This week, I had the pleasure of attending Three Part Advisors’ Midwest IDEAS Conference, highlighting promising small- and micro-cap companies that are often overlooked by research analysts at bulge bracket investment firms and brokerages. During lunch on the first day of the conference, three seasoned small cap investors joined in for a panel discussion highlighting some of their favorite investment ideas and detailing some of the lessons they had learned about investing through the years.

During the question and answer period, your correspondent asked a question about position sizing: “How do you think about position sizing and when to add to or reduce your allocation to a particular investment idea?”

Each of the portfolio managers mentioned the importance of starting with a relatively small initial position. Remember that the panel was comprised of small cap managers, and smaller companies usually have greater “valuation risk” because the results of their operations are often volatile and difficult to predict. As such, taking a relatively small position – 1% to 2% of the overall portfolio at first – is a good way to mitigate the risk of substantial capital loss due to a valuation surprise. Note that Warren Buffett tends to allocate much larger proportions of his portfolio to individual investment ideas, but the underlying reason for his more concentrated positions is tied to the concept of valuation risk as well. According to research by academics working for the large hedge fund AQR, Buffett’s investing success relies upon his selection of low valuation-uncertainty stocks (they use the finance term of “low Beta”) coupled with his use of investment leverage in his portfolio. In other words, whereas a small cap manager must mitigate valuation risk through position sizing, Buffett mitigates valuation risk through stock selection.

In addition to this gem about position sizing, one of the panelists – Elizabeth Lilly, CFA, formerly a portfolio manager for one of Mario Gabelli’s funds and now the manager of a new fund specializing in small- and micro-cap opportunities, Crocus Hill Partners – made a comment that I thought was particularly insightful and important. Ms. Lilly’s early years in the investment industry were reportedly influenced by her job working for Jack Byrne, one of Buffett’s close associate from his college days at Columbia. She fondly recalls barbecuing hamburgers and drinking Cherry Coke with Buffett and listening to his thoughts on value investing while working for Byrne in Connecticut.

Elizabeth Lilly, CFA

Ms. Lilly mentioned that after her initial small investment in a company, she would monitor the operational results of the company and decide whether to increase, decrease, or close her position depending on how closely those results matched with her expectations and managements’ plans. As long as the company was doing what its managers said it would do and the operational results were in line with Lilly’s projections, she would consider increasing the size of the investment allocation to that company as long as the company was still trading for less than its intrinsic value.

While Lilly’s may seem like a straightforward approach, it is, in fact, revolutionary.

Many investors, professional ones included, focus on the price of a stock in which they are invested, rather than on the value the company is creating for its shareholders. A laser-like focus on the operational measures that drive value – revenue growth, profitability, reinvestment level, and the likely outcome of the company’s investments – is, in my opinion, the only way to generate market-beating investment returns over the long run.

However, focusing on operational performance and on the value that performance drives is easier said than done when the stock price is moving against you, or even when your investment’s price is stable but the rest of the market is rising. Human decision makers are born with ingrained behavioral biases that influence us to follow crowds, pay most attention to the last bit of information we heard, and to make decisions based on “feel” rather than reason. These ingrained facets of our personality helped our ancestors to survive and thrive on the African welt, but have been shown time and time again to be detrimental to modern investors trying to take in and assess the importance of investing data.

Cats chasing laser pointers presumably have fun doing it, but at the end of the day, they are always left empty-handed. The same thing can be said for investors caught up in whatever speculative frenzy is popular this month.

Good value investing is at once very easy and very difficult. It is easy in that all one needs to focus on are the cash flows a company will create for its owners over its economic life. It is hard in that focusing on cash flows in the face of a deluge of the noise created by intermediaries in the capital markets (all of whom have a vested interest in your listening to them and taking action based on their advice) requires a strong framework for making decisions and the discipline to see those decisions through.

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