From now on, I have increased my expected returns to 19%. Earlier, I wanted a doubler in 5-years (15% returns), now I want it to happen in 4-years.
Objective function: Weighted average portfolio returns > 19%
I look at each company from five different lenses which are stated below.
- Business quality (high/medium/low)
- Promoter quality (high/medium/low)
- Financial projections (high/medium/low)
- Valuation projections (high/medium/low)
- Is it a cyclical business (Yes/No)
Business quality: This is something I have written about in the past.
High quality business:
- Over the last 10-years, (#ROCE>20% and #positive FCF) > 14
Medium quality business:
- Over the last 10-years, (#ROCE>20% and #positive FCF) < 14 AND
- If ROE over a cycle > 12% but < 20%
Low quality business:
- Over the last 10-years, (#ROCE>20% and #positive FCF) < 14 AND
- If ROE over a cycle < 12% or free cashflow is generated <50% over last 10-years
Management quality: I define a high quality management with the following attributes
- Achieved organic sales growth greater than category average
- Is able to find new avenues to grow
- Treats minority shareholders in a fair manner
The first two criterion can be easily checked by looking at the past, however the third criterion is more subjective as different shareholders have different expectations. I bring in my own subjective judgement and categorize each management as High or Medium or Low.
Financial projections: The important metrics are future sales growth, margins, reinvestment requirements and ROIC. This is more a reflection of my understanding of the business and is a speculation on my part. If I have high degree of certainty in my speculation, I give it a High rating.
Valuation projections: This is done by comparing how market has valued a business or a sector in the past. Some examples are stated below.
- An auto-ancilliary company generating 14-16% margins with sales growing at >12%, the business having ROCEs > 18% gets valued at >2.5x EV/sales in a bull market (examples are Suprajit, Amara Raja).
- Generic pharma companies with reasonable ROCEs of >18% over a cycle gets valued at >4.5x EV/sales, even more if they have a branded business in some markets (numerous examples like Sun, Lupin, Alembic, Ajanta, etc.).
- Good lenders who generate 15%+ ROE over a business cycle trade at P/B > 2.5x in good times.
If I have a high level of confidence in my exit valuation, I give it a High rating. However, if a company has limited track record (such as RACL Gear) or I have applied a very high terminal multiple on that company (like 30x exit EV/EBIT for HDFC AMC), I bring down my level of confidence to Medium.
Cyclicals: If margins are all over the place, it generally implies a cyclical company. This is rather binary and easy to judge.
Now that I have summarized my thoughts on the five different lenses, here are my thoughts on how I size a given company in the portfolio.
4 different position sizes
- 8%: High confidence bets
- 2% and 4%: Most discretion is restricted to changing position sizes between 2-4%
- 1-2%: Deep value + optionality
Hard constraints
- More than 50% of my bets should in non-cyclical businesses
- <30% bets should be in cyclical businesses
- <20% bets should be in special situations
Order of weightage (in non-cyclical): Business quality > Promoter quality > Exit valuation
Order of weightage (in cyclical): Promoter quality > Business quality > Exit valuation
Non-cyclical businesses
R means expected returns over 3-5 year period
- High on business + High on promoter
o R > 19%: 8% allocation
o R > 15%: 2-4% allocation (discretion based on available opportunities) - High on business + Medium on promoter
o R > 26%: 8% allocation
o R > 19%: 2-4% allocation (discretion based on available opportunities)
o R > 15%: 2% allocation - Medium on business + High on promoter
o R > 26%: 8% allocation
o R > 19%: 2-4% allocation (discretion based on available opportunities)
o R > 15%: 2% allocation - Medium on business + Medium on promoter
o R > 26%: 4% allocation
o R > 19%: 2% allocation
Cyclical businesses
- High on business + High on promoter
o R > 26%: 8% allocation
o R > 19%: 2-4% allocation (discretion based on available opportunities) - High on business + Medium on promoter
o R > 26%: 4% allocation
o R > 19%: 2% allocation - Medium on business + High on promoter
o R > 32%: 8% allocation
o R > 26%: 2-4% allocation (discretion based on available opportunities)
o R > 19%: 2% allocation - Medium on business + Medium on promoter
o R > 26%: 2-4% allocation (discretion based on available opportunities)
o R > 19%: 2% allocation
You will see R values are divided into 15%, 19%, 26% and 32%. This reflects doubling in 5-, 4-,
3-, and 2.5-years.
Special situations
There are many different kinds of special situations. My one hard rule here is to sell after 2-years if nothing happens (basically bite the bullet and move on regardless or price). I currently invest in 2 types of special situations:
- Companies with in-built optionality
- Deep value bets
Companies with in-built optionality
Companies with leadership in multiple areas (like a research based company like Praj or a Natco with multiple Para IVs)? Allocate 1-2% when they are available at no-growth valuations i.e. current earnings stream and cashflows account for their market cap (10-12x normalized earnings). What should be the exit criterion? Can it be price based i.e. sell when <20% of peak price. I don’t have a comprehensive framework here, any help will be appreciated.
Deep value company identifiers (allocate 1-2%)
- Sustainable dividend yield of 8%+
- Net nets:
o Adjust working capital: Cash & short term investments + 75% account receivable + 50% inventory – total liabilities (including off-balance sheet items)
o Market cap < 0.66 * Adjusted working capital - Cyclically adjusted ROCE and ROE > 20%, P/B < 1 (maximum 1.2)
- Cyclically adjusted ROCE and ROE > 12% & <18%, P/B < 0.5 (maximum 0.6)
Further thoughts
All of these rules do not take care of one special scenario which is: How do I make enough allocation if I am able to spot a PI/Ajanta/Avanti early on? For now, I will keep on with my 8% rule for these opportunities and keep thinking about it. In the next few posts, I will summarize how I have applied these to a few of my portfolio companies.