The Role of Concentration for Cost Disadvantage of Extremely Small Sums of Money

This is a followup article to “The Role of Margin of Safety for Cost Disadvantage of Extremely Small Sums of Money“.

Just to recap, I define extremely small sums of money as not having enough money to generate low variable commission fees due to minimum commission fees (eg. Minimum commission fee = $18 USD / trade for 1st 1,000 shares of trade, therefore the larger the trade the lower the average commission fee).

The role of margin of safety in the last article helped minimize this problem by ensuring that the price I pay for stock & commission is still undervalued, thus making the commission fees not as painful.

That however is all bliss when dealing with index funds, but extremely painful when dealing with NCAV stocks , which is the next step that I plan to invest in after I accumulate 18 months worth of expenses in liquid assets.

The reason why dealing with NCAV stocks with extremely small sums of money is painful is because the nature of NCAV stocks (extremely unpopular stocks) requires diversification in order to pull off the strategy successfully. Unfortunately, diversification means buying into many stocks, which reduces the amount of money available to invest for each stock, and thus invites high average commission fees due to minimum commission fees.

To deal with this, I think concentrated investments makes the most sense to generate enough money to pursue NCAV stocks with low average commission fees, which means either investing in Great Companies or Active Indexing.

The reasons why concentrated investments only lie among Great Companies and Active Indexing is because, Great Companies by definition get better over an investing lifetime and thus have less chance of going bust, while it’s very rare that the whole stock market of regions all go bankrupt at the same time.

As for how what my signal is for buying great company stocks at discount, it would be where I can get at least a 20% return after deducting commission fees by the P/E I enter at and the ROIC it can generate and maintain.

The reason the investment hurdle rate is 20% is because that’s the minimum investment return I expect from pursuing a NCAV stock strategy, and because great companies require compounding over a time period (minimum ~5 years) in order to generate such returns, that’s the minimum return demanded from great company stocks if I were to invest in it as I expect the money to be locked up during the period that its earnings are compounded, which would otherwise have been used to compound money through NCAV stocks.

I will also sell 50% of my great company stocks if it doubles in value to provide liquidity to save up for pursuing NCAV stocks in later stages, and also to make sure I reduce the cost basis of my great company stock to zero (selling 50% of doubled stock value = purchase price) while I let it continue to generate 20% returns until perpetuity or until it’s not able to anymore.

The moment I stop pursuing Great Companies and Active Indexing is when I can fully pursue a NCAV stock strategy with at most 1% commission fees. The reason why at most 1% commission fees is because with careful selection of NCAV stocks, I expect to generate 20+% returns, which would leave me at least 20% returns after deducting commission fees.

As for why I don’t pursue a Great Company strategy from the get go if I can generate 20% returns from it, it’s because I’m only using it out of necessity rather than desire.

If given the opportunity I much rather invest in NCAV stocks until I’m no longer able to since there’s much less room for error and less skills required compared to accurately deciphering the durability of competitive advantage and earnings growth of great companies. It is ideal to invest in areas where competition is low (eg. illiquid stocks such as NCAV stocks) as Charlie Munger mentioned to investors with small sums of money to “Don’t go after large areas. Don’t try to figure out if Merck’s pipeline is better than Pfizers. It’s too hard. Go to where there are market inefficiencies. You need an edge. To succeed, you need to go where the competition is low. That’s the best advice I can give to small investors.

But for now, great companies and index funds will have to do until I get enough money to fully implement the “Small Sums of Money Phase” strategy.

[Disclaimer]

Not advice. No offer. Do not rely. May lose value. Risky. Conflicts hidden/obscured. (Borrowed from Terrence Yang‘s Disclaimer on Quora)

Advertisements

2 comments

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s