Trades v. Investments - A Difference
Why determining what a position is matters.
Trades v. Investments - A Difference
In 2020 I started my hedge fund after a few false starts - mainly from investing in private companies and getting dragged in that direction, so we're clear.
But as it comes out of this 3-year incubation with my LPs and prepares it's public debut, I've had to work on the pitch deck and my pitch - why I believe in the model I use, how it's done and why I believe in doing it that way.
In my world thinking about how to allocate risk in a portfolio is required but for most investors they tend to think of it in a binary manner.
Usually something like this:
You buy and hold stocks and there is a reason why 'X' company is being bought.
You are 'trading the market'
I've experienced that as people have asked what it is my fund does over the years and I'm certain going forward that will still happen.
Investing is not binary, and alpha is not static and being open to those ideas allows me to classify 3 types of portfolio positions.
There are investments, trades and speculative positions.
And as I was working on the deck and pitch to explain things thoroughly it hit me that many don't differentiate between trades/investments & speculation.
I like all three but with some rules/framework in using them within the portfolio.
Let's talk about them.
I like investing in companies. But not the ones that that most average investors do (Apple, Amazon, Google etc). I'm looking for names not covered by CNBC or traditional Wall Street. Companies that have good management, great balance sheets and sometimes, corporate catalysts. One thing I believe in in this: I don't mind investing in situations, then, within said situation finding a gem of a company to express the view on. They might be companies in a sector that is inflecting due to government policy change, macroeconomic policies or some other tailwind that will drive the value higher - and by higher I mean 2x/3x - not 20% in a year stuff. If we're going to put larger amounts of capital to work in investments then I want to be rewarded for that risk, handsomely.
I want to treat these as investments, not trades. So, by that I mean not worrying about watching P&L weekly on it but also not being dumb and just recklessly getting in without assessing sometime of market-timing overlay via price action. Quality technical entries are key, but not a big deal, because I'm concerned about the intrinsic value of that company so waiting for value to appreciate over 12-36 months is alright with me.
Then you have trades. Trades can be anywhere from a week to 180 days in time. They come in the form of locating some dislocation or event in say an overbought $SPX, as an easy example. They can be a situation like Carvana last year where, it was not really an investment, but a trade, because of an understanding of their balance sheet (in depth) and their loan with Apollo/Pimco. With trades you want to keep capital allocation smaller than an investment position because they're trades and not investments so I expect there to be more volatility in them so I want to measure that as a tool for position risk.
Unique trades present themselves all of the time but when I look at them, I want to understand two things:
What are the potential upsides on the trade?
How can I structure it to minimize the loss/or keep the loss small?
If I can answer those questions first, then I can measure whether or not the trade makes sense for the portfolio. I want these to work rather quickly, inside 6 months, and better, if inside 60 days if at all possible. And because these situations tend to present themselves rather often, I get extremely picky on finding what I consider to be the best ones based on the above measurements.
With trades I don't want to get married to it an make it an investment. The idea is to generate alpha and get back to cash. Sure, there are times where it may work out really well and something changes, so I am not opposed to trimming the position and keeping some for an upside. This is something that I did recently with some of my real estate basket ETFs - they had great gains, rather quickly, over a 6-week period, so I trimmed some and kept some.
Speculative positions. These come and go every year and they are more of educated guesses on certain situations/stocks. Now I want to be clear - speculation on a penny stock or some bio tech stock passing FDA approval is not what I mean: that's just straight gambling, to me and if we're doing that we may as well find a high-stakes poker game and back a great poker player to find us alpha.
I also don't mean just blindly diving into an idea because "I have a gut feeling" - there needs to be some situation there that provides some theme. In recent years there was a lot of hype on electric companies: the entire sector, charging companies, all of it. Hot money was in it but it's hot money meaning it leaves at a moment’s notice. There was a stock, EVGO, that I traded as speculation and did quite well on. I didn't really care for their balance sheet or management, but the sector was moving and being a part of it through a small, speculative position, made sense.
This same thing happened on Lucid motors a few years ago. Terrible balance sheet but 'hot money' was fleeing into that sector and that stock soared for a short-while. I'm happy to put speculative trades on ideas like that but there's no chance I'm putting investment style risk on into a company/situation where there is no true value/business behind it.
Finally, I don't add to these positions. They get put on and they get trimmed or exited once they reach a target I am satisfied with.
Markets are not constant, especially now, given the change in Fed policy after the last 10 years. So determining what type of position it is you are putting on is key to delivering alpha for the portfolio and managing the overall business.
Investment, trade or speculation? Decide that then you can work from there.
Thanks for reading,
This article is presented for informational purposes only, is an opinion, and is not intended to recommend any investment, and is not an offer to sell or the solicitation of an offer to purchase an interest in any current or future investments. Any such solicitation of an offer to purchase interest will be made by a definitive private placement memorandum or other offering documents.
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