As the managers of Cook & Bynum, we make concentrated investments in equity securities when we feel that risk is low and potential returns are high, recognizing that bigger stakes can be taken when information is adequate and outcomes are more certain.
We use ideas taken from the Kelly Criterion to help determine our position sizes. Our main takeaway is that a position’s size is a function of both its expected return and its anticipated range of outcomes, such that: Position Size = Expected Return / Range of Outcomes. The math implies two important points (with the first being more obvious than the second): (i) the larger the expected return, the bigger the position should be, and (ii) the larger the possible range of outcomes, the smaller the position should be.
In the absence of compelling long-term equity investments, we feel very comfortable holding cash and cash equivalents. It is our obligation to not put partners’ capital in harm’s way without the prospect of an adequate return, and the call option cash affords can be very advantageous in falling markets. This investment strategy may not be the best way to earn high returns in any given year, but we believe it yields a portfolio that (i) avoids the permanent capital losses endemic to short-term strategies, and (ii) earns the highest cumulative returns over a 20+ year time horizon.
While we are long-term, buy-and-hold investors, Cook & Bynum will generally sell a security under the following conditions:
- We will begin to liquidate an investment when it appreciates to the point that it approaches our estimate of its intrinsic value. An investment reaching our appraisal may have further upside potential, but it will no longer offer an appropriate margin of safety for putting capital at risk.
- We will also sell any investment that has a material adverse change in business, management, or return prospects since we invested. Negative developments by themselves do not necessarily trigger the selling of a position, but should an event lower our appraisal enough or prevent us from reliably appraising the intrinsic value of the investment, we will sell it. Positive events may cause us to adjust our appraisal of value upwards. We appraise our positions on an ongoing basis throughout the life of the investment.
- Based on opportunity cost considerations, we will generally sell relatively overpriced securities to buy relatively underpriced securities as these specific opportunities arise.