Saturday, 15 March 2014

Capital Allocation Framework: Game Changer for Long Term Wealth Creation: Part I

Long term and disproportionate wealth creation is a dream chased by many of us. Value investing is not-so-exciting yet perfect to tool to achieve this objective in the long run. As we all know value investing is all about investing in businesses at price substantial discount to its intrinsic value. It's all about buying "$1 worth of business at 50 cents". However, I personally feel that identifying an investment idea based on value investing principles is only half the job. It is a necessary but not a sufficient condition to achieve the long term objective of disproportionate wealth creation. We still have a missing piece in the puzzle..and the missing piece is capital allocation! What I have observed is that many a times we keep generating very good ideas but fail to allocate capital that each idea deserves. We end up over/under allocating capital to some very good and not so good ideas. 


In the initial few years of my journey in value investing, I was solely focused on stock-picking and paid very little attention to allocation of the available capital amongst my ideas. Allocation of capital was completely arbitrary. However, as I interacted more with some seasoned investors, I realized how important capital allocation was for disproportionate wealth creation! Even on most of the blogs and forums focusing on value investing, the discussion threads largely revolve around stock ideas and capital allocation is seldom discussed. I still don't know why it is so as most of the senior investors invariably point out the importance of capital allocation in wealth creation. My guess is, because the stock picking exercise is far more stimulating than following a dodged process of capital allocation.



It  is very difficult to outline complete capital allocation framework and process in this blog. However, there is an excellent discussion thread on this topic at Valupickr that I would recommend all of you to go through! It's worth your every minute that you spend on it! However, in this post I will try to present distilled ideas from the valuepickr thread and learning from some well known value investors on capital allocation principles with my own "idiosyncrasies" superimposed on them!  



Optimal number of stocks in a portfolio: This is one topic on which I have witnessed many discussions which never end conclusively! Proponent of both concentrated portfolios and diversified portfolio  pound on the other side with merits of their own philosophy and de-merits of others's philosophy. Here are some key ponderables for an investor


  • One must achieve a balance between sufficient diversification and dilution in return from potential winners due to diversification. Let me give you an example: Consider two portfolios of same size 40 Lakhs but having different capital allocation.  
                    1) Portfolio A has 40 stocks and each stock gets equal 
                        allocation of 1 Lakh 
                    2) Portfolio B has 10 stocks (A subset of 40 stocks only)  and                             each stock gets equal allocation of 4 Lakh each.
       Now let's assume that in 5 years one of the stocks turns out to be a 10 
       bagger, 1 stock 5 bagger and both the stocks are common to both the 
       portfolios and rest of the  stocks generate average return of 15% 
       annually.  Following will be the performance of both the portfolio

       Port. A: 38 * (1.15^5) + (1*10) + (1*5)= 91 Lakhs= 18% CAGR in 5 yr 
       Port. B: 32 * (1.15^5) + (*10) + (1*5)= 124 Lakhs= 25.5% CAGR in 5 yr


       So the investor who diversifies highly and have substantially lower                allocation to its "winners" will generate far lower returns than the 

       investor who commits substantial capital to its potential winners.
       
       Naturally, the opposite of this scenario is if investor made a mistake and
       incurs permanent loss of capital. The returns in a less diversified 
       portfolio will be lower than a highly diversified portfolio. However, two 
       things are important to consider in loss of capital scenario 
       
       1) As a value investor, one always tries to avoid/minimize permanent 
          loss of capital. Hence if the due process is adhered to, the probability 
          of permanent loss of capital shall be less

       2) It is important to recognize that investor's limit to downside is 
           maximum 100%. You can't lose more than 100% of your money in 
           stock while theoretically there is no limit on upside. What if you                    stumbled upon a 100 bagger? your upside will be 10,000%
       
       So, how do you strike a balance? How much is good enough to diversify 
       enough to cover risk while gaining decent "kicker" on returns from your 
       "winners"? 


My personal take is 12-15 stocks provides reasonable diversification while still giving decent upsides from potential 5,10, 50 and 100 baggers!  Having 12-15 stocks on portfolio will ensure that each of the ideas get decent allocation and hence a winner can create serious wealth for the investor



Capital allocation based on judicious mix of different investment approaches:


Even within value investing framework, different investors follow different investment approach and yet generate remarkable superior returns compared to benchmarks. Even though each investment approach has its own advantages and limitations, at the heart of each of these approach remains three golden words of investing "margin of safety". Even though such as deep value investing, growth at reasonable price, high quality businesses at fair price, turn around, cyclicals and special situations.  My hypothesis based on the understanding that I have gained by analysing the investment return of various successful investors following different investment approaches is as follows:


   Investments under each investment approach behave differently under 

specific market conditions and is likely to under-perform or outperform the market under given market conditions. Hence, creating a portfolio of stock covering various investment approaches can increase the likelihood of  out-performance across varying economic conditions and market cycles. 


So stocks in one's portfolio belonging to high quality business bought at fair price (ITC/Colgate/Asian Paints/Pidilite) are well placed to outperform in the declining market because of the high predictability of the business and consistency in performance. At the same time, same set of companies are likely to under perform in rising markets. On the other hand cyclicals are likely to display quite the opposite behaviour i.e. out performing in rising markets while significantly under performing in the declining markets. Similarly, a well understood special situation is likely to provide significant out performance in declining market while may under-perform in raging bull market. 


However, this does not mean that one has to consider allocation to all investment approaches all the time. The ideas is to be open and flexible in trying and understanding various approaches instead of sticking to just one particular approach and  take advantage when appropriate opportunity arises. Having said this, two important things shall be kept in mind

  • Even though investment in turn around and cyclicals can yield excellent returns if one has acquired the skill of spotting cycles and sustained recovery in ailing companies, in general, the failure rate is much higher and one is more prone to incur permanent loss of capital if the prediction about length of cycle or end/start of cycle does not work out as assumed
  • Irrespective of the investment approach used for selecting an investment, the basic tenet of "margin of safety" must be followed.
I will cover some other important points in capital allocation framework in the next part 


  • Capital allocation based on conviction,business quality and valuation.
  • Cash allocation in the portfolio 
  • Displacing the existing investment with new idea
  • Rebalancing the portfolio (Sell decisions and entry of new investment ideas)

 Till then happy investing and happy Holi to you all.
        

9 comments:

  1. You are focussing an important topic. This may, in fact, be the most important topic in investing. Many thanks for this.

    ReplyDelete
    Replies
    1. Hi Lucky,

      You are most welcome. Look forward to more inputs/discussion from people like you.

      Best Regards,
      Dhwanil Desai

      Delete
  2. Thanks Dhwanil for discussing this important aspect of portfolio creation/maintenance.

    Look forward to your future posts.

    Vikas

    PS I couldn't locate your email contact, pls email me @ vic_rana@yahoo.com. Would like to meet you during my next visit to Mumbai. thx

    ReplyDelete
    Replies
    1. Hi Vikas, my e-mail address is desaidhwanil@hotmail.com. Btw, I have relocated to Ahmedabad again from Mumbai, just few weeks ago! But anyways, we shall be in touch and meet up whenever mutually convenient.


      Best Regards
      Dhwanil Desai

      Delete
  3. Thanks for the post.
    Informative and with clear instruction.

    ReplyDelete
    Replies
    1. Thanks a lot for appreciation.

      Best Regards
      Dhwanil Desai

      Delete
  4. thanks dhawanil, Very useful discussion. How much amount of cash is optimum. eagerly waiting for second part on this.

    ReplyDelete
    Replies
    1. Hi Alient,

      Thanks for your comments. The optimum amount of cash can be a very subjective number considering many factors such as liquidity requirement, market valuation, investment horizon and available opportunity set. However, typically, as the market moves away 1, 2 and 3 standard deviations from long term average valuation, one has to be more and more in cash. At 3 standard deviations away from long term average, lot of people advise complete exit and switching to hard assets/cash. However, there is no holy grail for this. If the investment horizon is very long (20-30 years) and quality of investment is very high, than, market gyrations of 2-3 years don't matter.

      Best Regards
      Dhwanil Desai

      Delete