Hi guys I am starting this thread with a view to share my own portfolio strategy and learn from the different strategies that members at value pickr use for the same.
Its bit of a long post because i have used analogies from the field of cricket to explain some concepts. please do share your thoughts on it thanks.
Applying mental models from cricket to create and monitor a stock portfolio.
Building your Squad / Portfolio
Think, If you were a selector how would you pick your squad?
- You will try to pick the best players from all that are available. Including a mix of batsmen, Bowlers, Wicket Keepers & All Rounders.
- This translates into trying to pick the best companies/businesses available from a mix of different sectors like Pharmaceuticals, Banking, IT, Auto, FMCG etc.
- You would want a mix of youth and experience in your squad.
- This means you will have a mix of Large, Mid and small cap companies in your portfolio.
- You would want a mix of Aggressive (Sehwag) & Defensive (Dravid) players.
- Trying to pick a mix of high growth (symphony, Page Inds) and steady compounders (HDFC, Sun Pharma)
- You will mostly select players who have performed well in the past looking at various stats like their matches played, runs scored, batting/bowling averages, strike rates, economy rates etc… also on their recent form and performances. Finally making an assessment on ones that fit your criteria the best.
- Similarly while selecting a stock one needs to understand the business by going through its annual reports, analyzing it on various financial and valuation metrics. One needs to assess its growth potential both in terms of revenue and profits going forward. Like you would not select a player, unless he has a track record of performing well or you have yourself seen him perform in a match. Similarly one should not select a stock which one does not know about or understand. Buying stocks on tips from brokers or friends or recommendations from experts on TV is like including a new face in your team because he has influence with the selectors. he might be good but would you bet your money on this guy without first getting to know what he is capable of. It is better to use tips and recommendations as ideas for further research but not investment. Invest only after you are convinced of the stock.
Team Selection / Portfolio Allocation
- You will select the combination of best openers, Middle order batsmen with your best wicket keeper batsman and a mix of different fast & spin bowlers. Your playing eleven will have the best players from your squad going out and performing in the matches.
- You will allocate most of your available funds to your best 11-15 stocks upto 70-80% of your portfolio. simply translating into allocation of 5-7% to each stock you deem fit to be in your playing 11 with the rest of the stocks having 1-2% allocation.
- You will now monitor your team performances and try and not make too many changes giving them enough opportunities to perform preparing for the next big event like a world cup. occasionally giving your young inform players a chance to prove themselves by resting or benching your regular player who is out of form.
- You will stick with your selected stocks for the long run (at least 4-5 years) and not shuffle too much giving them enough time to create wealth over time. By including some of your other portfolio ideas. Ones that are in an uptrend or upward momentum to perform by increasing your allocation to it by shifting cash from one of your major stock which is likely to under perform in short term or is in a down trend.
- Any new addition to the squad will not directly go to your playing 11 but will spend time with the team on the training grounds and friendly games where his performance will be assessed before being promoted to the main side.
- Any new stock idea will only first be in your portfolio with a minor allocation of 1-2% only after the stock has proved its fundamentals and you have a better understanding of the business it should be promoted with higher allocation of 5-7%. This will ensure mistakes will cost less and will not impact portfolio adversely. Protecting the downside is extremely important. Remember what Warren Buffett said Rule No 1 : Never Loose Money, Rule No 2 : Never forget Rule no 1.
- At the end of every season you will look at your overall squad and replace players who are plagued with injuries with better and fit players available. Also replace ones who you thought were promising at first but realized that you were wrong in your assessment and there are some better players available who should be in your squad instead.
- At the end of one year you will relook at your entire portfolio and replacing some ideas with better ones. You don’t have to do this if you believe your current portfolio already has the best ideas. It is important to make the selection or replacement on basis of business fundamentals and not simply because the prices have declined or are going down. You should replace business whose fundamentals have declined, ones with injured balance sheets with ones that have good or improving fundamentals. (For Eg. A company you liked has now diversified into an unrelated business which you believe will have negative implications or have taken on major debt which you are not comfortable with).
- You need to ensure continuity in your squad. Frequent changes or too many changes in the short term will effect the balance and hence the performance of your team. The captain will not know the strengths and weaknesses of the players, if they are constantly changed and hence will not be able to bring out the best desired performance from them. Your best players are your assets they bring the team forward and win you major tournaments. You will not drop Sachin or Kohli from the team beacuse they had a bad series as you know they will bounce back. You have seen them perform and know they are strong players.
- When you ensure to stick around with your stock picks, you start understanding the business and stock behavior better. You should not drop a fundamentally good company just because of a bad quarter or two. You will have to ask whether this dip in performance is due to a business cycle or some structural issue. Remember Form is temporary but class is permanent. If you indeed find stocks similar to sachin or kohli you should not let go of them. Look what some of the great stocks have done during their lifetime likes of Infosys, HDFC, Hero Motocorp, Sun Pharma, Kotak Bank have made many a fortune. All these stocks went through business cycles and also corrections in their stock prices but they had the inherent strength to bounce back and create great wealth for investors who stuck with them.
- Cricket is a team sport results of your team matter more than any individual performances. High reliance on one player can be detrimental to the team performance. Like Indian team in the 90’s heavily depending on sachin to win them games. The day sachin gets out early the team suffers. We want to focus on creating a solid team with many match winners and not one.
- Performance of your portfolio is more important than gains in any individual stocks. High allocation to one stock can be disastrous to the entire portfolio as any negative stock specific event could lead to the entire portfolio performing badly. Any stocks which becomes more than 10% of the portfolio should be trimmed and gains should be allocated to other scripts in the portfolio to create balance. Remember rapid gains are generally followed by rapid declines unless backed by fundamentals. This should strictly be followed for stocks which rise rapidly due to PE expansion or the ones who have run way ahead of valuations. Most stocks that are in an uptrend will find new buyers in the short term but will reverse sharply in absence of earnings growth to support the momentum. Make sure the earnings are growing alongside the stock price to avoid getting caught by a negative surprise.
- In cricket you have Test match players who generally have sound technique and more flamboyant players for the shorter version ODI’s & T20’s. But you will occasionally have players like AB De Villiers who excel at both. Adapting ones game and adding to ones skill or range of shots only help one in becoming a more complete player.
- In Investing most investors tend to follow either a fundamental approach or a technical approach. Both sides have a lot of merit attached. Fundamentals always prevail in the long run but if you equip yourself with technical knowledge it can only add to your skill set. One can select stocks in their portfolios on fundamental basis as they are for the long haul but technicals can certainly help while deciding where to allocate new or additional funds as and when the funds are available. Why own a stock which is only fundamentally sound, why not own a stock which is both fundamentally and technically sound. (Eg One of your playing 11 stock has just hit an all time new high and looks good fundamentally having the ability to assess technicals can help add more funds and average up hence avoiding the price anchoring bias). Technicals can help you understand the trends better and one can avoid value traps. Also that markets are not rational at most times, in fact they are irrational most of the time. Just because a stock becomes fundamentally cheap does not mean it will not correct further. Markets can go to extreme when there is panic sometimes making business available for less than cash on their books. Technical knowledge will help the fundamental investor when he tries to catch a falling knife
If you analyse portfolios of successful investors like Rakesh Jhunjhunwala, they normally have their bets concentrated in a few stocks (playing 11) and have low allocation to their other ideas (Members of your Squad) where they have less conviction. Your allocation should depend on your level of understanding of the business fundamentals and its current valuation. For most investors having more than 20% in one stock could be very risky and can lead to a huge negative impact on the portfolio. It is better to be more diversified if your understanding of the business is only basic which is the case for most participants in the market. Every portfolio decision need not be complex as modern finance teaches us using correlation and regression charts, sometimes the simple approach can lead to best results.
