What went right for this stock to give CAGR of more than 40%

[8sarveshg]

As a fund manager, I have spent countless days and nights thinking about allocations. Of course, what you do when one is handling outside money for clients is very different from what you do when one is managing just your own money. Because if you are managing your own money only, then allocations and hence the risk associated with them has to be first judged in the context of your overall net worth and income per year. And then we can layer it up with other considerations.

For instance, Person A having a yearly income of 20 lakhs, a networth of 2 cr and a direct equity portfolio (of this networth) of just 10 lakhs can easily afford to put the same in just one stock also. Ideally, however, Person A should do it in the industry he has good knowledge about (Peter Lynch).

On the contrary, Person B having a yearly income of 20 lakhs, a networth of 2 cr and a direct equity portfolio (of this networth) of 1 crore should ideally restrict himself to no more than 10% at cost.

However, Person C with yearly income of 50 lakhs and a networth of 2 cr (presumably the networth not on account of lower savings rate but because Person C has just started to earn a few years back) and a direct equity portfolio (of this networth) of 1 cr can take much riskier bet say up to 20% at cost.

For a fund manager, however, the risk has to be seen in the context of having the right set of investors. Hence it is partly a fiduciary duty to understand the client’s risk profile to be able to have a portfolio that is in sync with risk for the client and is sync with his financial goals. This is where a good adviser can make all the difference as opposed to plain vanilla buying on Zerodha. This is because of my experience that proper allocation is even more important than stock selection.

The other very important thing while understanding allocations is the study of valuations (companies which are trading at historically low valuations can be given higher allocations and vice-versa), study of the type of companies (lower debt, high cash flows, better reward through dividend and buybacks, some sectors are better suited for higher allocations, etc) and study of your own competence in understanding of the company in depth.

To summarize there can’t be any rule as such - to each his own. A thorough study is required. If you think you are not up to the mark - just do a SIP in some standard indexes. If your thing your money is substantial, consider hiring an advisor or fund manager whose risk-return temperament matches yours. If your portfolio is small and you have an edge in a certain industry (not as a technical guy but as a business guy who has some understanding of financial numbers also), do use it for your own benefit.

Hope this helps.

[bheeshma]

Hi @homemaker

In general, the market doesn’t reward you for risk that can be easily diversified away by holding a diversified portfolio of assets. Only the risk that you are undertaking that cannot be diversified away at a portfolio level is rewarded if you are paying commensurately less for that risk. If your portfolio consists of small/mid cap names then in my view diversification is not very useful as most of the names will have to prove themselves in the future and by definition are risky and will have higher returns in the future if you have paid less for the risk assessed. However, diversification is useful if your portfolio consists of names that have proven business models and are well established names. Beyond a point you cannot diversify away all the risk by capping allocation.

It all boils down to your risk appetite and how well you have assessed the business risk you are taking on (not market risk).

What I do is that I look at the maximum drawdown in the stock price over the last 5-10 years to give me a sense of the risk and then take a call on the stop loss I want to put instead of capping allocations. At a fundamental level I look at the cash flow statement and see if the co is generating sufficient cash to run operations. If both give me comfort I give the co a good rope and decide accordingly. Hope this helps.

For e.g Avanti has had serious drawdowns of 50% + several times in the past. However, it’s cash flow statement is superb. So one can decide to give it a long rope. As against Safari let’s say, which has cash flow issues and also significant drawdowns. There I will be stricter with my stops. Another example is Colgate which has not had any serious drawdowns and has a good cash flow statement. Here I don’t worry about stop loss at all.

Best
Bheeshma