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Constructing The Ideal Equity Portfolio

Constructing the Ideal Equity Portfolio

Think Like a Captain!

In my discussions with prospective customers, friends and even subscribed customers, how to build the perfect equity portfolio is often the topic of great interest and debate. How can one build a portfolio that will be able to bear (not sail) through the market crashes, seize the opportunities of the bull market and have the flexibility to bet on potential multi-baggers? How does EVM as a portfolio fit in to the big picture? How do financial products like PMS, Mutual Funds, Exchange Traded Funds and others make their way in to the portfolio? How can the investor start managing the investments like a business rather than a “fill it-forget it” approach. This is what the post is about. As an actively-passive investor, how should one go about building their portfolio? I will also touch upon the need and the role of the advisor. This is not a financial planning recommendation; this is what I believe and practice. This is more applicable for those who are actively-passive in the market i.e. they do invest in direct equity and have a portfolio of market based products. Such investors do not mind making their hands dirty, doing their own analysis if required. At the same time, market returns is not their primary source of income and use investments in the market to generate wealth over the long term. If you are a passive investor, Mutual Funds and ETFs can be used to build a portfolio on the similar principles, with a few caveats.

Promise, Form & Class

The exercise of constructing a portfolio is very similar to say building a sports team. Let’s say we are building the Indian Cricket Team. Assume all the past & present players are available for selection. The goal is to build the best team for current and future tournaments. The criteria used to select such a team will be the same that we use to build our portfolio. When you select players for the team you choose them on three factors, viz. Class, Form and Promise. A combination of these three types of players builds a team that can deliver well in the current and also prepares for the future. Study, knowledge and conviction required to invest is lowest for the Class companies and the highest for Promise companies. Important: We believe that if any of the stocks you own does not fit in any of the three factors, you are probably trying to make money by trading or gambling. Please do review that investment.

Summary of Class, Form and Promise portfolio styles:

CRITERIA CLASS Wealth Builder FORM Income Generator PROMISE Bounty Hunter
Qualification Criteria Battle-hardened companies with long of history of consistent performance and stock returns much more than markets Extremely positive recent performance Long runway for growth. Either the company or the industry is in its infancy.
Investment Type Systematic Investment, Bump up the investments with the market crashes Exactly as per the underlying model, Entry and exit would be pre-planned and well-defined before you invest. Investment amount should be in direct proportion of your conviction. Start small and add in large quantities as you build your conviction.
Holding Period Long Term Per the model/advisor Long Long Term
Exit Criteria Only when you need the money for expenses Pre-planned and well-defined exit criteria should exists before you take any position Exist when the “promise” no longer exists and not because the company has not yet been able to deliver on the promise
Emotion Associated with the Company RESPECT OPPORTUNITY POTENTIAL
Strategy to Maximize Returns PERSEVERANCE DISCIPLINE PATIENCE
Allocation Maximum allocation, Mandatory in all portfolios. Money left after Allocation to CLASS companies is done Money that you do not mind losing 100%
Need for an Advisor Not Required Required Required only to seek idea. Do not invest on your advisors conviction, build your own.
Involvement/Study Required Minimal High (unless you follow your advisors recommendations) Highest, continuous tracking is also required
Lets see them in detail:

Class – Wealth Builder

Class players get selected automatically or should I say they select themselves. In case of the cricket team, players like Sachin Tendulkar or MS Dhoni or a Kapil Dev will get selected automatically. You do not need external help (read advisors) to select class players. Their past performance over multiple decades in varying conditions and under extreme pressures has hardened them enough to ensure good performance in the future. You can bet on them at least until the rules of the sport or the sport itself changes. We have similar examples in our markets as well. Companies that have performed well through multiple economic cycles, have maintained their profitability and more importantly generated market beating returns for their investors over decades are Class companies. Quantitatively we can look at three “returns” metrics viz. Return on Sales (Operating Margin), Return on Invested Capital (ROIC) and Return to Investors (Capital + Dividend). A company performing consistently, say over 10-15 year period, as measured by these three metrics will be a potential candidate. The returns to investors should be much much better than the market returns over that time period. One common characteristics of Class companies is their ability to adapt and even re-invent themselves over time. They are not static. They have strong ethics but are not tied down by their culture. They are aggressive in capturing market share but also contribute to social causes. Typically class companies are large cap companies with known brands and good pricing power (also termed as Moat). By virtue of their size, they are also part of market indices. They have good institutional (FII and DII) and/or promoter holdings, professional management and are investor friendly. Commodity companies rarely make it to the Class list. Lack of pricing power is a key reason. Their performance is determined by market forces which are out of their control. As I said earlier, you do not need an advisor to tell you about these class companies. You know them already. What matters here is that you invest consistently in these companies and persevere with them for a long time. You exit from these companies only when you need the money (for expenses, not investing). If the company fails on the three return parameters over a longer period of time, you invest the new money in the next candidate company. There are some class players (e.g. Wasim Jaffer) who never got their due. Similarly there are class companies who have also not got their due. I do not recommend taking a contrarian approach while selecting class companies. Best is to follow the market. Remember the word that comes to mind when you think of class companies is “RESPECT” and what will generate good returns is “PERSEVERANCE”. When the market crashes, that is when you double up your investments in the class companies. Think CLASS, think LONG TERM. To implement a “class” strategy thru ETFs or Mutual Funds stick to large cap ETFs or indices. For e.g. NIFTYBEES ETF is a good choice. HDFC Top 100 or Parag Parikh Equity Funds are other good options (not recommendations). As an investor, you need not have any Form or Promise companies, but you should surely invest in class companies. New investors should start with class companies, the earlier you start the better.

Form – Income Generator

As the saying goes, Class is permanent, Form is temporary. This means any positions we take in the “in Form” companies would be temporary. Ride the wave as we call it! We often see this working very well in real life. A cricketer who does well say in IPL eventually gets selected for the Indian cricket team and performs very good, case in point, Shreyas Iyer. “In Form” companies have the potential to generate the maximum returns in a given amount of time. Form of a company can be determined by its price performance or its operation performance or both. This is why all kinds of analysis can be used to identify such companies. Technical analysis uses charts, patterns, indicators to identify such companies based on price-volume action. “Follow the trend” is another way of saying the Company is in-form. Momentum based portfolios offer similar style of investing. Fundamental analysis can also be used to identify these companies though it is a time-consuming task. Here you end up having to spend a lot of effort in studying the company results, understanding the future prospects (and hence intrinsic valuation) before you build your conviction to invest. Quantitative models (like EVM) try to automate the analysis by finding patterns that seem to repeat. Using these patterns or factors or simply filters, companies with a certain set of characteristics can be identified as good investing candidates. Note that any of the analysis you use must be accompanied by hold-until (or exit) strategy. These companies are not a part of the hold-forever portfolio. As soon as a new alternative is identified, the existing investments must be diverted to the new ones. This is the only portion of a portfolio where advisors play an important role. Research Analysts or equity advisors giving “buy/hold/sell” recommendations usually focus on in-form companies. Technical analysis is an excellent tool here. All analysts have their methods to determine companies that have potential to generate returns better than the markets. EVM falls in this category. The word that comes to mind when we think of Form companies is “OPPORTUNITY” and what will help generate good returns is “DISCIPLINE”. Adhering to the models/methods/entry-exit criteria without getting emotional about your investments is the key. Fix your exposure before you take positions in this type of portfolio. Think FORM, think SHORT TERM. Note: Form need not always mean good performance. After a string of bad performances, many a times we believe that a player is due for a big one. It is similar in stocks. It is called a contrarian approach. To create a Form portfolio using Mutual Funds is tough, it is best implemented based on advisor inputs. The ones that come close to “Form” portfolio are the “Special Situation” funds.

Promise – Bounty Hunter

Unless the team management invests in potential winners, we would have never seen a Jasprit Bumrah or a Sachin Tendulkar in Indian colours. They were spotted at a young age; someone believed in their potential and had the conviction to stick with them thru thick and thin patches of their performance. They then turned into the biggest multi-baggers of Indian cricket. It is the same for “Promise” part of the portfolio. This is the most difficult aspect of portfolio building. This is also where the potential multi-baggers are found. Not all companies identified as part of the promise portfolio will give good returns. Some may even just blow away the capital. They are inherently very risky investments. Promise companies should be invested in only after one studies them in detail. Only self-knowledge will help you build the conviction to hold them thru their good and bad performance (both operational and in the stock market). Promise companies are characterised by long runway for growth. Without this no company can be a part of the Promise portfolio. Long runway and faster growth rates will be hallmark of promise company. Everything else becomes secondary, be it operating margins, cash flows, debt ratios and other traditional metrics. I am not saying that these need to be overlooked, what I mean is despite the traditional metrics being poor, these companies can deliver strong stock market returns. Think Jasprit Bumrah, his metrics on a standard bowling action were difficult to bet on. Yet he finds way to deliver outstanding performance. Having a long runway for growth would typically mean that the company is in infancy or the market in which it operates is in its infancy. Small companies are volatile in nature; both in their operational performance and their stock market performance. You can get ideas about such companies from multiple sources but unless you build your own conviction you will not be able to profit from them. I will never recommend anyone investing such companies just from borrowed ideas. You need to do the dirty work. This is the reason I think an advisor is not useful apart from providing ideas. But then there are so many forums where you can get such ideas, why would you pay just for ideas. ValuPickr.com forum is an excellent source for such ideas. The word that would fit such companies is “POTENTIAL” and what will help you benefit for such companies is “CONVICTION”. Think PROMISE; think LONG TERM. You do not exit a promise company because it has not been able to deliver per your expectations. You exit when the promise no longer is valid. There are many situations when investors sell such companies just before they start delivering big returns. You shortlist the company on promise, and you should only exit when that promise or potential no longer exists. Look at mutual funds with names like emerging/opportunities to build your Promise portfolio using mutual funds.