People brag about their picks on multiple social media sites, but what matters the most is how you maximise returns on a portfolio level. How does it matter if I make a 10-bagger on a 1% allocation bet? In this blog, I will explain my thought process towards portfolio allocation and how I try to maximise my gains on a PF level. Let me be honest: I am a bit scared of writing this blog as it is a very vast subject, and it can not be written in a 10-minute read. Even if I try, I know I will fail as there are a thousand variables to consider, and each one changes according to the individual's need, which is why I will focus on my approach and the thought process behind it.
Concentration vs diversification
One of the most talked about subjects in portfolio allocation is the debate between concentration and diversification. We have legends like Warren Buffett, who has had 30% in a single stock, and also legends like Peter Lynch, who has had thousands of stocks at a given time and still managed to make a CAGR of 30% or so. So let's make one thing clear: there is no single right approach, and it is dependent on each individual differently. Everything is subjective and should be viewed as a spectrum. Perfect concentration would be betting on a single stock which operates in a single line of business in a single geography and perfect diversification would be buying all the stocks of all the listed markets all over the world and in my opinion, both are futile.
My approach leans towards concentration. What do I mean by concentration? 100% of my networth is in the Indian stock markets. In that, I have about 12 stocks, and the top 5 occupy 80% of my total capital, and the top 2 occupy 50% of my total capital. That is a daunting number, but I still don't think it's concentrated enough.
Why am I leaning towards concentration?
There are multiple reasons at play here. First, my personal life allows me to take higher risks. I am a twenty year old whose family doesn't depend on my stock market income and they would also be fine with a 100% capital loss.
Secondly, My aim is to generate the highest CAGR I possibly can. And the thing is, I can not do that with a diversified approach as my selection critera for a business is quite difficult to meet. So even if I want to, I cannot but have a concentrated approach as only a few businesses meet my criteria, and even fewer I understand amongst them.
Thirdly, I do not think a diversified approach should be adopted to 'play it safe'. Respectfully, no. Diversification is a substitute for research and depth of work. I would rather be safe by researching deeply enough to understand the risks instead of diversifying it away. If I know everything there is to know about my business, I am OK with a concentrated approach. Hypothetically, If I see a company will generate a 50% CAGR with 100% certainty, would I concentrate or go all in? Go all in. Why? Because there is a 100% certainty as I know everything. Of course, it is impossible in real life to know anything with 100% certainty, but you can increase your certainty by going deep. Hence, I am OK with a concentrated approach as I try to understand everything there is to know about my business. I tackle the risk of concentration by focusing on information and its synthesis.
A lot of people need to understand that the definition of concentration is not just the number of stocks you own. Think of it as the number of business lines and geographies you are exposed to. If I were to buy Reliance or Tata Sons, it's already a well-diversified bet as they have multiple businesses under them, and all of them operate all over India or the world. Not all companies and micro-markets will do well; only a few will outperform; when I look at concentration, I aim to concentrate on those businesses and those micro markets. For example, Max Estate was a bet on the Delhi NCR real estate market.
How do I decide what to buy?
There are multiple criterias I keep a mental checklist of before investing but it all comes down to expected returns. I want to appreciate my capital and hence will aim for increasing my CAGR expectations. Lets first look at what I mean by expected returns and then the factors that contribute to it.
It all comes down to Expected returns
Returns matters the most to me. The higher, the better. But why did I not directly say growth? Because returns are a function of multiple things and all should be taken into account. I see three key criterias: earnings growth, valuation expansion and probability of success.
Earnings growth is quite simple to understand: I want businesses to grow quickly. As simple as that. What type of growth do I prefer? I prefer a company expanding its top line rather than focusing only on bottom line leverage. Of course, PAT matters and so does operating leverage but I like a top line led earnings growth. This is because it suggests that the runway of growth is high. Moreover, I prefer margin expansion by changing product mix, etc, as it also tends to lead to valuation expansion. I like asset-light businesses more as they can grow quickly and do not need to invest much to set up capacity.
Valuation expansion is a product of a few things: the growth, business quality and liquidity. If the starting multiple of your business is 25 PE and it doubles its earnings in three years but also halves its ROCE, will you expect the PE to stay the same? Probably not; you are most likely to lose some of your returns as the business quality declines. But let's imagine the business doubles its earnings in three years and also doubles its ROCE, then you can expect to make windfall gains. We can't control liquidity, but we can study the growth and how the quality of business will shape up. I will discuss the quality of business later in the blog.
Probability of success:If my returns from earnings and valuation expansions are expected to be 40% CAGR, what is the probability of this happening? If it's 100%, then the expected returns are 40%. But if it's 10%, then I would consider my expected returns to be 4%.
You essentially multiply the expected returns with the probability of success.
How do you get this probability of success? You dig deep and research as much as possible to know what you are getting into. Another thing is that it is necessary to consider your understanding of the business and sector while giving this a probability. If you struggle to understand the business but still want to bet on it, remember to take a hit on your probability of success to account for your failure to understand the business deeply. It is impossible to pinpoint this probability to a number. Hence, what I do is assign a bandwidth to my investments. For example, GPIL and Senco, at my buying price, were assigned a high chance of success at 75-85%, while Nuvama was assigned a 60-65% chance of success due to market cyclicality. We can never truly know the probability of success, but we can surely try to gauge it to better understand the expected returns.
All my criterias will fall down to these three cores. Everything is designed with the aim of capital appreciation. Lets delve a bit deeper and see how we can increase expected returns.
Longevity of growth: I want to stay in the business longer when I buy. If I had two businesses, which are expected to grow by 30% next year, but business 2 can maintain this growth rate for three years, I will go for the second one. There are multiple advantages to this. First, I increase my return on time, as I do not need to study a new business for the same returns. Second, I increase my understanding of the business by exploring it more. That way, I can be okay with a higher concentration if needed. Another advantage is that LTCG will not stop the compounding as the gains remain unrealised.
Industry tailwinds: As per the research conducted by William O Neil of MarketSmith, most of the biggest winners are part of a sectoral move. With the backing of a sectoral trend, the longetivity of growth rate increases, so do the odds of valuation expansion and most importantly, the odds of success. Even the worst of businesses will perform well if the sector supply demand supports it.
Direction of Business quality: This is essential for everything. It increases the growth potential, valuation expansion, and odds of success. What matters when I look at business quality is balance sheet health, stability of earnings, increasing return ratios, and increasing cash flow from operations. The direction of these will determine a lot of your returns.
Management quality: A very necessary thing to evaluate is if the management is capable of executing their guidance. It is a difficult variable to track and understand as you need to have multiple conversations with them and observe what they do. However, in my opinion promoters/ management are extremely important and substantially increase the odds of success and the earning potential.
I hope I kept this simple and effective. My approach to allocate % capital will come down to the expected returns of the business. This is the end of my blog. Subscribe if you like my content.
Thank you
Very nice article. It clearly mentions criteria for allocation.