I am putting up my presentation that I did at recent event in Delhi at Investor’s Carnival. I have put down some of the key learning that I have had over last few years in market and has shaped up my investment philosophy today. As we all know, learning and relearning is a constant process in investing and I endeavor to refine my learning over time or unlearn/relearn as time goes by.
About the event: It was a well organized event with an opportunity to meet with some very smart investors including the ones from these forum and learn from them. Marathon sessions by Dr.Velumani (founder of Thyrocare) and Prof.Bakshi’s were simply amazing. Both sessions lasted for 7-8 hrs (till early morning hours) and had so many lessons embedded in it. I will post my notes from the sessions once I am done compiling from both these sessions too, in this thread.
Thanks for hosting the presentation here and the key-learnings.
If you could kindly present your thoughts on slide 9 and 10 - to what you talked about (what exactly did you explain on the points mentioned in the slides) to the audience. Perhaps you made your points with examples. It would be great to have your notes on those slides.
On 10, you have ‘introspection’ questions, and it would be good to know how you think through those and the answers you come up with.
Is there a template for the ‘Conviction / Valuation matrix’, you mention on slide 10, that you follow. If it is not inconvenient please do enlighten us.
Slide 9- I had done a presentation on the same topic in last VP annual meet in goa which contained examples- you can find it here
Slide-10: Capital allocation is an individual choice and we must create a framework that suits our investment style, investment objective, financial condition, risk bearing capacity and most important our own psychology. Hence, I guess, there is no right or wrong approach here. Coming to my approach
No of Positions: Typically I have 70-80% of my portfolio on 7-8 positions, 15-20% in opportunistic bets and rest 10% in 5-6 ideas where I create tracking positions as I find something interesting but do not have sufficient information/conviction to allocate large capital. These ideas are more like sowing seeds and nurturing them to see which will eventually grow up and bear fruits.
Allocation of capital: I find the VP allocation framework very intuitive and effective. High conviction- Low Valuation- will get the highest allocation- for me it means around 9-10% of capital. You can refer to capital allocation thread on VP for more understanding on the framework
Managing risk with position sizing: It is indeed a risk return trade off. Generally, trimming one’s position means, selling the winners. On the contrary, I have heard from many senior investors that one must allow the winners to run its course to make big money. Being a risk averse guy, I am generally more conservative and trim positions if it goes above certain threshold and is sustained at that level for some time. The argument that has appealed to me is - Inspite of all over hard work and conviction, businesses do operate in environment where there are many uncertainties and uncontrollable factors. In short, SHIT HAPPENS. And when it happens, you still should be able to have a good night’s sleep.
Reallocation of capital: There is absolute meritocracy here! The weakest idea has to give way to the new entrant. However, considering the looming reinvestment risk in selling the existing idea and buying a new one, the new entrant has to offer significantly better risk-reward over the incumbent one to merit a place in portfolio. It is generally a good idea to keep the relative ranking of one’s portfolio stocks ready as we do keep our buy list ready.
Wealth of wisdom all condensed in 13 slides. Kudos!!! Particularly liked the slide #7 on second level thinking. Hope to hear more on that from you.
Hope you can clarify few other points:
Slide 3, bullet point 5: you have mentioned “re-rating and earning growth can create…”. Do you mean “Re-rating OR earning growth.” Clarifying since assumption is that re-rating and earning growth go hand in hand with the later driving the former. (rational market theory). What specifically you mean by a combo of earning growth and re-rating playing together? Any example in more recent time that can put this in perspective.
Slide 8, table 1: Case 1, 60% operating expanses are fixed. However the tabulation below uses the 45 UoM (units of measure) as fixed cost. Likewise, on table 2 fixed cost is 52.5 UoM however header reads 70% fixed operating expenses. is this a typo or I am missing something.
As an aside, your argument about valuing a prospect beyond P/E multiple (slide 9) resonates very well with me. Though it may sound juxtaposition to traditional sense of Margin of safety. Reality is that P/E is an perceived notion of ‘potential of downside’ however not a reflection of ‘possibility of downside’.
The point that I am trying to make is that one can find good opportunities in business models where the operating leverage is very high, while the growth is not happening or de growth is happening due to some temporary industry/business challenges. The important aspect to figure out is whether the challenges are transient or not. The interesting part is, if the growth returns, the operating leverage will lead to non-linear growth in bottom line and hence suddenly, business that was looking expensive, can start looking fairly valued/undervalued. I personally like those kind of business models.
At the same time, I must point out the downside, that it is an double edged sword. The moment, growth starts tapering off, the fairly valued business will start looking very expensive.
My limited point is that while looking at valuation, it is very important to have the context of operating leverage in mind.
The point I was trying to make was that when I started looking at deep value stocks, mostly I will benefit from re-rating ONLY which is limited. However, once we focus on business quality and get them cheap, we will benefit from re-rating and earning growth both. Later is much more powerful in generating superior returns. This kind of tilted my approach away from looking at “deep value stocks” to “buying quality at discounted price” I hope it clarifies.
On your point on operating leverage part, Total cost in example 1 is 75 (45 fixed + 30 variable). 60% of total cost is 45 and 70% of 75 is 52.5.
You have specifically mentioned about ‘The business model- is fixed cost heavy- while the demand/top-line may fluctuate based on external environment’ through separate slide 'understand the power of operating leverage. How to look at fixed cost in a company.
Thank you for sharing the presentation. It is very helpful.
I am especially interested in Slide #8 on Operating Leverage, which I feel is one of the most under discussed investment strategies, despite the fact that it offers a chance to capture gains from re-rating and growth without going down on the quality ladder (as in cigar butts), and is a way to ensure that your portfolio is insulated from the vagaries of the market.
To that end, I have been trying to put together indicators (financial and otherwise) that might help spot cases of operating leverage. These include capacity utilization levels, and margin analysis to understand the fixed cost component (as you have pointed out). Capacity utilization is generally available through management commentary/presentations/ARs, while looking at the ratio of (% change in EBIT)/(% change in Sales) answers the question on the margin front.
In-line with the above, I have a couple of questions where I would appreciate your thoughts:
Are there are any other KPIs/indicators (financial or others) that you look at? E.g. BS analysis to look at growth in asset base? If so, please do share those indicators, and your approach to analyse them?
Identifying operating leverage is step 1, how do you approach the critical question on a company’s ability to utilize those assets optimally? Turnaround in industry demand environment is a key factor, but it is applicable to all players, so what is the best approach to assess that ability at a company level and how to factor that into valuations?
Typially, all costs that go below gross margin calculation (i.e. except for RM cost) shall be looked at carefully for each line item to determine which costs are fixed and which are variable. Typical fixed costs are such as (rent, admin cost, advertising and promotion (in most cases) etc while the variable cost will be fuel and power cost, logistic cost etc.
