February 2, 2014

A 2X in 3 years

I wrote earlier about a Darwinian approach to portfolio construction. This approach involves the ranking all the stocks in a descending order and replacing the last position with a better stock/ idea. The key concept behind this idea is to replace the weakest position with a stronger one and thus improve the portfolio quality.

I did not discuss about how to rank the various stocks in the portfolio. I will discuss the business aspect of the ranking in a future post. Let me share some thoughts on how to consider valuation when doing this exercise.
A 2X in 3 years
As the title suggests, I have now started asking a question for each position (at the time of quarterly and annual results) – Does this position have the potential to double in 3 years ?

Note the use of the word  - potential. One can never be sure if the stock would double.
How does one look at the potential ? There are two variable driving the stock price – earnings growth and valuation. Lets say the stock is selling at intrinsic value and the earnings are growing at around 24% per annum. At the risk of over simplifying (and not stating some additional factors), we can expect the stock to increase at roughly the same rate and thus double in 2 years.

If however the stock is selling below fair value, then we may get an additional bump from an increase in the PE ratio. However I would prefer to place a higher wieghtage on the earnings growth than the valuation – which depends more on the whims of the market.
Not a scientific exercise
One can easily find a lot of flaws in the above thought process. You can argue that, no one knows the market situation three years from now. In addition, the company performance may turn out to be much lower than expected, thus negating the entire exercise.

All the above points are true and I could add more. However the point of the entire exercise is to look at the potential of each stock (atleast annually) and assess its attractiveness based on new information. It is easy to fall in love with a position (especially in my case) and hang on to an old thesis, whereas the world around the company has changed completely.
What do to with such cases
Lets say you identify a stock where the potential return is unlikely to be 2X in 3 years. What now ? do you sell and buy another stock ? What if you don’t have another idea ?

Lets bring in the concept of opportunity cost. Lets say you dont have a better idea. Then the alternative is to sell and invest it in a fixed income instrument. Is the opportunity cost around 9% then? .
I don’t think so. I would say the opportunity cost is the average returns you have made over the long term. Lets assume that your portfolio has returned  15% per annum on average in the last 10 years. I would say that this is your opportunity cost and the existing position has to be above this threshold to remain in the portfolio

Why is this your opportunity cost ? The reason is simple – you have been able to make this return in the past on average and if you sell the existing position and hold cash, something will surely come up in time to deliver this kind of return. You may not make this return the next month or next quarter, but can expect to make it over the next few years.
So the question to ask is – does this position meet my opportunity cost threshold? If yes, hold on to it till you can find a better idea – preferably a 2X or 3X in the next few years.
Stocks discussed in this post are for educational purpose only and not recommendations to buy or sell. Please contact a certified investment adviser for your investment decisions. Please read disclaimer towards the end of blog.


Stable Investor said...

Hi Rohit
This Darwinian approach to portfolio construction seems to be an interesting one. Atleast one will make a genuine effort to critically evaluate his stock holdings.

Anonymous said...

Hi Rohit,

I would not agree with you on HDFC bank,whatever little knowledge i have on the industry i would say they blew it,the pressure to deliver 30% year on year has wrecked them


Rohit Chauhan said...

Hi stable investor
the entire idea to prevent the confirmation bias and endowment bais in the portfolio


Rohit Chauhan said...

Hi anurag
I have made no mention of HDFC bank in the post ..not able to understand the context of your comment

besides that, why do you think HDFC bank blew it ?


Vikas Rana said...

Loved the title of this post, sweet returns..:-)

My expectation of this decade was to multiply my money in 3 years..worst case 5. Now it is 2..worst case 3...which is going back to the Real Estate scenario of early 2000.

Glad that we're on the same page :-)


Balaji said...

Hi Rohit,

You are only talking about growth investing. What about dividend investing and cyclicals ?
Don't you have them in your portfolio ?

Contructing a porfolio based on only growth stocks is a risky idea during down turn ?
What say!


Rohit Chauhan said...

vikas - you have high expectations :) for me 2X in 3 yrs is just to filter ideas ..whether it happens remains to be seen


Rohit Chauhan said...

growth, cyclical etc are all labels which tend to confuse.

the logic is simple - at the current price what are your expected returns ? 1 yr , 3 yrs 5, 5 yrs - depending on your time horizon

in cyclical stocks it will come from valuation change and normalization of earnings, in growth from secular growth of earnings

anyway I don't care for such labels much ..for me its a question of looking at the company and trying to figure how cheap it is and what the returns could which anyway is just a guess - but atleast it forces me to think


Anonymous said...

Hi Rohit,
When you say opportunity cost is avg portfolio return in last few yrs or in the long term, do you mean that if the weakest idea cant meet this threshold then you would sell this stock and invest in other better ideas within the portfolio to maintain the long term avg portfolio return?


Anonymous said...

Hi Rohit,

Do not have any tweeter handle nor is tech savvy so i replied to your twitter post on the blog response page.

GDP is relentlessly falling but banks shows more than 25% growth with asset quality intact.kuch hazam nahi hua,or may be i need hazmola:)).

What are banks? borrowing from peter to lend paul...and the backbone is 'feet on streets'....and they have terrorise their ground forces to such extent that most of them have left.

I invest in cos by interacting with lower end staff.

Sorry if my previous comment was blunt


Rohit Chauhan said...

Hi raj
it is generally not as clear cut, but yes if the stock is going to return less than 15% per annum, I start reducing the position size .

again this estimation is subjective


Rohit Chauhan said...

hi anurag
my twitter handle is @rohitchauhan.

yes some banks are showing 25% growth ..who knows what they are doing. I am wary of such growth and staying away from them. more power to people who can understand these companies

on the other comment - I think you are mixing things. which company is nice and sweet with their employees ? I personally don't mix these things with my investing

unless the company is doing illegal things with their employees I don't want to pass a judgement.

I am an employee too ..so if I don't like my working condition, is the company forcing me to stay there ?

anyway I digress. personally I don't look at these factors ..but it is upto each individual to decide

Shashank P said...

Hi Rohit, I appreciate ur awesome work of sharing ur experience with all and at the same time trying to teach something out of it.
I had a doubt abt how do one value commodity/cyclical stocks. One can value the company it after normalizing the earnings but I hav observed tht when the trajectory of the margins are downwards or abt to, the stock under-performs dramatically in future, off the valuation predicted using normalized earnings. Recent example are tyres sector for past few yrs and sudden spur to fair valuation.
Do u hav a way to predict the margin rise, as even the stock/sector analyst are often caught off-guard with the sector reversal, thereby overestimating future on good recent past & underestimating future for the bad past.