Whenever you
bump into fellow investors, the conversations often steer into – “Aur Kya dekh
rahe ho ? Kya aacha lag raha hai” (What new stocks are you looking into ? What
is looking promising ?)
Our obsession
to always chase the “Next Big” idea is often detrimental to our portfolios and
wealth creation. In doing so we often miss out on the far most critical aspect
of investments – that of portfolio construction and position sizing.
As we have
seen from numerous investors through their investment journey – that it is
often one/two large winners which are pivotal in their overall wealth creation
and makes good a lot of mistakes – both of omission and commission alike.
Many
veteran investors also list a common trait – of selling their winners too early
and missing out on the huge runaway.
It was a great
opportunity to connect to a highly revered investor of Indian equities, who
have had huge multi-bagger returns not only at the stock level, but at the
overall portfolio level in the past two decades.
The following
is an attempt to capture key insights from the discussion and share this with the
broader community of investors.
Portfolio Construction:
Your
portfolio should ideally contain only three types of opportunities.
A) Compounders [Allocation: 50%] – Well discovered businesses, with steady
operations and large size of opportunity growing at 20% available at decent
valuations. The key to understand the importance of this bucket and the
allocation. Here P/E discovery is matured and earnings fuel all the returns.
“Even if other parts of the portfolio – do not
yield any results in a 5-year period, having 50% allocated to 2x+ bond yield
will ensure your equity portfolio at least matches risk free returns”
B) Fast Growers [Allocation: 35%] – These are fast growers –
rapid growth in sales with rising operating margins, here both legs of market
cap growth – Earnings and P/E re-rating can come to your aid and create tangible
wealth in a meaningfully short period of time.
"This part
of the portfolio is also ideal for focussed cyclical baskets, opportunities
that can yield high returns in short bursts to create future growth capital."
C) Seeds [Allocation: 15%] – Seeds are new emerging ideas, promising
yet unproven ideas, which needs to be tested further before they can graduate to
the buckets A) or B)
Portfolio Allocation & Position Sizing:
Initial Allocation:
For
companies in bucket A) and B) start with an initial allocation of 5% (can be
for a single stock or the commodity/cyclical basket of stocks) and exceptionally up to
10% only for bucket A). As we would see further down, we would end up upward averaging and increasing allocation to biggest winners.
For stocks
in bucket C) start with a initial max allocation of 2%. As they graduate to Bucket
A) or B) their allocations can be revisited thereupon.
Position Sizing:
It is of
paramount importance to let your winners run freely but at the same time it is
critical to prevent too much dependence of portfolio on few stocks.
·
Allow position up to 15%: If
the recent unexpected growth is led by a tailwind – China factor, Anti-Dumping
Duties, sectoral rises etc.
·
Allow position up to 25%: If
the recent growth is led by something truly unique and organic to the company –
strong brands, distribution moat etc.
Portfolio Maintenance
Weed Removal: During the wealth creation phase one needs to be
really brutal in terms of allowing any non-performance. Typically examine the
quarterly performance of the your investment candidates – against the
hypothesis and key assumptions in your valuation framework and act decisively.
Based on
the homework and management action in face of perceived risk and mitigations,
be quick to act and get out completely if reality is deviating significantly
from your hypothesis. Doing so will forcefully free up capital for
allocation more to your top-performers
Quarterly Bonus: The impact of not upward averaging your key
winners is perhaps one of the most underrated aspects. Whenever you see
businesses and management performing extremely well – ahead of and surpassing
your expected levels – always incrementally add to your winning positions. This
completely breaks any price anchoring you might have had and when done together
with weed removal – forcefully moves capital to better allocation within your
portfolio.
Bucket Changes – It might often happen you like 2 or more opportunities
from the same sector or just because you already had a large position in that
sector, the new stock – despite all the positives – could only secure a seed position
for itself.
The weed
removal can often pave the path for removal of overvalued candidates faltering
on expected growth in A) or B) to be replaced from a promising candidate from
C).
Annual Portfolio Re-Balancing
Annual Portfolio Review and Re-Balancing
Typically,
in a bull market, Bucket A) will underperform while in a bear market Bucket B)
and C) would fall back on returns. Rebalancing portfolio once a year is
extremely important to protect the irrational exuberance and lock some of the
volatile gains into core compounders.
Allocation
|
Bull Market CAGR
|
Bear Market CAGR
|
|
Compounders
|
50%
|
20%
|
30%
|
Fast
Growers
|
35%
|
60%
|
20%
|
Seeds
|
15%
|
30%
|
15%
|
Overall
Return
|
100%
|
36%
|
24%
|
The annual
rebalancing is best done post the AGM session once the full year performance
can be analysed in greater details and the next year can be planned
accordingly.
Coming back
to our discussion, the single biggest contributor of portfolio returns are by
no means – stock selections. It is the ability to cut your losses early and
upward average to ride your winners with meaningful allocation.
I will
leave you with this beautiful
presentation from Ian Cassel and this great quote from Bill O‘ Neil
