[Guest Post] Capital Allocation in a Portfolio

This post is from Prabhakar Kudva (http://investment-in-sight.blogspot.com). 

Capital allocation is probably one of the most important aspects of investing. Every time I need to decide how much capital to allocate to a particular company i use the following steps:

Step 0: Identify the companies whose business dynamics you understand reasonably well - either because its inherently a simple business and/or because you've spent time and energy to understand what factors affect a particular business' performance. This is basically your universe of companies.

Step 1: Predict the approximate EPS (a range,may be) one year down the line.If you are unable to predict the EPS with a reasonable degree of accuracy then it means two things:
a) This is a complex business where profits depend on a number of totally unpredictable factors.Its better to remove such companies from your universe/sample space.
b) You don't understand the business well enough.Read more about the business.Do some scuttlebutt.This is a learner's game.If you spend time understanding simple businesses, their sources of profit and external factors that affect business, eventually you'll be able to estimate the one year forward EPS with a reasonable degree of success.

Step 2: See if there is a possibility of a PE re-rating. Or will the PE remain the same. Or may be the PE will be de-rated? Estimate what the PE might be based on your projections in Step 1.Remember to be conservative.In most cases assume PE will remain the same or there'll be a slight re-rating(if expected profit growth in step 1 is out of the ordinary).If you think there's going to be a de-rating you know what to do.

Step 3: Now you have an approximate PE and an approximate EPS range. Arrive at your target price.

Step 4: Now based on the CMP and target price - check what the expected return is.

Step 5: Repeat steps 1 to 5 for all companies in your universe (step 0). Compare the expected returns arrived in step 4. For example if you have three companies A,B,C and the return expectations 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

Assumptions
a. Ofcourse this is not exact science.Every year that you repeat this exercise,learn from your mistakes, learn new things about your business you'll get better at predicting the EPS of the businesses you understand and hence better at capital allocation.
b. I use just one year because I feel predicting more than one year ahead for ANY business is futile. The business environment and the capital market that we operate in is way too dynamic to talk about the 'really long term'.So we take one year at a time.

Portfolio Construction: How many stocks should I have in my portfolio?

The first question that I had was on the number of stocks I should be holding in my portfolio. Typically, investors are mostly over-diversified. Some, on the other hand, in trying to be contrarions, hold very few stocks. Both have their merits and demerits. Having an over-diversified portfolio dilutes the overall returns whereas a highly concentrated portfolio increases downside risk.

So, why do we need to diversify in the first place? We all know that all great wealth was created by concentrated holdings. Bill Gates has his whole networth in Microsoft. Ditto Dhirubhai Ambani. So, why not do the same thing? Well, the issue here is that we are not insiders or promoters of the companies we own stocks in. We don't have a handle on how the company is being run and don't "really" know the inner details that is required to have a great level of conviction.

There is also another factor. Although, concentration (in the right company) can bring huge rewards, it can also destroy great wealth. Think of the Modis and the Bangurs of India. They would probably have done better if they diversified their wealth in other ventures (maybe invested in the Reliance IPO!!!) than put all their money in their own companies.

So, diversification is important from a wealth-preservation perspective. And also because our level of conviction of a company's performance is never 100%. There are risks involved in investing. There are various types of risk involved, main ones being:-

• Individual business risk - the conpanu you invest in goes bankrupt (Enron, Satyam etc)
• Sector/industry risk - the industry declines (VCR, Walkman, Pager etc)
• Market risk - the stock market crashes (1929 US, 2008 Worldwide)
• Personal risk - you need money urgently for some unforeseen expenses

Equity diversification, actually mitigates the first two risks. It cannot really do anything about the last two. For those, you need to have a proper asset allocation in place. That is a topic for another post.

So, how much is enough. Charlie Munger, one of my gurus, had at one time only four stocks in his portfolio and was very comfortable with them. Others have somewhere between 10-25. Peter Lynch, also one my gurus, on the other hand had more than 1200 stocks in his Magellan fund!! But all of them, and other great investors, have said that having a portfolio of between 10-20 stocks is optimum for an individual investor. I prefer to have about 10 stocks in my core portfolio. And some more where I am either building up my positions or dwindling down. So, I personally try to stick to the 10-15 stock range. That is more so, because, I have seen beyond that I am not able to track the news flow in the companies I am invested in.

Another reason I try to stick to the range is that if I already have say 15 stocks and I get a great new idea, I would be forced to think about which one to replace. This, sort of, helps in moving out holdings where my conviction is lower than the new idea that I have.

Questions on constructing a portfolio

When I first seriously thought about building an investment portfolio, I had a lot of questions that came to my mind. What I wanted was to build a portfolio that would help me build a sizable capital over a period of time. The plan was that I would add to the portfolio periodically and build up positions. The time-frame that I had (and still have) was around 15 years.

The questions at the top of my mind were:

1. How many stocks should the portfolio hold?
2. What is the maximum percentage that a single stock should be within the portfolio? 
3. When should I sell? Should I have target prices?
4. How much cash should be there in the portfolio?
5. Should I have stop losses?

I though that answering these questions were very important to be prepared for building a log term portfolio. I will try to take you through my thoughts on each of these questions on subsequent posts.

Conversation With Charlie Munger

Conversation With Charlie Munger (Notes taken by http://inoculatedinvestor.blogspot.com)

Charlie Munger's Parody (distributed at the last Wesco meeting)

Shriram Transport Finance Complay Ltd (STFC) - RBI Policy Update

RBI's monetary policy announced on May 3rd had created a lot of confusion on whether STFC's securitized assets would continue to be treated as priority sector loans. (Read the probable impact of it here)

On RBI's policy statement on July 1, 2011, it has clarified that investments made by banks in securitized assets that are originated by banks or other eligible financial institutions shall continue to be classified as priority sector.

This means that any bank's investments in securitized assets will be eligible  for classification under priority sector  only if it was eligible to be classified as priority sector advances before their securitization.

So, for STFC, this is good news, as their cost of borrowing is unlikely to go up.

However, the underlying concern of slowing of growth is still there. So, although the stock may not go below 600, it may be difficult for it to gallop away beyond the 720-750 range in the near future.

Portfolio Review: Half-Yearly

H1 2011 comes to an end. Sensex started the year at and is today at 18763. During this period., India's primary index has lost 8.51%.

My portfolio fund which I started last year has returned a meagre 6.44% during this period. From a relative performance view, the portfolio has outperformed Sensex by 14.96%. But then, you cannot eat relative performance, can you :-(

Here are the highlights of the portfolio activities during this period. 

• Added a few stocks to the portfolio - Astral Polyteknik, Elecon Engineering, GEI Industrial, Manjushree Technopak, Pidilite and Titan
• Booked profits in Supreme Infrastructure
• Enhanced cash levels of portfolio from nearly 0 to over 10%

Click on this link for current portfolio details