Sunday, October 21, 2018

Portfolio Construction & Position Sizing




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