Towards a Capital Allocation Framework!

[Donald]

Ever since the astute senior investor (Mr D) brought my attention to it, I have been trying to refine my thoughts on the subject and create my own models.

They have reached some shape and structure - that I feel confident of sharing the outcome with all fellow-learners. This is NOT a complete model but rather in the nature of a Work-in-Progress document.

While one senior pointed me to it and helps me with refinements, another (Mr M) helped me tremendously in creating the model(s). Both of them shy away from active participation in forums, so I cant acknowledge them openly:(.

This is my way of paying it forward - Mr D & Mr M. Hope I can do justice in introducing the concept as lucidly as you did for me and then build on it!

[Donald]

Mr D asked me "Suppose you had 5 good picks. How would you allocate your money among them? I suppose today you do it randomly, or roughly equally"

I was stumped and had to admit I was doing it pretty randomly. So I asked him "How would you do it Mr D"?

He said, see if you like my method:

Undervalued		Conviction	Allocation
High	vs	High	Highest allocation
High	vs	Medium	Normal allocation
Medium	vs	High	Normal allocation
Medium	vs	Medium	Nibbling allocation

And he added I refer to "Undervalued" here from a sheer/absolute undervaluation perspective - not relative to historicals, market or industry peers! Similarly "Conviction" is your conviction in the business - the level of homework/research and understanding of the business or company you have achieved, not whether everyone agrees!

This resonated with me immediately! It was a big jump up my learning curve, just having this framework with me - simple, elegant, easily transferable :)

[Donald]

It did not take me long to start assigning allocation weights for Portfolio construction. I was ready to create a Concentrated Portfolio for myself!

A word of caution as we proceed: This exercise is probably relevant for people who can devote full-time, or a major part of their, energies into actively Investing in Markets. Passive Investors (with full-time jobs) are better off with a well-diversified Portfolio. But even they would benefit from being able to differentiate among their bets!

Why a concentrated Portfolio for myself? As I looked back over my last 3 years or more or less pretty active Investing, I have a natural bent to go deep, to understand the stock story as best as I can, I put in much more effort into stock selection than most people do or need to:) Many folks like Hitesh get it 80% right with 20% of the effort I tend to put in:). I don't have that gift...but hey I like knowing in & out of the company I am invested in!But have I made the most of my real hard work? The answer is NO!

So I offered back this model to Mr D, and asked for his comments.

Undervalued		Conviction	Max Weights	Allocation	Portfolio
High	vs	High	40%	Highest allocation	long-term
High	vs	Medium	20%	Normal allocation	short-term (long-term as conviction builds)
Medium	vs	High	20%	Normal allocation	long-term
Medium	vs	Medium	5%	Nibbling allocation	short-term (long-term as conviction builds)
Screaming	vs	Highest	Call addl. funds	Can override guidelines	long-term

He said "You got it!".

Allocation Limits

I asked him isn't 40% like way too high/risky. He smiled "Why not? Remember, it is your stock - you know it in and out, its pretty individual, you know that - your personal situation and risk taking ability decides. Even a 25% max allocation may be too much for most folks. But I would think everyone needs to think on these lines and differentiate among their best picks. Which is No#1, and why? and why is that one No#5? Can you explain that lucidly to a layman in 2-3 paras - A framework like this forces you to think that way, that's the idea"!

Liquidity Impact

I asked him "What about illiquid stocks with low average trading volumes? Our kind of stocks have an impact cost in entry and exit." He said "In my experience, stocks with strong fundamentals, good growth and low liquidity has actually worked to my advantage, most times! Low liquidity shouldn't matter, if you are invested for the long term. That reminds me, your Portfolio must always have the strength to encash on big drops in your high conviction stocks, say when the whole market tanks. As a rule, I like to remain 20% CASH, atleast. In times like now I like to be 40-50% cash. Work out yours"!

[Donald]

Next I told him, "It looks like if I were to follow above model, I will always be running 2 Portfolios. One a long-term portfolio, and another a short term "Opportunistic" Portfolio. The short term portfolio contenders are work-in-progress prospects, may get discarded after valuations have caught up, or may even migrate to long-term Portfolio as conviction builds up". Or may even be average prospects with great undervaluation due to xyz reasons - to be exited, once valuation catches up".

Big Picture	Allocation	Characteristics	Expectation	Holding Period	Profit Booking
Portfolio	100%	Concentrated bets	Doubling in 2-4 years	5 years
Emerging bluechips	50%	long term compounding	Doubling in 2-3 years	5 vears	Only when it can't double from here
Opportunistic	50%	short term mispricing	upwards of 50% in <1 yr	max 1 year	closely review post target/holding period
Cash	incl. in above	Averaging down on bets	not missing out on unexpected bonanzas	-

"Righto" he said! Mr. D was happy that I was progressing. "What I like about your twin portfolio is - by design, you would probably always be 20% plus in cash, else you cant take these opportunistic bets".

[hitesh2710]

Interesting discussions donald. Maybe you should come out with the actual names of stocks and the percentage allocation to each.

I will give my views here

PI inds 30% high conviction, reasonable valuation(but likely to re rate upwards)

Mayur 15% high conviction, cheap valuations (may remain cheap)

Ajanta 15% high conviction, cheap valuations(again may remain cheap)

In all the above re rating triggers can happen anytime and till that happens growth should take care of price appreciation.

This locks in 60% of capital for long term investing. Rest 40% can be played around in various opportunities.

Would like to disclose that these are not necessarily the percentages that the stocks occupy in my portfolio. Its just to provide my viewpoint to an excellent discussion started by you.

[Donald]

So far so good! This was the easy part!

Now I had to apply myself to the task of sifting through my stock picks and assigning each of them a "Valuation Rating" (VR) and a " Conviction Rating" (CR).

This was a pretty stimulating exercise, but something that I could not have proceeded on my own! As is my won't I sent off mails to many seniors that I knew. Mr M stepped forward and practically drafted the CR model for me, as he penned down his detailed thoughts to me!

And this is what I got back to Mr M with:

Conviction in Company's business prospects (CR)
Business Quality	Management Quality	Fundamentals	Industry Position & Track Record	Growth Prospects
BQ	MQ	FM	IPTR	GP
20%	20%	25%	15%	20%

I realised it was important to have all these 5 distinct parmeters in mind while I think about a stock and its prospects. One may decide to assign different weights to each parameter- that's okay. You may decide 40% should go to Fundamentals, thats okay. Also, useful to remember that if in your scheme of things, any individual parameter has only a 5-10% weight, it becomes pretty much insignificant in the overall picture, and may not be necessary to model in!

[Donald]

“This seems more or less right”. Mr M gave me another insight. "As you go thru this exercise you will see that the CR aligns very well with FM rating. That is if you get high rating on Fundamentals for a company, you will usually see a high CR following!

And when I presented this back to Mr D, he had more to add. He said “the Model is roughly right, but the weights are probably off the mark”! “In my experience in Indian markets, Growth or the absence of it, is the single biggest determinator of Capital Allocation success - coupled with the discounting you accord for future earnings - like for today’s high inflation, high interest, longer credit cycle situation you have to have higher discounting. If you get either the Growth or the Discounting wrong, 9 times of 10 your stock performance suffers. In my book, Growth Prospects weight is as high as 40-50%, the balance distributed among others”!

As I thought more about this and correlated with the experience over the last year, I am tending more towards Mr D’s weights! Growth is King! Fundamentals and other aspects need to be strong for sure, and if they were weak such stocks don’t figure in my picks, right.

I realised, all other things being equal, the Size of the Opportunity before a business, its competitive advantage, and its Ability to Scale Up (ability to fund, manage the growth environment, execute, etc.), determines the Growth prospects for a business - and the success of my Portfolio allocations.

Simple. You already knew that, right?

Till I had actually worked myself through thinking about a variety of stocks in my basket, using the framework stock by stock, many of these were not even present in my mental models:). I think I used to think about my stocks individually in independent, but incomplete ways!

Now I think, we have a base Working model. Thoughts Invited.

[hitesh2710]

I think you need to elaborate on each part of weightage-- what kind of questions you will ask yourself to determine how much marks or points to give to each set of parameters?

what comes under management quality, fundamentals, business quality, and so on. may be a small list of 2-5 questions addressing each parameter.

regards

[Donald]

Thanks Hitesh! Excellent suggestion.

I was wondering how to present my thinking process behind each of these parameters. A small list of pointers/questions may prompt good discussion.

That’s tomorrow’s agenda!

[dkirand]

This is absolutely phenomenal stuff! Thanks Donald for all the hard work and Hitesh for his pointers.

I have a few fundamental questions -

1. How do you define/What is Business Quality? - Any business is good business, as long as it makes money. Even commodity businesses make money. Even waste extraction/recycling makes money. So, what do we mean by business quality? Is it the moat or competitive position or margins or ROCE or all of these? I don’t understand the Oil or the Real Estate sector and hence will not invest in them - should Business Quality consider this too?

2. What is/How do you arrive at Management quality? - I know this one’s a little subjective, but let me take a shot at it. Does Management quality involve good and comprehensive reporting (like Infosys does)? Usually this quality is defined over long periods of time (or history) - so should we wait for this to pan out? The only way I enumerate this quality is through their dividend policy, but then again, Microsoft never paid dividend for years. That doesn’t make Microsoft’s Management quality to be defunct - it makes my blinkered view to be horribly wrong.

3. Fundamentals and Industry position are relatively easier to figure out since they are quantitative. Margins, ROCE, EPS, D/E, Total debt, Asset turnover etc.

4. Growth prospects - This one is interesting, but I think Phil Fisher’s book gives you a pretty good idea on this along with the wonderful investors of Valuepickr forum. But as the senior investor ‘D’ said, the indian market stock price hinges on this and it would be interesting what we come up with.

So yeah, framework’s excellent (I think Hitesh already had this framework in the thread ‘Your Top 5 picks’ regarding fundamental and conviction grade and this one refined over it). I’d love to learn from this.

[JAISHRIKRISHNA]

Thanks donald for writing this, this is real good, the material we are posting on valuepickr is just too good, no site offers such material, i know people will argue that there are some, but valupickr comes right at the top. in my view a low base m.cap with 15-20% growth attached to it and less to no debt, makes a good combination to start with.

[Donald]

Glad to see some enthusiasm pouring in. Please keep pouring in your comments, questions & suggestions. Thanks a lot for the encouragement!

We will add refinements, once I am through presenting the base model.

Business Quality (BQ)

I thought of Balaji Amines (Chemicals) and Opto Circuits (Medical Devices) as leading examples. When I thought about the quality of the respective businesses - a few things immediately sprang to mind. The businesses were radically different!

The 5 parameters of Business Quality was Mr M’s generous gift to get me started. I realised I had not been paying enough attention to these, as they logically demanded! Now all I had to do was think a bit and fill in the sub parameters:)

1.Nature of the Business

(commodity, commodity processors, high-tech, cost plus, price setters, monopoly/ oligopoly, fiercely competitive)

2.Moat/Competitive Advantage

(brand plays, economies of scale, ability to pass on price, entrenched customers, long complex approval process, patents, R&D, product innovations)

3.Sector Attractiveness/Market Fancy

(defensives, glamour sectors, dull & boring, high growth, likely PE ranges)

4.Cyclicality

(sales and earnings growth cycles? over 5 and 10 year periods)

5.Raw Material Dependence

(RM/Sales percentage, RM price swings and correlation with OPM)

With rubber prices shooting up, Relaxo was having a tough time on margins. Gujarat Reclaim also had a problem on hand - scrap rubber prices were increasing in tandem with rubber prices. On a full year basis, the impact on margins for Relaxo was drastic 4-5% fall in OPM, whereas margins for Gujarat reclaim had a much smaller, 1% impact!!

RM dependence may be drastically different for different companies for the same commodity! So the correlation of OPM to fluctuations in RM pricing is important to differentiate.

Views Invited! Help solicited in adding, refining sub parameters as above.

[Donald]

Growth Prospects (GP)

Opportunity Size!

We may be looking at 2 companies dominating their respective “Niches”. But the size of the niche may be very different! I thought of an Astral Poly Technik Pan-India Plumbing current market worth 17000 Cr, contrasted with a Specialty Chemicals oligopoly like Vinati Organics ATBS market size. And then thought of Suprajit Engineering addressing current global cables market of $2.5 Bn. And then the,

Ability to Scale up

To address growing opportunities from initial successes! Not every company is able to scale up. Who are the most likely candidates to make it to the next level?

Again Mr M came to my rescue and supplied (other than the usual suspects) 2 crucial parameters -any guesses?

1). Industry Growth

(current size, annual growth rates, projected CAGR)

2). Company Growth

(organic, inorganic, sales growth, earnings growth

3). Ability to Fund Growth

(existing d/e, industry median d/e, previous track record, industry confidence, free cash flows)

4). Barriers to entry

(from a competence to manage growth perspective; regulatory approvals, govt approvals, patents, entrenched customers, difficult to switch vendors, economies of scale, nearest competition)

5). 1 year Earnings estimate

(TTM EPS, Half year EPS, prev year YoY growth,YoY Growth estimate)

Again I realised, I was not thinking enough on these lines. Sub-parameterising helped me construct more mental models to readily tap-into while thinking of a prospect!

Views and suggestions Invited!

[Donald]

Management Quality (MQ)

Now, this is a subjective task as Kiran points out. But in Dec 2008, I was pointed to a fine book that showed how you could bring in lot of objectivity into the subjectivity:). This time by, my first investment guru, another senior investor Subhankar Ghose from Calcutta, who played a major role in my shaping up as a wannabe individual analyst. Thank you Subhankar, I can never thank you enough!

5 rules for successful Investors - PAT Dorsey, Director Equity Analysis, Morningstar has a whole chapter dedicated to studying Management! A synopsis is available in ValuePickr Stock Analysis Framework

Even without meeting Management, a whole lot can be found out!

No Kidding. Is it any surprise that the largest no of parameters (10 in all) belong to MQ? No guesses required, I had Mr M to fall back on.

1). Type of Management

(First generation, Family run, Professional)

2). Management Drive

(stated objectives, growth and track record, domination of its niche)

3). Management Depth

(Top Management team, Board composition, Performance, Attractiveness as employer)

4). Management Integrity

(Related party transactions, Habitually talking up the stock, warrants conversion premium/discount, Ability to retain high-quality talent, Auditor differences/resignations, tax payment records)

5). Disclosure Norms

(Annual Reports, Prompt Announcements on developments, Auditor’s qualifications)

6). Follow-Through

(Walking the talk, 5 years track of plans and execution record, deliver on commitments)

7). Self-Confidence

(Ability to think and do things differently, planning 2 steps ahead)

8). Compensation

(Fairness, Industry standing of top management, peer comparisons, linked to performance)

9). Shareholding Pattern

(promoter holding, MF Holding, FII holding, sharp changes in promoter holdings, pledged shares)

10). Regulatory/Compliance

(SEBI strictures, IT raids, BSE/NSE bans, Penalties imposed)

Going through this was enjoyable. These were framed almost 8-10 months back. It struck me as I came to listing Management Depth - how for example, Mayur Uniquoter’s ratings have changed as it inducted top quality professionals in senior management positions!

Each parameter is important. Not all them remain in our active mental models!

Views, suggestions?

[Vedant]

Hi Donald, thank you for this special journey…it feels like your are taking us thru a jigsaw puzzle

In management depth, woudntmeeting the managementhelp in assessing “self confidence”, “Integrity”, “Drive” and “Depth” which brings in the subjective part. How confident will one be in taking a large bet without somebody in our circle meeting the management?

Will a management’s “proven skill set” be part of depth?Take the case of Balkrishna tyres wherein earleir top management started a new com in the same bus. And there are many promoters who ownmultiple cos. How about performance of group cos?

Rgds

Vinod

[Vedant]

Donald,

Your profit booking portion in the earlier post does not talk about exiting in overall weak markets.

When Mr D talks about liquidity, he mentions exiting (partly/fully) when the overall market conditions look weak. This exit is also for your high-conviction, high-undervalue picks, your 40% allocation ones includedright? Or are we saying, to beon cash we will exit only that part of the portfolio which comprises the remaining 60% allocation? Isnt this were your NIFTY PE analysis comes in?

Hope thisquery doesnt affectthe existing flow of the discussion…

Rgds

Vinod

[Donald]

Thanks Vinod! I am glad this is of use to folks like you. Exactly how I felt as I was being introduced to it a year back, by well-meaning seniors!

Yes, “proven skill set” is a factor. Deepakh Parekh on board of IDFC immediately accords it an advantage in the eyes of investors.

Meeting Management - for assessing MQ, fist-hand

There are pros & cons to meeting Senior Management of a company. Mr D for example, assiduously avoids meeting company management one-on-one. He will rather meet them at AGM sidelines, if at all. Some people say there is the risk of you getting biased, be completely floored by strong magnetic personalities, and fall in love. My experience so far has been good. As a rule, I don’t go and meet Management till the time I have satisfied myself that I know as much as could have been possibly known about the business by an outsider. So I have homework ready (contributed by stalwart ValuePickrs) and follow-up 2nd or 3rd level of details on most questions asked. That way we get Management to start talking freely…that kind of environment if it happens…is great to observe body language, the conviction in the eyes, connect small small observations/ viewpoints, and the like

So far we have not been disappointed on Management Quality part on any of the companies we have met. Ayush & me keep joking…a day will come soon, when we will fall flat. Probably its a reflection of the kind of screening that we collectively are able to do, before proceeding to the next level for a company.

Yes - meeting the Management firsthand, seeing a plant buzzing with action, talking with people down the line…and noting a fire in their eyes…well these things can double your CONVICTION in just a 2 hour interaction.

No amount of second hand information/conviction transfer can match that. Thatswhy I try to record the Management Q&As in as much detail as possible. I have often come back and doubled my stakes in the company post a satisfactory Management meet. In my way of doing things, there is no substitute to that!

But I believe you can still get most of it right. Somehow these things have a way of adding up! A company with a solid track record and strong fundamentals happens because of the Management Quality, not otherwise.

[Donald]

@Vedant

Donald,

Your profit booking portion in the earlier post does not talk about exiting in overall weak markets.

When Mr D talks about liquidity, he mentions exiting (partly/fully) when the overall market conditions look weak. This exit is also for your high-conviction, high-undervalue picks, your 40% allocation ones Or are we saying, to cash we will exit only that part of the portfolio which comprises the remaining 60% allocation? Isnt this were your NIFTY PE analysis comes in?

Profit booking/Exit decision

Well, the idea is to exit/book profits as soon as your targets are met. Assess if it can still double form here within the next 2-3 years. If not, you are better off taking it out and putting it in the next opportunity that can compound at 25% plus CAGR. If nothing can, i.e. markets are way overpriced, you better stay in CASH and wait. Mr D can wait endlessly:) I can’t get him excited at all:).

In 2008 I did not have access to Mr D or others. I had no experience of a bear market, like most others who started in 2005 or so. Consequently, I have a pretty poor track record of exiting in 2008 - I stayed invested, completely, throughout the mayhem:) …with not much pain…BUT huge huge Opportunity costs!

So, from what I have assimilated so far (understood, but way to go in practice):

1). Short Term Portfolio : You start booking profits once your targets are reached. Think Pondy Oxides, Rs 30-45, our 50% appreciation target happened in 1 or 1.5 months. I booked 20%, saw it ride to 60, booked another 25%, touched 70…sold another 35%, and back at 65…exited completely. Veterans have told me…just as you get in slowly and keep betting more as conviction builds, exit also slowly never at one go…so you can ride most of the way…never wait to cream it off fully, either!

2). Long Term Portfolio: Whenever my target of doubling gets met, I must book profits if I think the stock cannot double from here again within the next 2-3 years. Take the case of Mayur Uniquoters (it has corrected with overall market) it had almost doubled form my entry of 230, but it had not got over-expensive, the valuation gap had ceased. In my books Mayur can keep compounding at 30% for next 3 years. I agree with Hitesh, anywhere around 370-380 is a good price for additional buys (may be re-entry for him!).

2008 like situations - where everything is primed for one big fall. You better conserve CASH. if your picks have been right, then you would have met your targets anyways, and would not find anything that will compound at 25% CAGR

That’s only the theory. I have to see how well I can stick to the discipline!

Do I have the character or the stomach to be emotionless about my winners? I still have to get rid of my legacy large caps - Infy, Bharti, Reliance, Telco and BHEL, L&T for my wifey’s. I have done 50% of the job, balance 50% as I build more conviction!

includedright? beon

Vinod

[basumallick]

Donald…great thread…a very very important aspect of managing money (for oneself or others) and one which gets happily forgotten!! In fact, I have been looking for some book on portfolio structuring (not based on CAPM or Modern Portfolio theory) and my search still continues… anyone, who knows of any good book please let me know…

One thing I think you have not covered in detail is the allocation to cash. It is very easy to say that we should have some cash always, but let’s say if I had 20% cash in my portfolio in 2003, by 2007 I would be looking like a fool and cursing myself. On the other hand, if I had 20% of cash on Dec 2007, I would be cursing myself for not being 50%-70% in cash on after the crash.

My question is (and I keep struggling with this myself) is what do others including seniors like Mr M and Mr D say about cash in the portfolio? Do they decide on cash levels based on overall market levels?

But overall the capital allocation framework is extremely valuable and we need to think about it and gain from the experience of the seniors.

[basumallick]

Another factor that we need to consider in this whole equation is that of valuation. How much weightage should it get? For example, if there are two companies A & B and both have similar characteristics but A is available at half of B’s valuations (on some standard parameter like PE,P/B,DCF etc), then what would you do and why?