Improve your odds of investment success with these three stocks

How much should you allocate to a great investment idea? Over 60% of the Large Cap Active Global Equity portfolios in a popular fund database have more than 50 stock holdings. That implies an average investment of around 2% of the portfolio and, say, 3% for the best ideas.

Almost 40% of the database is made up of funds holding more than 80 stocks, which tend to invest even less than 2% in individual investments. This seems quite low, especially for a best idea, which is where John Kelly comes in.

Kelly was a scientist working on noise reduction in long-distance telephone signals at the famous Bell Labs in the 1950s. But it turns out that his algorithm was useful for sizing gambling bets appropriately for a given set of probability-weighted outcomes. The “Kelly criterion” calculates the portion of funds you should place on a bet, with probability-weighted win/loss outcomes, to maximise your long-term return.

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Playing with probabilities

We know that investments can be winners (or not) and we can estimate the degree and probability of the win. So the Kelly criterion is useful for investment decision-making as well as Las Vegas.

Let’s say we have a great investment idea with a 75% chance of 30% upside, but a possible 10% downside. Kelly suggests you invest two-thirds of your available funds with an expected return of 20%.

Interestingly, by working the Kelly criterion backwards, we can infer what a portfolio manager thinks of his or her best ideas given the amount invested. For example, a 3% position (roughly 2.5 times the average weight in an 80-stock portfolio) implies that the manager sees the idea as having equal upside and downside but with an upside probability of 51.5%. This does not sound very convincing, and of course the manager is unlikely to agree with that range of outcomes and probabilities. So why not concentrate the portfolio on the few best ideas and forget about the rest? That is what we do. Here are three stocks that we hold with real conviction:

Growth potential in the cloud

Alphabet (Nasdaq: GOOGL) is a well-known internet service provider; the search engine and YouTube form the foundation of the company. Alphabet’s ability to continue to grow its share of advertising revenue is underappreciated, while you might not realise that it has a large cloud- computing business, an area that offers long-term growth.

DaVita (NYSE: DVA), provides dialysis treatments for patients suffering from end-stage renal disease (ESRD). Costs and a rise in client mortality owing to Covid-19 have been a problem, but the market does not appreciate the likely margin improvement as costs normalise. The transfer of patients from Medicare to Medicare Advantage (under the US healthcare system) also offers the potential for margin improvement.

Consider also NVR (NYSE: NVR), a housebuilder in the US with a geographically focused operation (some rivals spread themselves too thin) and a policy of not buying land. This allows it to benefit from economies of scale in construction and minimise the capital employed in the business, improving returns on capital, an important gauge of profitability. It is an unusually shareholder-friendly company.