ValuePickr Forum

Towards a Capital Allocation Framework!

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)

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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

Thanks Raj.

Now that you mention it, will go back and read up more on the Kelly Formula! I had read the Dhando Investor (thought there was nothing new:)), and had seen this section too but somehow didn’t retain anything of the Kelly formula.

Will try and capture inferences from that back into this discussion as applicable.

-Donald

http://www.cisiova.com/betsizing.asp Link: http://www.cisiova.com/betsizing.asp

Some nuggets of wisdom from Phil Fisher’s book – conservative investors sleep well.

He summarises his investment philosophy in following eight points

1). Buy into companies that have disciplined plans to achieve dramatic long range growth in profits and that have inherent qualities which make it difficult for newcomers to share in growth.

2). Focus on buying these companies when they are out of favour, i. e. when either bcos of general market conditions or because the financial community at the moment has misconceptions about its true worth, the stock is selling at prices well under what it will be when its true merit is better understood.

3). Hold the stock until either a) there has been fundamental change in nature (such as a weakening of management) or b) it has grown to a point where it will no longer be able to grow faster than the economy as a whole. Only in exceptional circumstances ever sell because of forecasts as to what economy or stock market is going to do. Never sell the most attractive stocks you own for short term reasons.

4). For those seeking major appreciation of their capital, de-emphasize the importance of dividend. The most attractive opportunities are most likely to occur in the profitable but low or no dividend payout groups. Unusual opportunities are much less likely to be found in situations where high percentage of profits are paid to shareholders.

5). Making some mistakes is as much an inherent cost of investing for major gains as making some bad loans is inevitable in even the best run and most profitable lending institutions. The important thing is to recognize them as soon as possible, to understand their causes and to learn to keep from repeating these mistakes. Willingness to take small losses in some stocks and to let profits grow bigger and bigger in more promising stocks is a sign of good investment management. A profit should not be taken just for the satisfaction of it.

6). There are truly a small number of outstanding companies. Their shares cant be frequently bought at attractive prices. Therefore when favorable prices exist full advantage should be taken of the situation. Funds should be concentrated in the most desirable opportunities. For individual investors, any holding of over twenty stocks is sign of financial incompetence. Ten to twelve is usually a better number.

7). A basic ingredient of outstanding stock management is the ability neither to accept blindly whatever is the dominant opinion in the financial community at the moment nor reject the prevailing view just for the sake of being contrary.

8). In handling common stocks as in most other fields of human activity, success greatly depends on a combination of hard work, intelligence and honesty.

Fisher used to find out companies which could show very high growths for many years to come and then invest in them for years and often decades.

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I have been thinking for a while on the issue of how much one should allocate to one’s best ideas. It’s true that unless and until one bets high amount on one’s best ideas, that idea will not make any difference to one’s portfolio. Rather than conviction (not implying that its incorrect), another way to look at the issue of capital allocation is to look at theinvestment approach one is following**.****If one wants to invest in âWonderful companies at fair price like Buffetâ then concentrated investing (allocation of 10% and above to single stock) is the way to go as there are not many of such companies are available, but if oneâs approach is to buy âfair companies at wonderful price like Tweedy and Browne partnership firm (they basically pick stocks which are cheap on PB and PE basis and some competitive advantageâ then wide diversification is the way to go. **I am more comfortable with Tweedy and Browne approach of restricting position in single stock to maximum of 3-5% as I invest in stocks which are cheap by PB and PE basis and try to avoid value traps. In simple words âHow much diversification is enough: As much as, if that stock goes bankrupt it will not result in undue financial stress to you.â See at the end for what Tweedy and Browne shareholder letters says on diversification

In my opinion Stocks like Kaveri Seeds, Atul Auto, Muthoot Cap (these are just examples) are not the Wonderful companies at fair price but Fair companies at wonderful price. Any regulatory change or new product from competitor can destroy the competitiveness of Kaveri. Same is the case with Atul Auto where sales can take hit if competitors enters into price war or introduce a better product. Now whether one is investing for short term of 6-9 months or ultra long term holding, in my view allocation should be more dependent on whether its wonderful company with enormous moat like Asian Paints or Pidilite then high allocation can be justified. My whole point is not to confuse between conviction and wonderful companies.

Some extract from Tweedy Browne’s letters to shareholders:

âTo minimize errors in analysis or events which could adversely affect intrinsic values, we adhere to a policy of broad diversification; with no one issue generally accounting for more than 3%, at cost, of the net assets of the portfolio and no industry accounting for more than 15%, at cost, of the net assets of the portfolio. Not only does diversification reduce risk, it also increases the probability through the workings of the law of large numbers that a return will be realized from the entire portfolio.â

âSome very successful money managers prefer to make larger, concentrated bets in fewer stocks. Our confidence in our abilities may not be as great as their confidence is in theirs. People should do what they feel comfortable doing. We feel comfortable diversifying to a degree others may feel is excessive. When we ask ourselves, ââWhat is the downside of diversification?ââ, we do not get an answer that makes us want to change that policy.â

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Hi Donald,

I am reading “The Dhandho Investor” by Mohnis Pabrai. In chapter 10, he has given a way to decide portfolio weight by using Kelly Formula. It is based on calculating how much percentage of your total wealth in a single stock based on the expected return and their probability, and then doing a weighted average of different stocks. Initial thinking seemed a nice strategy to me.

Anilji,

Currently even my portfolio contains several undervalued stock. Something similar to kind of stocks you have. The number is large due to value traps. I have been gradually moving towards concentrated portfolio.

The primary reason for reducing the number is that it is difficult to track so many stocks as I am not a full time investor. My returns have been low due the problem with timing the exit in the value stocks.

Regards

Thanks to Ayushâs last post of 2012, I decided to re-read the entire thread of capital allocation once again. I will try to reconcile the entire discussion with my investment approach and some areas where I differ. Let my split my thoughts in few posts and I will start with summarising the key takeways for ME [it will differ from what others think, so strictly not a SUMMARY of discussion]

Buy Decision:

  1. You need to have a CHECKLIST to evaluate each company on its management quality, Business quality, Fundamentals, Industry position and track record and growth prospects.

  2. All other things being equal, theSize of the Opportunitybefore a business, its competitive advantage, and itsAbility to Scale Up(ability to fund, manage the growth environment, execute, etc.), determines the Growth prospects for a business - and the success of oneâs Portfolio allocations.

Allocation to your investment ideas:

  1. You cannot allocate randomly any % to your investment ideas. HIGH CONVICTION AND UNDERVALUATION should play a key role in determining overall allocation.

  2. Everyone should be able to differentiate among their best picks. Which is No#1, and why? and why is that one No#5?

  3. Increase your allocation to stock slowly as you gain CONVICTION [increase your allocation even if share price increases as long as valuation gap and growth opportunity remains. Itâs very difficult for myself though]

Sell Decision

  1. Sell decision: Exit/book profits as soon as your targets are met. Assess if it can still double form here within the next 2-3 years [I am fine even if I believe it can double in next 3-4 years]. In other words if you the reason to buy are no longer valid, sell and do not try to find new reasons just because stock price has declined steeply.

  2. 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!

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Now let me pick up TWO points where I think there is possibility for many people to get it wrong [ or its possible that I am in minority and majority believes its right]

Portfolio concentration is not for everyone. Here I would repeat Howard Mark famous quote âIn Vegas they say, âthe more you bet, the more you win when you win.â Although the logic of this statement is impeccable, it omits the obvious addendum â. . . and the more you lose when you lose.â

Donald in his very first post had given a word of caution and I would like to repeat it once again, as I found many people who might have started their investment journey post Lehman crisis started maintaining very concentrated portfolio of 8-10 stocks. âThis 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) [I would add even ACTIVE INVESTORS WITH FULL TIME JOB] are better off with awell-diversified**Portfolio [I am not talking about spreading your investment over 40-50 stocks but it cannot be just 8-10 stocks either]. But even they would benefit from being able to differentiate among their bets!

Again many times itâs not the actual number of stocks in your portfolio which matters for diversification but what level of correlation they have, is your portfolio is such which will expose you severely from any black swan event to an extent that you cannot recover.

Here are few pointers from âCommon stocks and Uncommon profitsâ by Philip fisher and these are equally important for people who believes in maintaining concentrated portfolio of 6-8 stocks and equally important for people like me who believe in maintaining portfolio of 15-20 stocks [with 5-7 themes which can be sector themes or growth vs cyclical theme or anything else]

  1. Nature of stock itself has a tremendous amount to do with the amount of diversification actually needed. Eg. A single product company entirely dependent on a single industry or a single product company with application in varying industries. A company with multiple product but whose fortunes are entirely dependent on one industry vs a company with multiple products with exposure to varying industries whose fortune not tied up at all.

  2. Cyclical industries whose fortune fluctuate sharply with changes in the state of business cycle

  3. Investor with ten stocks with eight of them from banking is inadequate diversification and in contrast another investor with ten stocks from completely ten different industries may have more diversification than he really needs.

  4. When maintaining highly concentrated portfolio, ensure that there is no more than a moderate amount of overlapping, if any, between the product lines of his selected companies.

  5. Companies dependent on single management vs companies having well established management team

Refer page no. 135 to 144 of his book for more detailed discussion in which he divided the total portfolio into three categories A, B and C and prescribed some % allocation. It quite detailed discussion with links to some other sections of his book. Will try to do post on it sometime later.

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CASH ALLOCATION: There has been lot of discussion on cash allocation. But I think when we talk about cash allocation, we should think terms of our NETWORTH (excluding one house) and not in terms of part of the money you have ALLOCATED TO EQUITIES. For eg. One might have allocated only 20-30% of oneâs net worth to equities, another 30% in real estate, 20% in gold and balance 20-30% in debt or fixed deposit. Now when coming to cash allocation, I think itâs NOT necessary again to allocate some portion to cash from your equity portfolio.

So coming to CASH ALLOCATION first determine the buffer cash one needs to maintain for emergency or any unfortunate event, how much debt you are carrying for your car, house etc and finally determine your allocation to equities. If one is already maintaining 20-30% of oneâs networth by way of fixed deposits or debt fund or any other cash equivalent then its not necessary to have another cash portion in your portfolio.

But if one is entirely into stocks (70-80% of his networth) then he will have to give a serious thought about cash allocation within equity portfolio.

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