. Our return targets are roughly three years, 50%, and five years, 100%, essentially triggering a low-teens type rate of return on an annual basis. If we evaluate a company and the returns start to fall below these targets, we will begin to trim the position, and then over time we will exit the position entirely if the prospective rate of return is not high enough.

When we are evaluating companies, we’re looking at them from a few different aspects: on an industry basis, a private market value basis and a free cash flow yield basis. If the investment no longer meets those thresholds, we will begin to sell the position or to exit entirely.

Another reason could be a tax loss. If we have a company where we’ve been wrong and we’ve lost money on it, and there is an opportunity to increase our position in another company that is similarly valued and in a similar industry, we could sell the name taking a tax loss and add to the position where we do not have a loss. We would then reevaluate at a later point down the road as to whether we would repurchase. Aggressively harvesting tax losses is something that we strive to do for our clients, as our overall goal is to maximize after tax risk adjusted returns.

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The views described herein do not constitute investment advice, are not a guarantee of future performance, and are not intended as an offer or solicitation with respect to the purchase or sale of any security. Investing involves risk, including loss of principal. Investors should consider the investment objective, risks, charges and expenses of a Fund carefully before investing. Please review the offering memorandum or prospectus of a Fund for a complete discussion of the Fund’s risks which include, but are not limited to: possible loss of principal amount invested; stock market risk; value risk; interest rate risk; income risk; credit risk; foreign securities risk; currency risk and derivatives risk.

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