I would like to put across my thoughts on ‘Portfolio Construction’. Stock picking and portfolio construction I believe are two different aspects. Please note that there will be a lot of gaps in my current thinking about portfolio construction and it is still a work in progress (that’s why I have not constructed a portfolio yet). Your inputs are welcome.
As a retail investor, I tend to focus a lot on individual stocks and stock picking, etc. but I have paid very little attention to the question – ‘’what is the right way to construct a portfolio?’’.
With the limited resources and skills, I possess to construct a portfolio, there is very little I can think on my own regarding this topic. Fortunately, there is a section of the equity market that focuses a lot on this aspect - in fact, portfolio construction is their bread and butter – and that section is the Mutual Fund industry. My effort is how I can learn from Mutual Funds about portfolio construction.
This is a five-part series that includes the following topics – 1) Portfolio Philosophy 2) Risk-adjusted returns 3) Allocation and position sizing 4) Market Cap equation 5) Cash, market timing, and valuations
In this post, I am going to talk about Portfolio Philosophy
Portfolio Philosophy (style)
Portfolio philosophy is important because of two aspects – (1) It gives you overall construct to select companies in the portfolio and (2) which is the most important – it helps you to assess your underperformance objectively
Some of the examples of portfolio philosophies are Quality & Growth, High beta, Value, Growth at Reasonable Price (GARP), etc. I agree with the point that the definition of these philosophies is a ‘grey area’ because growth is part of value and value is in the ‘eyes’ of the investor. So on so forth. To keep the discussion simple and objectively assess different philosophies or styles, I am going to give some examples
||Don’t mind overpaying for growth stories – Bajaj Finance and Avenue Supermart
||Focus on outperforming markets massively in good years by taking help of high beta avenues like – Small caps, Metals, Industrials
|Mirae and Parag Parikh
||Conservative on paying high monies for growth. Equal focus on quality and valuations
Why knowing or defining the portfolio philosophy (style) is important
I am going to talk about in detail the second aspect of the importance of defining portfolio style which is - it helps you to assess your underperformance objectively
It is proven that no portfolio or an investor can outperform the benchmark every year. To try outperforming NIFTY/Sensex every year is futile and if someone tries that then in fact there is a higher chance of underperformance. Conviction to stick to style when it is underperforming decides long-term investment success.
As the underperformance in some years is almost always guaranteed, portfolio philosophy helps to determine in which market conditions the portfolio can underperform. For example – Axis portfolios underperform when there is a broader market rally like FY 20 but they tend to outperform when there is a sideways or bear market. Similarly, IDFC portfolios fall hard in the bear market but compensate more than they lost in the bull market (high beta).
If we know or have some guidance on when our portfolio will underperform then it is very easy to judge objectively whether underperformance is due to portfolio style out of favor or else whether it is due to the process is broken
Case study - IDFC Fund style
The following screenshot shows, how the return of IDFC fund house’s philosophy was looking like in July 2020. Five years’ CAGR returns were less than 5%. All the thoughts which would come normally like returns less than FD, MF never make money, etc. flashing in my mind
Knowing IDFC employs a high beta style, I asked my self – Is the underperformance due to style out of favour or the process is broken. I concluded it is because style out of favor since 2018 broader market and high beta stocks have taken a hit. I held on and check below what happened in 8 months. In Mar 2021, 5-year CAGR was 18.30% ( from less than 5% just 8 months back)
Conclusion and takeaways for portfolio construction
Knowing and defining portfolio philosophy helps to navigate through underperformance which is as certain and routine as the sun rising from the east for any portfolio