Over the years, we have learnt an important lesson in investing! The lesson is that picking the right investment ideas is only half the work done. In order to create serious wealth, capital allocation is vitally important. In absence of structured and disciplined approach towards capital allocation, even with the best investment ideas, one may still end up with sub-optimal or even mediocre returns from the portfolio.

    We adopt a structured approach towards capital allocation while constructing the model portfolio. In order to optimize the return from the portfolio, we have to deal with number of different facets of Capital allocation. Our philosophy with respect to few important aspects of capital allocation is outlined below.

    Portfolio Concentration

    Typically, the common belief is that more the number of stocks in the portfolio more diversified it is and hence reduces the risk for an investor substantially. However, what is often overlooked in this approach is that more you diversify, the less pronounced is the effect of outperforming stocks on overall portfolio performance. Thus, one of the key aspects in capital allocation is to strike a right balance between the risk and return.

    We believe that a portfolio of 20-25 well researched, high quality businesses bought at right price will strike this balance well.

    Fundamental Analysis:

    In this step, we try to determine how sound the business fundamentals are how they are reflected in numbers. We carry out detailed quantitative analysis based on the projects, the developer, the marketing team, the venture capitalist and many more parameters before choosing one. - Sustainability of Business model- Ability to grow at high rate without resorting to excessive leverage. - Business Economics –Capacity to sustainably generate above average return on capital for a long period.

    - Nature of growth – Secular vs. Lumpy vs. Cyclical. - Profitability & Pricing Power- Constant /Improving margins vs. fluctuating/Declining margins - Cash generation and Utilization – Free cash flow generation from business and management’s ability to effectively allocate cash.

    Cash Allocation in Portfolio

    As Warren Buffet nicely puts it “Cash combined with courage in time of crisis is priceless”. Thus, cash has a tremendous option value, especially when the going is tough. At the same time, cash parked in liquid investments or sitting in the bank account will generate much lower return and hence has opportunity cost attached to it. Thus, the key question for an investor to ponder over is, how much cash is optimal in portfolio? Our view is as follow

    • In all the markets, except where we feel the market pendulum is swinging towards, undue exuberance leading to unsustainable valuations, we do not have any minimum/maximum threshold for cash in the portfolio. Over all cash allocation in the portfolio is governed by the availability or lack of attractive investment opportunities in the market. Thus, if there are enough attractive investment opportunities in the market, we remain fully invested or in absence of such opportunities, we do not mind sitting on large portion of cash.

    • In times, where market pendulum has swung in favor of unsustainable optimism and overall market valuations look stretched as compared to historical averages, we adopt a more risk-averse approach (and one that we think may also provide us some golden opportunities). We progressively increase cash levels by making partial/full exit from existing positions. The extent of cash levels in the portfolio is then a function of deviation of current valuation of benchmarks from average historical valuations.

    When to Sell:

    • When we realize that we have made a mistake in buying decision

    • If in a portfolio, allocation to a single business remains much above the upper limit of allocation on sustained basis

    • Due to change in any internal or external factor, if the underlying investment thesis no longer holds true in case of business quality, management quality or valuation

    • The markets pendulum swings to undue exuberance resulting into market valuations (measured through benchmarks) that are more than 2 standard deviations away from the average historical benchmark valuations

    Portfolio structuring process

    We follow a rigorous process while structuring our portfolio. Our portfolio structuring process revolves around the capital allocation principles that we have established. The process is summarized in following steps

    • All the businesses that pass through the Investment Process are evaluated based on following frame work

    • Even though, we believe in concentrated portfolio, considering our primary objective of ensuring safety of capital, we strictly follow the capping of allocation to a single business, except for the extraordinary circumstances.

    • Once a business enters in the model portfolio, we partially/fully exit the opportunity only for the reasons as explained in capital allocation principles

    • Even though, we may replace one business in the portfolio with another one occasionally, the new entrant in the portfolio has to offer significantly better risk-return trade off as compared to the incumbent investment in the portfolio. If we come across such opportunity, we again follow the process and try to ensure that the least attractive incumbent in the portfolio is replaced with the new business.