Hi all,
I am sharing my rational regrading Investment Thesis & Portfolio Construction approach. I will love to get your thoughts. The goal is to generate ~25% compounded returns over long period.
We divide out portfolio construction approach in three buckets: Deep Cyclicals, Decent Compounders and Cigarbutts. We generally prefer to take 5% position in one single idea and have a maximum capping of 20 ideas in the portfolio. Our primary thesis of the portfolio is to buy at cheaper valuations and sell when the price and value converges or when we find more compelling opportunity. Buying cheaper provides margin of safety (MoS). MoS from our own understanding point of view as well as future business performance.
1. Deep Cyclicals
Cyclicality is inherent in most businesses and industries. Corporate revenue, costs, margins, growth rates, profit levels and working capital requirements change with supply-demand balance, input cost movements, capacity additions and macro conditions. While some industries show mild cyclicality, deep cyclicals exhibit a very large gap between peak and trough performance. This gap creates mispricing and therefore investable opportunity.
Markets often value cyclicals by extrapolating the near-term past or present to perpetuity. During downturns, valuations compress as if weak conditions are permanent. During upcycles, valuations expand as if strong earnings are sustainable. The opportunity is to act against this extrapolation by buying when performance and valuation are depressed and selling when performance is strong and valuation multiples are elevated.
Examples include paper, cement, sugar, steel, alloys and oil-related industries. These are mostly commodity businesses where supply-demand balance drives profitability.
Opportunity in deep cyclicals emerges when the following conditions exist:
• Earnings and margins are depressed due to industry cycle
• Valuations are low based on historical standards or on normalised earnings
Since these are commodity businesses, preference is given to companies with structural advantages such as:
• Low-cost producer
• Economies of scale
• ROE and ROCE above cost of capital over the cycle
These companies survive downturns better and benefit strongly during recoveries.
Industry structure is equally important. We evaluate:
• Number of players and there trends
• Capacity additions and supply situation
• Raw material availability and cost structure
• Historical EBITDA per ton ranges
An important observation is that inefficient players can sometimes show larger operating profit jumps during upcycles due to operating leverage. This can support tactical gains, but it does not replace the preference for structurally advantaged companies when the aim is risk-controlled compounding through cycles.
Valuation of cyclical companies differs significantly from valuation of secular growth companies. Traditional price-to-earnings ratios during peak or trough periods can be misleading.
Therefore following valuation approaches are more appropriate:
(a) Average Earning Power Valuation**:** This method focuses on normalized earning capacity across the cycle rather than current earnings. Key metric to gaze earning power value is to look at average EBITDA per ton (or unit margins). In many cases long term normalised operating cash flow (CFO) reflects an accurate picture. This normalisation prevents overvaluation during peaks and undervaluation during troughs.
(b) Historical Valuation Range Analysis**:** Historical valuation multiples provide important reference points. Key multiples include Price-to-Book (P/B). This ratio helps determine whether the stock is trading near historical lows, averages or highs. Historical price behavior often rhymes, provided industry structure has not materially changed. So it is important to evaluate whether industry dynamics remain similar to previous cycles.
Recommended allocation guidelines are:
• Individual idea allocation: 5% of portfolio
• Allocation above 5% (but less than 10%) should be done only when there is deep conviction and strong understanding
• Sector allocation limit: Maximum 10% per sector
This prevents excessive exposure to a single cyclical industry.
Our general expected return is 3-5x over five years period if cycle is decoded correctly.
2. Decent Compounders
Some companies possess long term visibility of earnings due to the presence of structural strengths in their business. This strength is often referred to as moat. Such companies are able to sustain profitability over long periods of time. These companies typically generate consistently return on capital employed (ROCE) which is above cost of capital.
Free cash flow generation is an important indicator of business quality because it represents surplus cash available to shareholders after maintaining and growing the business. Companies that consistently generate free cash flow are generally more financially resilient and capable of sustaining long term growth. We would a company more if it is dividend paying.
Valuation of these companies is done with focus on earning power and financial strength rather than only historical multiples. The following valuation approaches are more relevant:
• Owner’s earning basis
• Debt servicing capacity
Historical valuation metrics can also be observed to understand where the company is trading relative to its past. However, these should be used only as reference points and not as the sole basis for valuation.
We invest in these companies with long term time horizon (10 yr.). We will hold these companies if the business economics is intact and valuations are not egregiously high. We will allocate mostly 5% of portfolio in a single idea. Higher allocation (10%) only in these cases:
• Extremely cheap valuation (historical low as well),
• High predictability earnings,
• Obvious and above avg. growth prospects,
• High dividend yield (>5%) which is sustainable as well and above all
• Safety of capital by having limited downside.
3. Cigarbutts (Low P/B / Net Cash / Below WC)
There are certain companies which appear obviously cheap based on asset value or low valuation multiples, but the underlying business quality might be weak. These are often referred to as cigarbutt opportunities. The investment case here is not based on long term business strength but on the gap between tangible value and market price.
These companies may trade at valuations lower than their net working capital (WC), lower than cash and investments or at historical low valuation multiples. Examples include holding companies, net cash companies and low price to book companies. In such cases, the downside appears protected by asset value, while the upside comes from valuation rerating rather than business growth.
Opportunity in cigar butt investments emerges when the following conditions exist:
• Market price is significantly lower than tangible asset value
• Company is trading below net working capital, net cash or book value
• Valuation multiple is at historical lows. Also a couple of such pricing situation in the past to form predictable pattern
• No signs of asset value destruction (losses or asset write-offs) in the past and future
• Minimal outstanding debt (D/E < 0.6). If D/E > 0.3 then ROE should be above cost of capital
• Predictable selling as per past performance
At such times, even a partial convergence of price to asset value can lead to meaningful returns.
Valuation in these cases is based primarily on asset value rather than earning power. Key reference points include:
• Price to Book (P/B) significantly below 1,
• Market value lower than net working capital, or
• Market value lower than cash and investments.
In most of these cases the upside is limited (2-3x) and there is uncertainty involved as well. The timing of value realization is uncertain and the stock may remain undervalued for extended periods. There is also risk of capital loss if asset value deteriorates and opportunity loss if capital remains locked in low returning investments. Here we are not betting on business but only on the difference in tangible value of assets and market price. In some cases we might have less understanding about the business (or, industry).
Here we deploy 2.5% or 5% bet in a single idea depending on conviction and other opportunities in the market. We never allocate more than 5% in a single idea.
Many times there is less differentiation if the idea belongs to Category 1 or Category 3. In most of these cases there is a cyclicality attached to it, not business cyclicality but rather stock market cyclicality.
Note
Apart from all these which are ground rules of the portfolio. If these things are not there then we are not even interested in looking at the opportunity.
• High Debt (D/E > 1)
• Negative CFO over long period
• Lack of long-term track record
• Abnormal related party transaction, extremely high remuneration which is unjustifiable, or management is a chore
• Outside of Circle of Competence