How to assess your investment portfolio?

The year has ended with a 21% return at NSE 50 level. Your portfolio might have grown better or worse than this, depending upon your investment objective.

Investment Review

Often, people look at the news that the index has done so well, but their portfolios have not. This is not a proper comparison.

An individual may have a combination of investment objectives ranging from short-term, medium-term, to long-term. Equity investment is a long-term investment with a minimum five years’ time horizon. When you compare your portfolio designed to meet short-term needs with a long-term asset class, you will be disappointed.

The sole purpose of financial planning is to meet financial objectives. Once the goals are defined, you create specific investment portfolios catering to those financial needs.

Additionally, you consider the kind of person you are. For example, if you have funds but do not like to take positions in long-term assets, naturally, the return expectations should be muted.

So how should you assess the performance of your portfolio?

First, break down the portfolio into debt and equity asset classes. The benchmarking must be at debt and then at equity level. At this stage, you do not worry about the sub-asset class level.

In 2020, RBI reduced interest rates impacting FD returns across all financial institutions. The benchmark return may be a fixed deposit return for one year.

SBI 1 year FD rate is 5%, so this may be a benchmark return for a debt portfolio.

Now compare your debt portfolio return to this fixed deposit rate. If the return is lower than the FD rate, understand why. Often an interest rate movement may impact the return for a brief period, so that must be adjusted. Similarly, a higher return due to increased credit risk should also be factored in. These nuances may be better understood at a granular portfolio level. We will discuss this when we investigate sub-asset class-level benchmarking.

Similarly, the broad equity market return may be gauged from NSE S&P 500 Total Return Index (TRI). You should not base your benchmarking for equity portfolio on one year. Instead, you should base it on five years.

5-years NSE S&P 500 TRI return is 18% p.a.

Now compare 18% p.a. to your equity portfolio return. Again, any difference, positive or negative, must be studied more deeply.

Benchmark return for the portfolio will be arrived at by assigning specific portfolio weights to the asset class return.

Let’s assume that you weighted 40% to debt and 60% to equity.

2021 Benchmark portfolio return = (5% X 40%) + (18% X 60%) = 12.80%

This should be the anchor number to compare portfolio returns.

Now we understand sub-asset class returns.

Debt

Often investors take positions in various debt categories—the return expectation changes across the spectrum. The least risky, i.e., the least volatile category, is the liquid.

The benchmark return for liquid, i.e., Treasury bills in 2021, is 2.05%.

Government bonds are not always low volatility. As the duration of the bond increases, so does the volatility—a 10-year government bond, maybe as volatile as equity. Investors should be careful when they invest in long-duration bonds.

In 2021, G-Sec 10 year generated 2.58%.

Corporate bonds are yet another category. Often returns may be made in this segment by assuming a certain level of credit risk.

The one-year credit risk category varies greatly across fund managers, but a 7% return in 2021 should be reasonable.

As you can see that the within debt, the returns may vary drastically. A good sense of what drives the return is critical for fair benchmarking in the sub-asset debt class.

Equity

As you may be aware, equities are broken down as big to small companies depending upon the company's market capitalisation.

In 2021, a large-cap generated a return of 26.5%, a mid-cap has generated 48.7%, and a small-cap has generated 59.1%. This is a one-year return. You will not look at this return because a low-quality investment often leads to a run-up in the short run.

A five-year return, a large-cap has generated a return of 17.5%, a mid-cap has generated a return of 20.3%, and a small-cap has generated 17.4%.

Individual allocations must be benchmarked against specific categories.

If an investor is holding a direct portfolio of equity investments, the benchmark returns may be NSE S&P500 TRI index return, i.e., 18% p.a. over five years. Do not celebrate short-term success because low-quality companies often do well and may hide reality in a bull run.

“Only when the tide goes out do you discover who's been swimming naked.” – Warren Buffet

Bull run sows the seed for sorrow in the future. It is better to prepare yourself for a marathon than run a sprint and hurt yourself. Portfolio evaluation can help you understand whether you are walking on the right path or not.

Portfolio evaluation takes time but can provide a great insight into your portfolio. This is exceptionally challenging when working with your banker or advisor and bulking up the portfolio.

Disclaimers

• Investment in securities market are subject to market risks. Read all the related documents carefully before investing.

• The securities quoted are for illustration only and are not recommendatory.

• Registration granted by SEBI, membership of BASL (in case of IAs) and certification from NISM in no way guarantee performance of the intermediary or provide any assurance of returns to investors.

Details of the advisor

• Advisor: Ankur Kapur

• SEBI RIA No.: INA100001406

• BASL Member ID: BASL1337

In the long run, all companies will be dead!

Everything has a beginning, a middle, and, most definitively, an ending. This is the first dharma seal in Buddhist philosophy, the Law of Impermanence.

Death of a Company

(However, ancient Vedic philosophy believes in the Soul, which is permanent. Let’s focus on the ‘impermanence’ for now)

It is a well-established understanding that even companies have a beginning, a middle, and an end.

The East India Company (EIC) was founded in 1600. Philanderer Mughal emperors allowed East India Company to access and exploit India. However, after ruling India for almost 275 years, even the East India Company was dissolved in 1874.

In the book ‘Ikigai: The Japanese secret to a long and happy life, the author studies a small town in Japan where the maximum number of centenarians are found. A person who is 100 years old or older is a centenarian. There are many centenarians’ habits including eating well, walking regularly, breathing clean air, listening to music, dancing, and the general flow of life. As per the author, these habits as a collection increase the odds of a person having a life of more than 100 years.

A company is an artificial person representing an association of people with a specific objective. A company may also be viewed from an ‘impermanence’ perspective. For example, a company that lasts longer may be taken as a company whose products or services have some endurance or competitive edge.

In the last 20 years, we have encountered several events that severely impacted the economy. Tech bubble, 2008 housing bubble, 26/11, hyperinflation in India (2013), demonetization, and more recently lockdown due to the pandemic. A lot of businesses have flourished despite these challenges.

Strong management navigates through ever-changing conditions while executing its corporate missions. Unlike the west, where technology innovation plays a significant part, in India, many businesses adopt technology rather than innovate.

A of technology firms have a short life because new emerging technologies challenge their products. However, as technology users in India, most Indian companies stand to benefit from this innovation because these more recent technologies often improve the financials by reducing costs.

Innovation is not the primary driver of endurance, so how do businesses survive and thrive in India?

The answer may lie in understanding how a business restricts competition. One of the ways to identify a company keeping its competition at bay is to look at the history of return on equity or return on capital employed. A high ratio indicates a company maintaining or improving margins by using its capital efficiently.

Any business that earns a high return will attract competition. Conversely, if the business does not have a competitive edge, more players will flood in and take away the high returns of the business.

In India, this competitive edge is seen in companies that dominate specifically. For example, Asian Paints has almost 60% market share in the paint industry in India. The same logic may be extended to Pidilite, Colgate, Titan, etc. The source of competitive edge tends to be specific and not general.

Proprietary technology, product differentiation, or branding are insufficient to keep the competition at bay. These advantages must be combined with some edge related to strong habits, high switching costs, or substitutes.

Habits lead us to buy fevicol, Colgate toothpaste, Gillette razor, etc. (Habits may also include more people using the same product, example Whatsapp)

It is the taste of Maggi that restricts people from switching to other instant noodles.

People use Microsoft Excel because an acceptable closest substitute is not available.

Let’s extend the example of Microsoft Excel. The software is written once but can be sold to many customers without adding a lot of expense. This is called economies of scale. As the scale of the product grows, the fixed cost is spread over more units, the variable cost per unit stays the same, and the average cost per unit declines.

A business with these advantages will first grow its market and then defend its market share. A business may be successful for a while, but if it is successful for an extended period, it must protect its market share.

Once the market share is established, the business must ensure customer captivity. This may be done by encouraging habit formation in new customers, increasing switching costs, and searching for more complicated alternatives.

For example, Asian Paint has an edge on its supply chain management. They have used proprietary technology to forecast internal demand for its products. Asian Paints provide unmatched supply chain standards by delivering its products four times a day to nearly 50000 dealers. This way dealers are happy and so are the customers. Asian Paint is still selling paints even after eight decades. They continue to invest in ensuring and strengthening their ‘competitive edge.

A business with a high return, a decent market share, and a relentless focus to guard the market share has a probability of surviving long. Eventually, even this business will die but may allow you to make wealth for your lifetime. So, in a way, the business may outlive you.

If a business operates with no advantage, the only savior is exceptional management. If the management can effectively manage costs across product development, marketing, and financing, the business can survive. However, the lifeline of a business is still challenging to predict because management can always join the competition.

Now let’s reflect on how to incorporate the life of a company into an investment decision. It is better to break the expected return of businesses that earn high returns. There are three parts to this return: the first is dividend payout, the second comes from within the business, and the third comes from outside the business.

EXAMPLE

The organized market of a pressure cooker is around Rs 1600 crores, 55% belongs to Hawkins cooker. 5 years average RoCE is 60% with 8.5% pa sales growth. So, let’s look at this high return business making pressure cookers since 1959.

Part 1: Dividend return

5 years average dividend payout = 57% (excluding 2019-21, 77%)

5 years average net operating profit growth = 9.4%

Dividend return = 57% X 9.4% = 5.36%

Part 2: Organic return

Organic return = Net operating profit growth X (1 – Reinvestment rate) X (1 – Dividend payout)

Reinvestment rate is the capital expenditure and working capital investment required to generate sales. In the case of Hawkins, it is ~16.3%.

Organic return = 9.4% X (1 – 16.3%) X (1 – 57%) = 3.38%

Part 3: Inorganic return

If a company invests outside, i.e., buy businesses, and those businesses generate a certain return. In the case of Hawkins, we do not have that history, so we assume 0%.

Total return = 5.36% + 3.38% + 0.00% = 8.74%

As of 2019, the average Indian life expectancy is around 70 years. There must be an average age of a company as well. Let’s look at how we assess the average life expectancy of a company.

The life expectancy of a company can be roughly estimated as a sum of survival probability and growth. We estimate the half-life of a company, the number of years in the future at which its survival probability declines to 50%. For a durable business such as Hawkins Cooker, the life could be around 80 years. Whereas tech businesses such as Policy Bazaar, Zomato, etc., would be around 15-20 years. The half-life can be translated into annual fade probabilities using the rule of 72 (half-life = 72 / expected life).

Hawkins Cooker Fade Rate = 72 / 80 = 0.90% per year

This is a negative number to the total return.

Expected return = 8.74% (calculated above) - 0.90% (fade rate) = 7.84%

You must now compare this 7.84% to the cost of capital. In the case of Hawkins, with very stable cash flows, we can assume the cost of capital to be 1-2% more than the risk-free rate (10-years government bond yield). Currently, the government yield is around 6.5%. So, the cost of capital for Hawkins would be 7.5%-8.5%.

Comparing the expected return with the cost of capital, Hawkins Cooker does not stand out.

(Every company has a value and there are many ways to assess this value including DCF, multiples, etc. We should consider all indicators; in this article, I am just covering one of them i.e. expected return using fade rates).

The purpose of this article was to give a perspective that companies have a life. It is good to be aware of that life span.

Stable cash flow generating companies that have been in existence for the last few decades are expected to live at least for a decade. In contrast, new-age tech companies may have a short life span. Nevertheless, these new-age tech companies may still command a high valuation if the expected return is high (more than the cost of capital).

If you identify a competitive edge, you must understand whether the company would protect that edge in years to come. Interestingly, if you believe that the company will generate a high expected return with a low fade rate, you have stumbled upon a jackpot. Therefore, do not hesitate in allocating a high portfolio weight to this company.

(In this article, many perspectives are developed from ‘Value Investing: From Graham to Buffett and Beyond by Bruce Greenwald’.)

Disclaimers

• Investment in securities market are subject to market risks. Read all the related documents carefully before investing.

• The securities quoted are for illustration only and are not recommendatory.

• Registration granted by SEBI, membership of BASL (in case of IAs) and certification from NISM in no way guarantee performance of the intermediary or provide any assurance of returns to investors.

Details of the advisor

• Advisor: Ankur Kapur

• SEBI RIA No.: INA100001406

• BASL Member ID: BASL1337

Portfolio sizing is the key to portfolio return

If a portfolio is not created with the right size, capturing a good investment may not have any meaningful impact on the portfolio.

Portfolio sizing

Newbie investors often brag about the high return they made on the stock. If you deep dive, the portfolio allocation is usually so small that it almost immaterializes the portfolio return.

A mature investor carefully considers the mispricing and allocates substantial capital if the odds favor him. This way, when the gap between fair value and the current price reduces, the investor stands to benefit substantially from that move.

So how much to allocate, and what about diversification?

The concept of diversification is for those who do not understand investing. In simple terms, if you don’t want to spend time understanding how your portfolio can grow, you are better off just buying NSE 500 index fund. However, if you're going to generate a return better than the index, you need to build a concentrated portfolio.

Another reason you may want to move away from the index is when you invest only in high-quality companies. An index includes sectors and companies, but all companies may not be of high quality. One critical ratio to evaluate a high-quality company is to look at a long history of high Return on Capital Employed (ROCE).

You might be wondering, why not mutual funds? A mutual fund that operates with the logic of mispricing is better positioned to generate high returns. However, most of the mutual funds that invest in 50 plus companies may not generate a return different from the index. The impact may be more pronounced for large-cap mutual funds. In a way, look for fund managers who create portfolios with 20 stocks and not 50.

“A well-diversified portfolio needs just four stocks.” - Charlie Munger

An expert may claim four stocks, but an average investor may be good with 15-20 stocks. Appropriate diversification must be ensured within the set of these 15-20 stocks.

There are many approaches to stock investing. Most mature investors consider the bottom-up approach. It means to pick stocks based on the company’s performance. A fundamentally strong stock available at a discount is usually a good bet.

There is a possibility that mispricing may happen in a certain sector due to some underlying problem. For example, a rise in crude oil prices will increase the cost for all paint companies. The task should be to select the best in the lot. If you choose all companies within the same sector, the portfolio may be skewed to the forces within that sector.

Once the overall selection is made based on mispricing, you should reflect on the portfolio and address any overlaps. For example, paint companies draw a lot of business from real estate. Therefore, if you have paint companies and real estate companies within your portfolio, the portfolio will be skewed towards real estate. Prudent investors will minimize these overlaps and select only the most eligible investments.

Once this trimming is done, you will see that 10-15 stocks with low correlation will be left. Again, this is prudent investment management that considers the risk of the portfolio as a priority.

To grow your investments, risk management is more critical than return expectations. This is because risk can be evaluated in today’s context, and return will always be in the future. So as far as you take care of your today, tomorrow will take care on its own.

Disclaimers

• Investment in securities market are subject to market risks. Read all the related documents carefully before investing.

• The securities quoted are for illustration only and are not recommendatory.

• Registration granted by SEBI, membership of BASL (in case of IAs) and certification from NISM in no way guarantee performance of the intermediary or provide any assurance of returns to investors.

Details of the advisor

• Advisor: Ankur Kapur

• SEBI RIA No.: INA100001406

• BASL Member ID: BASL1337