Towards a Capital Allocation Framework!

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!

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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?

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

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

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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

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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.

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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

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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.

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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?

The Buy Decision

We worked out a simple model for that:)

wCR + wVR = Stock Score, or its attractiveness, at a given point of time

Lets say CR and VR are on a 10 point scale.

Case 1

Your example is CR for Mayur Uniqoters and Astral Polytechnik is both 8, but VR for Astral is 8 and Mayur 6, right?

Astral would be a clear winner, in all cases.A better example, and I am guessing this was the debate in your mind:

What happens when CR and VR ratings are in different directions for 2 stocks?

Case 2

i.e, Astral has a CR of 6 and VR of 8, while Mayur has a CR of 8 and VR of 6

Then it will depend more on what you value more - the higher conviction or the higher undervaluation. i.e the weights you would assign to CR and VR

I am firmly in the higher-compounding camp i.e. an excellent business at a fair price, but I have seen many veterans too placing more emphasis on undervaluation. The jury is still out, even for me - as I can only find that out by my own experience, hopefully pretty soon!

I tend to assign CR with 60% weights, and VR with 40% weights.

CR

wCR

VR

wVR

SS =

wCR+wVR

Astral

8

0.6

4.8

8

0.4

3.2

8

Case 1

Mayur

8

0.6

4.8

6

0.4

2.4

7.2

Astral

6

0.6

3.6

8

0.4

3.2

6.8

Case 2

Mayur

8

0.6

4.8

6

0.4

2.4

7.2

Makes sense, or?

If it does, I can ask for further comments from Mr M & Mr D:)

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Yes…makes imminent sense…but let me digest what you said and think on this a bit more…and yes, please ask MD!!

Also, the cash level in a portfolio needs some thought as well.

Excellent flow of discussion!

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Donald,

Coming to the points put up as a checklist for looking at a company

Business Quality)-- This should be relatively easy. We should be able to ascertain whether quality of business is great or not.

1). Is the business suitable for long term investing? Is there ample opportunity for the company to grow its business at a smart pace over the next 3-5 years?

2). Does the business entail excessive capex? And does the capex generate sufficiently high returns to justify efforts to expand?

3). Is there any possibility of govt interference creating problems with the prospects of the business?

4). Is the business sensitivie to raw material price volatilityâis the business such that price hikes can be passed easily?

5). What kind of business are we looking at? Is it a sunrise sector(agri, water and waste water management, cloud computing, biotech etc), or a steady growth sector(consumer, fmcg) or a neglected sector(capital goods, infra space)? Many a times it happens that todayâs sunrise or a steady business is tomorrowâs neglected business.

6). How are the majority of companies in the sector doing? If most of them are doing well then it should be a good business to invest in.

**Management Quality **)-- Here there are a lot of subjective opinions possible. Essential questions one asks are

1). What kind of promoter holding is there? Any excessive pledging?

2). How have the management handled the companyâs growth in past few years. Whether they have taken unnecessary risks/debts etc. Whether any bets taken by them in the past have paid off or failed?

3). Does the management have the hunger to grow?

4). How are the shareholders been rewarded? Dividend payment and high dividend payout ratio is a very big plus for investing in small cap companies bcos that assures me that the profits reported are for real.

5). Some usual antics of managementsâwhether they allot themselves convertible warrants and donât convert?? Whether they sell their holding at opportune times in open markets? Whether they are likely to take the minority investors for a ride with the cash in the bag?

6). Management remuneration? Whether it is justifiable?

7). How do they answer investor queries at AGMs or other interaction platforms? Whether they walk the talk? Whether they promise less and deliver more? Or the other way?

FUNDAMENTALS: We at valuepickr seem to be good at this.

1). Starts with the growth or lack of it. Kind of growth shownâfast, medium, slow??

2). Whether growth if any has been achieved by resorting to too much debt or equity dilution?

3). Return ratiosâROE, ROCE etc. I dont need to elaborate on these.

4). Any chances of sudden change in fundamentals for better or worse? Is the company on the cusp of a phase of explosive growth? Or is the company at the peak earnings levels after which it is supposed to slow down/show degrowth?

5). Again dividend payout and especially increasing dividends with increasing profits.

6). Free cash generation or operating cash flows over past few years

Industry Position and Track Record

Here one asks where the company stands in the peer group. Most people want to invest in sector leaders only and believe that only these create multibaggers. I beg to differ here. There have been many instances where the sector leaders have reached such a big level that there might not be too much space to grow? Here the smaller nimble players with some kind of advantages make smart choice for investing.

And whether the company we want to invest in is growing at higher than industry average? If so what seperates it from others? Any advantages/niche?

GROWTH PROSPECTS:

This should has been covered earlier in fundamental analysis itself so does not need too much elaboration. But I would be wary of companies which keep growing their profits without significant increase in the sales figures.

VALUATIONS

I think all of the above factors may be considered in evaluating the company and then the valuation part begins? What kind of valuation am I paying for getting the business? Is there some flawed market perception which is giving me a chance to participate in companyâs growth at a very cheap entry point? What is the status of the general market mood? Is it a bear phase/bull phase or sideways market?

What kind of market cap the company has and what kind of opportunity the company has to grow a few years down the line. And while looking at market cap it is very essential to look at the Enterprise Value because only market cap is often a factor which is misguiding(. E.g Textile sector stocks)

17 Likes

Thanks Hitesh for putting in your detailed thoughts. I will use these to add to refine our checklist on BQ, MQ, IPTR.

Growth prospects need a separate focus - just the growth track (what we mostly do under fundamentals) is not enough, I have come to understand. Two companies may have similar growth tracks, but thinking about the Size of the Opportunity and the company’s Ability to Scale Upmay place them in different leagues, from a Capital Allocation perspective!

Please look at Growth Prospects (GQ) checklist above and help add more points that can help us guage - size of the opportunity and ability to scale up.

On the scoring front, I use a subjective scale and then sort of map it to a 1-4 scale.

For Conviction Rating

1 - Low

2 - Medium

3 - High

4 - Very High

**For Valuation Rating (upside possible in next 2-3 years)
**

1 - upto 25%

2 - 25%-50%

3 - 50%-100%

4 - More than 100%

Trick is to focus on companies where both are 3 or 4.

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Here is another checklist I picked up recently from a book I read (New Era Value Investing by Nancy Tengler)

, which I think is pretty useful.

Qualitative (2 out of 3)

Y

N

Quantitative (5 out of 9)

Y

N

Business Obsolescence

Sales (Revenue) Growth

Franchise / Niche Value

Operating Margins

Top Management & Board of Directors

Relative P/E

Positive free cash flow

Dividend Coverage and growth

Asset Turnover

Investment in Business OR ROIC

Equity Leverage

Financial Risk

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Thanks Mr. Hitesh forsharing thevaluable information on Business quality, Magt. Quality, Fundamentals, Industry position & Growth record, Growth prospects & Valuation. No book/ articlehave provided such a detail information on these topics. All value pickr members have understood your strength on stock selection.

As always another great Post Donald Sir.

For me capital allocation boils down to the following steps:

  1. Identifying businesses you understand quite well.This is essentially a screening process where you identify the ‘n’ businesses you think your portfolio should comprise of and that you understand reasonably well.
  2. Evaluating theirattractiveness vis-a-vis their expected prices (Expected Earnings x Expected PE) over the next 1/2/3 years.Estimating earnings is easier than estimating the PE. I work with an expected PE range of 1-1.25 times expected topline growth.
  3. Allocating capital based on how confident you are of the predictions made in step 2.For example if you have three companies A,B,C and the return expectations over the CMP over the next one year are 40%,25% and 10% respectively you should invest:
    a. 40/(40+25+10) = 54% in company A
    b. 25/(40+25+10) = 33% in company B
    c. 10/(40+25+10) = 13% in company C
  4. If the expected return from CMP is less than 15% for the year like is the case above, then that portion of the capital goes into cash or is divided into the rest of the companies in the same ratio that was earlier arrived at.This method forces one to have not more 6-7 stocks in the portfolio because the moment you have the 7th stock the expected return from that stock goes below 15%.

So in my case i own two stocks Hawkins and Page Industries.

I expect Hawkins to do an EPS of 85 and trade at a PE of 25-30 - a target return of 25-50% from CMP.

I expect Page to do an EPS of 85-90 and trade at a PE of 30-35 times - a maximum target return of 25% for the year.

So if i were to invest today my money would be 66% in Hawkins and 33% in Page.

Views invited.

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Just to add.

For businesses where there is some earnings visibility its better to compute expected earnings and prices over 2-3 years (rather than just 1 year) and then arrive at theweights. The portfolio should of course be rebalanced as and when new information emerges that forces you to change your estimates of earnings/PE.

Moving to CASH

**
**

You can never be prepared for a serious crash, can you. The events of the past week must have caught many under-prepared if not totally unprepared.

I had been preparing myself slowly over the last 2 months, to stay invested only in those with highest conviction and get rid of the medium-conviction candidates, even if they have been my favourites over the years and might have given me xx times over x years.

Abhishek had challenged that this is easier said than done. That’s true. But consider what Mr D had told me again and again. That made my job simpler and I have achieved 70% of what I knew I should have been doing:)

1). Critically assess your portfolio

2). If a business CANNOT grow 25%+ CAGR over the next 2-3 years, you have no business keeping the stock in your portfolio, just because it might be a stable counter

3). Get rid of such stocks and invest the same in businesses that CAN grow at 25%+ CAGR

4). If you cant find any, that from here on, will grow at that rate, sit on CASH

5). Re-invest the CASH only when visibility improves

His signature line: Above applies both for falling and rising markets! All other things being equal, the above helps me take rational decisions.

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That’s very good stuff. Will have to come back to read again with a more clear mind. However just wanted to share that i had read something similar to this topic in the book Dhando investor. For details one will have to read the book and search for the topic “Kelly bet size” as the topic is very long and has to be well understood with all it’s nuances . Here is a linkhttp://www.cisiova.com/betsizing.asp where one can get the bet size. Mr. Prabai has also suggested some modification to this outcome in the book.

Regards

Raja