Allocation to stock picks in your portfolio: hidden part about successful investing

18th Sep 2017,

Authors: Abhishek Gupta (https://www.dhirubhai.net/in/abhishek-gupta-2153b324/) and Abhishek Kumar (https://www.dhirubhai.net/in/abhishekrai1/)

We have all heard about capital allocation being one of the most talked about topic, mostly in context of promoters or firms while evaluating the management quality of firms to judge whether they are investment worthy or not. It is also talked about to some extent atleast in theory about capital allocation for an investor arguing the case for diversification using the efficient frontier. While this theory is helpful, it’s helpful for institutional / mutual fund mandate and not so relevant for individual investors.

In our experience, I found very limited content / literature on importance of allocating the right money to your stock picks, rather the primary focus of investors and popular books is on picking the right stocks. But I argue that picking the right stocks is only half the work done and one of the most difficult one. Warren buffet puts it rightly when he says it’s an achievement getting 3 out of 5 right is a big achievement.

How many stocks exist in our portfolio, how much money we allocate to them decides where we spend our time, how much money do we make and more importantly the emotional journey that one goes through?

Let’s look at a simple example to make the point, consider two investors with different portfolio 1 and 2. Portfolio 1 has 5 stocks and Portfolio 2 has 15. Let’s assume that both the investors are equally adept at choosing companies and have an equal success ratio (ideally success ratio goes down as stocks increase in the portfolio) of 60% but invest different amounts in each bet. While, the overall returns that both investors make are same, there are key differences in both these portfolios. The second portfolio, with higher number of stocks provides a higher sense of activity which psychologically makes people believe they can be more successful. But what one forgets is that it requires higher no. of right decisions which in my view is much harder. Moreover, the time spent per stock by investor 2 is much lesser than in portfolio 1, which practically should result in higher success ratio for investor 2. As a result what we are left with is a portfolio of 15 (for e.g.) stocks with primary information on all of them vs. 5 stocks (for e.g) with second level of information and maybe more confidence as a result.

Also, we find that despite investing more time and reading across different companies, 75% of our profit in portfolio 2 still comes from our biggest 5 holdings, with rest of the 10 investments contributing to only 25%, making the case for having a portfolio with lesser stocks with higher weightage to get more bang for the buck. There are a few people that might argue that portfolio 2 because of higher number of stocks has lower risk because of being more diversified, I slightly disagree, because I feel the difference between no. of stocks is statistically insignificant to impact portfolio risk materially.

In our experience, authors have noticed that investors to put in additional money into the stock market generally have the tendency to research on a new stock to add to their portfolio rather than research on the existing stock to increase stake in that. This is not only because it is more exciting to know a new company but the work needed to go beyond the first level of information in the stock already invested in, is rightly more difficult. This strategy of finding new stocks continuously, we would argue is more detrimental to one’s portfolio than beneficial because not only can it hamper our success ratio, it also makes us more prone to irrational behaviours during market downturns given lower level of confidence on our investments.

So our learning in the last few months have been to spend equal time on deciding the allocation to stocks in your portfolio and finding new investments, and that is if you believe in the concept of concentrated investing and are willing to get to the second level of information

Now that we have seen a mathematical way to understand the importance of allocation, let’s dive into how we decide on actual percentages of stocks in our portfolio.

While the model is a work on progress, a very crude way to illustrate the process would be:

wCR + wVR = Stock Score, or its attractiveness, at a given point of time

Let’s say CR and VR are on a 10 point scale, where CR stands for conviction ratio and VR stands for valuation ratio.

Case 1

For example you have two stocks, say stock A and Stock B. And one is impartial towards both – hence gives equal weightage to both conviction and undervaluation.

Also, CR for both the stocks is 8, but VR for A is 8 and B is 6. Which means B is more undervalued in your opinion (using any consistent metrics – Can’t use different metrics here or it defeats the purpose)

Here, B would be a clear winner, in all cases. Now, if the following combination is there:

But then, what happens when CR and VR ratings are in different directions for 2 stocks?

Case 2

A has a CR of 6 and VR of 8, while B has a CR of 8 and VR of 6

Then it will depend more on what you value more - the higher conviction or the higher undervaluation. i.e. the weights you would assign to CR and VR. Here, for example, one of the authors will go with B since he is a firm believer of buying fair business at wonderful price, while the other one will definitely choose A since he belongs to the higher-compounding camp i.e. an excellent business at a fair price.

Which is better? The jury is still out, even for us – as we learning on our way, and whatever you choose, one should be able to live with the decision and minimize stress.

For example, I tend to assign VR with 60% weights, and CR with 40% weights, thus putting more emphasis on undervaluation. Using these weights, whichever gets higher value, gets a higher allocation in my portfolio.

Now both conviction and undervaluation is an interplay of many factors and as you have guessed hard to quantify. Some of the factors (not exhaustive) to be kept in mind while assigning a score to them and not be biased are:

1.     Business Quality

2.     Management Quality

3.     Financials and historical trends

4.     Industry scenario and prospects

5.     Future growth prospects

One can further drill down into these factors and decide on weightages for each of them to arrive at a score for CR and VR. For example, I tend to put 40% on Financials and then 15% each. It all depends on what one is comfortable with, and it will be only with time that one will be able decide what works for them. We will attempt to share more on the five tenets mentioned above in our future articles.

Hence, be conscious of what you are doing with your portfolio, in the name of higher activity, it could be actually detrimental to your returns.