Towards a Capital Allocation Framework!


(T Anil Kumar) #41

**Too much emphasis on growth stocks: **If a business CANNOT grow 25%+ CAGR over the next 2-3 years, you have no business keeping the stock in your portfolio, just because it might be a stable counter.

I think [may be I interpreted it wrongly or hold a different view] top objective in any investment activity is to have capital appreciation and I am neutral whether this appreciation comes from secular earnings growth of 25%+ or cyclical earnings growth with PE re-rating. We should not ignore potential of cyclicals to be multi-bagger over a period of 4-5 years, if RIGHT CANDIDATES are picked up at RIGHT TIME.

In one of his letters to shareholders Martin laid down his reasoning for Investment in Companies hit by housing crisis and in another letter for companies hit by semi-conductor crisis, I think we can apply the same principles to invest in other cyclical industry which is currently going through tough economic conditions. Let’s see what these principles are

Bad side of these investments:

1)The stock market pricing for these equity issues is chaotic. There is no way Fund management is able to pick a bottom for securities prices, or a near bottom. - this is quite evident from the stock prices wherein stock prices of most of these companies are down more than 80%.

2_) Fund management has no good idea of how deep the crisis will become, or how long it will last. Our best guess is two to four years._

Second, the good side of these investments:

1)_In each instance, TAVF is acquiring common stocks at meaningful discounts from readily ascertainable NAVs.__For each of these companies, a normalized Return on Equity (equity equals book value) (âROEâ) ranges from 8% to 14%. Assuming a 10% ROE sometime in the future, and no further dramatic deterioration in book value during the interim, probably a realistic assumption; and current pricing at 40% of book value, Third Avenue would be paying only four times future normalized earning_power.

2)**Each common stock acquired, is acquired in a company which enjoys a strong financial position.**While there can be no guarantees, the probabilities are that each of these companies will survive as solvent going concerns either without requiring major access to capital markets for new funding, or by obtaining new funding from others on terms that are only modestly dilutive for TAVF.

**1) **Each company seems very well managed.

**2) **The industry seems bound to experience explosive growth over the next 3 to 7 years.


(Mallikarjun) #42

Anil paaji,

Kindly request you to see the portfolio ‘Novice’ in the Forum Portfolio Q&A.

Since its a concentrated one & micro-cap heavy, concerned about it.

It will be of immense help, if you can guide me on Asset, Portfolio & Stock allocation & concentration.

Any Classic books on concentration & portfolio handling

Regards

Mallikarjun


(Binu) #43

Hi Donald, I know its kind of late to ask this question from a discussion perspective,

**Industry Position and Track Record - **do you have the sector attractiveness and company’s position among its peers in mind? Is that very close to the “Sector Attractiveness/Market Fancy” from BQ?


(Donald Francis) #44

Thanks Binu for posing a question on Capital Allocation. It’s been 2 years since we posted on the subject and its about time for a re-look, review and bringing in refinements from the learnings we have had over last 2 years.

I will get to the review job in a couple of weeks.

Meanwhile “Industry Position and Track Record” is about the company’s standing in its industry vis-a-vis peers and its track record. Remember the discussion about 2nd/3rd player in industry growing faster and better than the incumbent - in Success Factors thread a la Amara Raja, Atul Auto, Cera. The IPTR focus will point you to evaluate this factor for a company.

Meanwhile you might have missed this, Hitesh our most “refined” investor has already mentioned what he thinks should constitute a IPTR scrutiny, as reproduced below. I have nothing much to add.

Industry Position and Track Record

Here one asks where the company stands in the peer group. Most people want to invest in sector leaders only and believe that only these create multibaggers. I beg to differ here. There have been many instances where the sector leaders have reached such a big level that there might not be too much space to grow? Here the smaller nimble players with some kind of advantages make smart choice for investing.

And whether the company we want to invest in is growing at higher than industry average? If so what separates it from others? Any advantages/niche?


(Dhwanil Desai) #45

Hi Donald,

Truly, we had a very engaging discussion capital allocation framework some time ago and it will be good to re-look at the same and refine it further. Few points that I have observed and learnt over last couple of years which can be useful in deciding capital allocation

  1. “predictability” and consistency of cashflow/earning/growth for next few years for a business is very crucial. In my opinion, this is one of the prime differentiator between category A and Category B business. There are some businesses which are so greatly positioned that one can predict the future with high degree of certainty . Market is willing to pay higher price for this “Certainty” and consistency (ref: our discussion on Page). Hence while evaluating quality of the business, “predictability” or "Certainty: of earning/growth should be one of the factors.

  2. “Asset intensity” of the business: Another takeaway in last couple of years is that a company which has “asset light” model has higher chances of sustaining the higher return ratios through thick and thin and generates enough free cash flow for scaling up its business manyfold without resorting to leverage. This will also ensure that asset light business will have higher “dispensable” cash flow to be distributed amongst its shareholders hence can afford to maintain healthy dividend payout. Again, this factor is clearly linked to quality of business and should be considered while we carry out analysis on quality of the business.

I am just scratching the surface here but it will be great if we can revive the discussion on capital allocation framework and refine it further to include “insights” that senior valuepickr members like you/Ayush/Hitesh have gained in last couple of years.

Best Regards

Dhwanil Desai

** Industry Record **


(Binu) #46

Thank you Donald for the clarification and sharing Hitesh’s quote. I find this thread and the framework invaluable. I am rebuilding my portfolio based on the framework, eagerly waiting for the updates.


(Bhaskar Bora) #47

I believe in holding a portfolio of 8-12 stocks.Keep tracking of results and keep buying winners along with time is a great strategy for a salaried individual. Even in case of crash one can add his winners at different times of decline as after the crash it takes months of consolidation to emerge into a raging bull market.

Now about quality of business I would like to go through the 13th MOSL wealth creation report and divide the companies into three types- Great, Good and Gruesome.

Great as we know are wide moat business with great valueable brands like Page, Nestle, Asian Paints, Pidilite etc. Problem with these type of stocks are that they hardly are available at low PE and low PEG due to their high ROE, ROCE and high dividend payout. They are no doubt gud compounding machines but not great compounding machines of future. A company can’t grow at 30% rate forever, and buying such company at 70 PE wont make u make huge money.

Good companies are where we can find lot of opportunities as they grow at a decent rate and may be available at reasonable price,for example Mayur, Ajanta, Cera, Kajaria etc.They have nice decent ROCE, ROE, small Dividends, so available at reasonable price But problem with these stocks are that we need to monitor them all the time.It is hardworking. As long as they keep churning out sweet results they remain amazing wealth creators. But once the story begins to slow you need to sell and shift to another growth story. It means full time effort with lot of passion. They are good as long as the growth story remains intact.

Gruesome business as we know are low ROE, ROCE wealth destroyers in cyclicals, airlines etc. and need to be avoided all the time.

Now about allocating the capital I would like to go with equal weightage first to all well selected group of good stocks and along with time as we will add the winners and remove the losers(mistakes if bought due to misjudgement).

Now lets say I have eight stocks A,B,C,D,E,F,G and I. Now every quarter I would monitor all the stocks A through I and add the ones(say A,B F and I show 20% plus growth that quarter) which shows better growth and wait for the others(C,D,E and G who degrows or flat results ) and learn about their results and try to understand the reason for any slowdown through management interview and concalls. If the growth story remains OK for all the stocks I will not sell any of them but sell when I convinced that I got a better stock to replace any of my laggards.


(Ishaan Gupta) #48

@bhaskarbora67 My take on this is to have a single sheet (which I call a moat list) with all the opportunities (price, earnings, growth, conviction grade, fair value, discount to fair value, expected exit P/E, expected 5 year return) and using the Kelly Betting criterion to figure out positions sizes. As this changes daily I dont replace that fast as I have a rule to not sell for min 1.5 to 2 years. When do I replace I also make sure that there is a minimum 10% discount to fair value differential between the two.

An article I wrote on one of the ways of doing conviction scoring is at : http://www.igvalue.com/2015/04/the-value-canvas-conviction-grading.html - This is based off of a methodolgy that @donald taught me that I adapted to my own needs.

Feedback and comments would be appreciated.

Cheers.


(CommonStocks) #49

This is a good topic and the gist of the matter has been covered very well. However what I want to bring out is the question on how much of your networth to invest in equities? People talk about conentrated portfolio of well researched 2/3/4 stocks with strong conviction and understandig of the business. But what is the point if your equity portfolio is less than 10% of your networth? Personally based on my interaction with fellow investors equities are still a small pie of one’s networth usually dominated by real estate and in some cases gold. I would like to hear and learn from investors who have more than 60% of their networth in equities and how they look at portfolio construction? Do they concentrate on a few names or diversify? What has been their experience over the past bull and bear markets?

Personally I hold a little over 30% of my networth in equities with a concentrated portfolio of 3 stocks making up 80% of it.

P.S: I have excluded the house I live, jewellery, car, etc.,while considering networth.


#50

I am more than 90% in stocks. I ensure following

  1. 15 but <20 stocks

  2. 90% is into consumers, financials and pharma.

  3. At least 25% into large caps. Some mid-cap pharma and consumer are closer to large cap now.
  4. No allocation more than 15%. Ideally, I would like it to be capped at 10%.
  5. No sector allocation more than 40%.

I have evolved this criteria for myself knowing well that this may not be most optimal. But after going through a meltdown like 2008 you know what works for oneself.


(Rupesh Tatiya) #51

A very good thread!

I have been struggling with capital allocation over last 2 years. This thread helped a great deal to put some structure to capital allocation. And then an idea appeared to me after discussion with friends. The idea is to look at Annual Sales of companies and use that in capital allocation.

e.g. something like this:

The simple idea is once you become big - you are going to run into hurdles for next phase of growth and upside may be limited. There will always be exceptions to this. Opportunity size is one factor in above discussion that covers above topic well but still when you grow above a certain size (2000 Cr is my threshold, it may be different for you or even based on industry), you have to work extra hard to get to maintain same % of growth.

Current rule I follow is, once company crosses 2000 cr, mark, I stop adding the new positions (but continue to hold previous position).

Within these categories, I follow excellent VP model which ranks stocks based on CR and VR. i.e. these categories are after we are convinced about Business Quality, Management Quality, Valuation etc.

Views invited.

Thanks,
Rupesh


(reacher) #52

agree . v few investors i know have put over 10% of their total nw in equities.I have no investment other than in equities ( other than primary house) even FDs or insurance.I also believe in concentrated bets .However its not as easy as it may sound - I will not advise this for many other investors.I think the key is that when you bet in such a concentrated manner ( 100% of one’s networth in equities that too in a few stocks say 4 or 5 ) one must track the co intimately and be willing to exit at signs of trouble .Else this approach can be self destructing.


(devansh_god) #53

WOW such an illuminating read… Thanks VP…
My queries and crude method (pls excuse me for being a newbie, and at any point, if the reader thinks that there has been a discussion for the same, pls tell me so, because I couldn’t find the answers):

  1. How do you buy? Suppose, we have shortlisted a company for buying (after CR and VR). Then,Would you guys do a
    a) Monthly SIP?
    b) Some pre arranged percentage of capital allocated to the position in question and wait for prices to correct to the desired valuations? For Eg. should i deploy capital at the rate of 25% capital per 10% price fall and so on? And space it out in four equal sized buys? Or should I buy more at lower levels? Personally, I tend to buy less at lower levels because of the realization that my initial reading was wrong.
    c) Would you wait for conviction to build (and how many bouts of buying in it, per conviction increase), I personally go for one lump sum buy once I home in on a stock. But I am feeling more and more resentful about my one time buy.
    d) Would you average down OR pyramid up. I usually pyramid up but I am suspect of the effectiveness of pyramiding.

(NNaik) #54

I had a similar query and had started a thread on it - Trading Query:How do you build a position in a company?


(devansh_god) #55

Thank you NNaik! I was aware of the thread you started. I posted here only because I didn’t find any answers there, Kelley’s formula allots quantitative values to qualitative parameters. I’m unsure of how its done and its reliability.

I still think our problem to be a capital allocation problem. Maybe some seniors, may illuminate the way on either thread, for both of us to get some answers.


(NNaik) #56

yes this is something that really would come with experience in the market.


(devansh_god) #57

Ohh!!! But cant we just cheat just a little tiny bit and learn from others’ experience rather than greying our own hairs on it?? :grimacing::stuck_out_tongue_winking_eye:


(NNaik) #58

definitely! that’s why this forum is great. The seniors are so open about sharing their knowledge.


(devansh_god) #59

Amen to that brother!!:grinning:


(Janarthanan Natarajan) #60

Folks,

Please be wary of using Kelly formula for capital allocation. Mohnish Pabrai’s book made it well known to many investors. But Mohnish himself doesn’t approve of it anymore. Please find a link to the video where he talks about the reason why?(roughly around 1hr 56min onwards).