Breaking My Valuation & Position Limits

It is official! I have broken my valuation limits on buying & selling stocks and position limits on individual stocks! Previously, I mentioned in What is My Target Price? that I have valuation limits of 1.8 to 2.0 times book value for buying stocks and 3.5 to 4.0 times book value for selling them. In Jan this year, I had broken these rules with the purchase of M1 at 4.7 times book value and Singtel at 2.5 times book value!

Also broken were my position limits on individual stocks. I have an initial position limit of $15K to $20K on each stock, depending on what type of stocks they were. These limits could be doubled to $30K to $40K if I need to average down on the stocks. The position limits were first broken in Nov 2015 with the purchase of Global Logistic Properties (GLP). Initially, I thought this would be the exception rather than the rule, considering the long-term growth prospects of GLP. However, after I invested in M1 and Singtel beyond the initial position limits, it is confirmed that the position limits have been broken. 

What caused the change in my valuation and position limits? To understand the reasons for the change, you need to understand why the valuation and position limits were put there in the first place. For a very long time, I have been using quantitative methods to analyse and value stocks, looking at only earnings, dividends, cashflows, debts, book value, etc. This approach has served me well in the past, but there are times when this approach turned up value traps whose share price keeps on declining. Thus, it makes sense to have valuation limits to ensure that I do not overpay for stocks identified using this approach and position limits to ensure that whatever mistakes I make do not become so large that I cannot recover from them. Quantitative limits on valuation and position size go hand in hand with quantitative methods.

It is also important to realise that quantitative methods have some underlying assumptions -- either (1) the stock will close the gap between price and intrinsic value, (2) the stock will recover to its past earnings and price (mean reversion), or (3) the stock will continue to generate good earnings and dividends (extrapolation). Sometimes these assumptions do not hold. Some stocks just do not recover in earnings and price after a decline, such as the few Oil & Gas stocks that have gone into judicial management. Other stocks are unable to sustain the good earnings and dividends, such as Starhub and M1. The problem with quantitative methods is that you cannot tell whether the assumptions will hold or not until the results are announced. By that time, it is probably too late to sell the stocks. Valuation and position limits make a lot of sense when you cannot see what is ahead.

Over the past 2 years, I have been gradually moving away from quantitative analysis into qualitative analysis, looking at issues such as business strategies, competitive environment, corporate governance, etc. This approach has the advantage of providing a glimpse into where the business is heading instead of extrapolating from past performance. Thus, if the business looks good, I could take up positions ahead of the market. Conversely, if the business looks bad, I could sell in advance. Valuation and position limits are less useful if you can see accurately what is ahead.

Furthermore, SGX is a small market. There are very few stocks in some industries such as banks, telcos, shipping, etc. But the amount of work necessary to analyse the industry is independent of the number of listed companies in that industry. For example, I wrote 8 posts on the telco industry but there are only 3 telco stocks, out of which I selected 2 for purchase. If I could only invest $15K on each stock, it really does not do justice to the amount of efforts put in. Position limits become constraints when there are limited number of stocks in a particular industry. Thus, my position limits were officially broken with the purchase of M1 and Singtel in Jan.

Having said the above, I have not fully discarded the valuation and position limits. There are dividend stocks that I purchase using the quantitative methods. For these stocks which I have no insights or time to analyse deeply, valuation and position limits will continue to be in place.

Will breaking the valuation and position limits lead me to make mistakes that I cannot recover from? I certainly hope they would not. I will still need to improve my skills at seeing the future prospects of the companies. 

See related blog posts:

• The Investigative Approach to Stock Investments
• What is My Target Price?
• A Look-Back at My Blog for 2016