“What on earth would I do if four bears came into my camp? Why, I would die of course. Literally shit myself lifeless.” — Bill Bryson
October 26, 2024
At the end of August, I found myself 24 miles deep into a Grand Canyon hike, climbing the North Rim, just about out of water, the summer sun beating down, an immediate return hike to the South Rim waiting for me at the top, and thinking…This hike is a lot like investing. Yes, it’s possible I was mildly hallucinating.
I don’t keep a formal bucket list, but this hike was about as buckety as they come. The goal was to hike from the South to the North Rim and back again all in the same day. It’s known as the Rim-to-Rim-to-Rim hike, and my route would cover 49 miles with 10,000 feet of climbing and descending. The trip had already been postponed twice due to a right and then left calf strain, so when a window opened in late August that worked with my schedule and my lower legs, I jumped on it.
The rewards were obvious — a beautiful day exploring parts of the Grand Canyon that few get to see as well as the satisfaction that comes from accomplishing a challenging goal. The risks were clear as well — I’m a flatlander with no particular climbing or descending skill, it would be 100+ degrees in the Canyon during the afternoon, I was going solo, there was a water line break in the Canyon so I’d have to depend on filtering water from creeks which I’d never done, there’s no cell coverage in the Canyon, and few other idiots hikers would be deep in the Canyon during the summer heat. On the flipside, I’m an experienced endurance runner, I’m a bit stubborn, I researched the hike extensively and was thoroughly familiar with the unanimous expert advice to not do this solo or during the summer, and I can scream like a startled howler monkey when necessary. Just like investing, it’s all about risk versus reward.
“Named must your fear be before banish it you can.” — Yoda, The Empire Strikes Back
This isn’t an Update about my hiking excursion, so suffice it to say that a rescue wasn’t needed, I had an amazing time, and I really did spend some moments that day comparing the risk/reward trade-off of the hike to investing. We’re all familiar with the investment concept that to earn higher investment returns we need to take more risk, but that larger risk also means a higher chance of very bad outcomes. We might make a fortune by investing our entire life savings in a promising Somalian sponge manufacturing startup, but there’s also a really REALLY good chance that we’ll lose our entire investment. Most of us would rather dial back the risk a bit and spread out our investments to limit a financial wipeout and avoid a third divorce, personal bankruptcy, and needing to sneak over the border as “Kentiago Bellnandez from Guatemala” to qualify for government bennies. Too soon?
[Disclosure: Aspera does not advise investing in Somalian sponge manufacturers…or Somalia…or any sponge-related company…or faking immigrant status.]
Most of my time is spent on research, looking for undervalued, unappreciated investment opportunities that have significant upside. Assessing and managing risk is a critical part of this process. There’s a risk that my analysis is wrong or incomplete. I’m immensely aware that there are plenty of intelligent investors out there with deep industry and company knowledge and
contacts and massive computing power. When we’re buying shares in a company, someone else is selling those same shares to us. Why are they selling at what I consider attractive levels? Do they know something I don’t? Is it the company CEO or CFO? Is it an outstanding hedge fund manager who just spoke to a competing CEO? Is it Nancy Pelosi, who never seems to make a bad trade? It very well might just be Jim Bob Smith Jr. who works as an auto mechanic and hit the wrong trade button, selling when he meant to buy. Regardless, I always assume that the seller is astute. This helps ensure that my research and reasoning are thorough and sound.
“I felt like a loser. I was unhappy as a child most of the time. We were terribly poor, and I hated my size.” — Don Knotts
Once an idea has been thoroughly vetted, the next issue is how much of it to own — position size. Of course, it can be very risky to take too large a position in any single risky investment (see sponge start-up above), but owning too little of an exceptional idea is also risky, in a sense. Incredible investment opportunities aren’t common, so we need to capitalize on them when we find them. I’m perfectly content not chasing high-flying stocks whose valuation, business, or financials I don’t understand thoroughly (cough cough…AI), but it irks me to no end to not own enough of an exceptional idea when I find one. Fortunately, I don’t make this mistake often.
As excited as I may be about an opportunity, the world is a dynamic, ever-changing place. I often say that if I’m right more than 60% of the time, we’ll do very well over time, but 60% < 100% [Trust me. I have an MBA in Analytical Finance.]. Of course, if I knew which ideas would fall in the “up to 40%” camp, I wouldn’t buy them in the first place! As excited as I may be about a stock, we could wake up to news that the CFO was indicted on fraud charges for embezzling funds from the firm’s Somalian sponge manufacturing venture. Uranium is still a key investment for us, but if there’s a reactor meltdown in China tomorrow...well, that wouldn’t be bullish. We could be upbeat on Argentina due to the policies enacted by President Milei, but if he’s overthrown in a military coup…we’d have less money to invest in those now depressed Somalian sponge manufacturer’s shares. I may be very bullish on an idea, but things don’t always go to plan. Size matters.
There is an art to picking position size, but it ultimately comes down to a balance between maximizing the return potential of the idea while limiting the damage if I’m wrong or the thesis changes, and that balance depends on individual risk tolerance. If I’m responsible for $1 million of your $50 million portfolio and the other $49 million is parked in Treasury bonds, you might be comfortable with me putting that $1 million in a single Permian Basin oil exploration stock since you’ll be perfectly fine, though perhaps a bit disappointed, if that stock goes to zero. If you’re retired, need your investments to fund your competitive duck herding hobby (really a thing), and I manage all of your retirement assets, then we’re going to be much more conservative. With a single company stock, I’ll typically limit our investment to 5% of an aggressive account and up to 3% of a conservative account. These are upper limits, and we usually start out with smaller positions that may build toward these levels. This allows us to benefit if I’m right on the idea while limiting any damage from “the up to 40%.”
Another key component of our risk management is not forcing investments. We don’t chase hot stocks or sectors just because they’re sexy, and we don’t diversify just for the sake of diversification. That diversification typically fails to protect when it’s really needed — during a serious market decline. We’ll take significant positions when we’re confident in a thesis and see the potential for significant upside and limited downside. Of course, the more of these ideas we find the better. Bargains abound near bear market lows when it’s easy to put together a diversified basket of great investments, but the stock market has been expensive for the last 15 years, and truly outstanding opportunities come along more infrequently in this environment. To the extent that there aren’t enough outstanding ideas to utilize all our cash, we’ll hold a higher amount of money market funds, CDs, and short-term Treasuries. Our “cash” allocation depends on the number of distinct opportunities we find which depends on the valuation levels of global markets.
“I was really a basket case. I admit that.” — John DeLorean
In recent years, most of our core investment ideas have been industry-based, particularly in uranium, precious metals, and oil/gas. Industry position sizes are larger than single company stock weightings, and there is once again a bit of art that goes into setting those limits. As with individual securities, aggressive accounts will have a higher industry target weighting than conservative accounts.
When we take an industry position, we manage risk somewhat by putting together a basket of multiple investments within the industry with the exact constitution of each basket dependent upon each client’s risk tolerance. For example, within the uranium space we can own a security that tracks the price of uranium, an ETF that tracks junior (smaller) uranium companies, and an ETF that tracks larger uranium equities, as well as a couple dozen individual uranium stocks of various sizes, potential, and riskiness. A small uranium exploration company with no revenue is riskier than a security that tracks the price of uranium or an ETF that holds more established uranium equities. Conservative accounts will be heavily weighted toward the uranium price tracking security and the larger, more established equities. Aggressive accounts will own those positions but will also have significant exposure to the more volatile juniors.
“In Brazil, we believe a lot in skill. We think it will decide matches and tournaments. Sometimes we forget the tactical side.” — Lucas Moura
An important way we augment return and manage risk is through our Core-Tactical approach. A core position is a significant investment that we’re likely to own for a year or longer. Our uranium, energy, and precious metals positions are core. We expect core positions to be strong performers over time, but we don’t expect a linear path higher. They could climb, languish for a bit, stage a large rally, pull back significantly, base, rally to new highs, drop back, and so on. Ideally, the chart would look like a mountain hike with higher peaks and valleys over time. We take advantage of the shorter-term rallies and pullbacks within the larger upward trend to augment returns.
We have target weightings for all of our core positions. For example, an aggressive account could be targeted to have 30% exposure to uranium. After a rally, this exposure may have grown to 40% from appreciation. That now larger position entails more risk exposure than we’d like, so we’ll tactically reduce that exposure back toward the targeted 30% by selectively selling some shares, often those that performed best during the rally. This instills discipline in taking some profits opportunistically while keeping risk exposure at appropriate levels.
Similarly, our exposure will drop following a pullback. Assuming our thesis is still intact and there aren’t better uses of our cash, we’ll opportunistically buy to boost exposure back to our target, often in the most beaten-up names. Essentially, our Core-Tactical strategy helps us to buy low and sell high. Over time, as prices climb toward our sell targets, we’ll reduce our core target exposure and eventually sell out of our entire position.
This tactical buying and selling, paring back after rallies and adding after pullbacks, accounts for most of the trading we do. The following two charts demonstrate how we’ve employed this strategy over the last few years. The first chart is of the URNM ETF which tracks the more established uranium stocks. This chart offers a good approximation of how uranium stocks have moved in recent years. The chart shows the periods in which we’ve tactically added shares of URNM and other uranium equities and when we’ve tactically reduced our exposure. We’ve done a good job of paring back our holdings after quick rallies and adding following sharp pullbacks. Although this is only a 3-year chart, you’d see the same pattern of buying and selling if we extended it back further. At current levels, we’re tactically neutral on our uranium holdings. You should expect to see some selling if we continue on to new highs or some buying again if shares drop 20% or more from here.
The second chart shows our tactical trading history for Agnico Eagle Mines (AEM), a long-time core gold holding. This is also representative of the trading we’ve done in some of our other precious metals holdings. Again, we’ve done a good job on the tactical side, maintaining appropriate risk while boosting performance over a static buy-and-hold strategy. We’ve had a core position in precious metals for many years, and we’ve employed this tactical overlay throughout. Gold, silver, and mining equites have had a powerful rally the past 8 months, during which time we’ve tactically reduced exposure a few times. If shares continue higher, you should expect to see more tactical selling in your accounts.
The Long and the Short of It
Financial academics mostly equate risk to a security’s price action. The more volatile the price, the riskier it is perceived to be. I take a different view. I welcome price volatility and take advantage of it to manage exposure and augment our returns. I also manage risk by keeping position sizes appropriate, not forcing diversification, and focusing on opportunities where I feel confident that the collective wisdom of the market is wrong. We can be “wrong” ourselves up to 40% of the time, and we will periodically own some securities that don’t work out as expected, but we want to keep those losses modest. We’d like those losses to be more of a “I lost my water filter, drank from a brownish stream, and had stomach cramps for a few days” loss than a “let me just take another step closer to the canyon edge for this epic photograaaaaaaaaaa…” type of loss.
Best,
Ken Bell, CFA, MBA, Canyoneering Survivor
Aspera Financial, LLC
The Market Rubbernecker is associated with Aspera Financial, LLC, an investment management and financial planning firm based in the Cary, Raleigh, and Durham area of North Carolina. This and all Market Rubbernecker missives and musings (written, oral, or mimed) are subject to the disclaimers, disavowals, and hindquarter-coverings found at www.asperafinancial.com/aboutrubbernecker.
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