CategoryInvestment process

I have tweaked my approach in the last few years. An outcome is higher number of transactions and re-entering the same position even though it did not work the first time. This is not about being proven right, but buying a stock if the probabilities are favorable, even if it did not work the first time

This gives an impression of flip flopping to my subscribers. I wrote the following note in response to that.

Winning the battle, losing the war

I have been fixated on the success of each position for a long time. This is a very common mindset among all investors. Although, everyone knows that it’s the portfolio returns that count, we get hung up on each holding

My guess is that some of this comes from our schooling, where we were graded on each question and the final score was a total of individual marks. It does not work that way in life and Investing

For example, if you hold 10 stocks in your portfolio and one stock goes up 10X and the rest drop by 50% before you liquidate your entire portfolio, you have made 45% on your portfolio

Is this hypothetical? Not in the venture capital world where one position can go up 100X and the rest can go to 0. Public market portfolios behave in the same manner.

Most of our alpha have come from a handful of positions

If this is the reality, it leads to a few logical actions

1. We should not chase a high hit rate. A less than 50% success rate is fine as long as we manage the downside risk. Portfolio management is not an entrance exam
2. The key is to get a few positions right and make the most of it. If that means, re-entering the same positions several times, so be it. Did it matter we lost 20% on Neuland labs before making 150% on it. The other downside of this approach is higher number of transactions
3. We will appear to flip flop and regularly change our mind. We will hold our position only if the company gives us reasons to do so. Each position has to earn its place

Disclaimer

• This report is published by RC Capital Management – SEBI Registered Investment Advisor (INA000004088).
• This report is for educational purposes only and should not be construed as an Investment Advice.
• RC Capital Management may have recommended the above stocks to our clients in the past. However, this is not a recommendation to buy / hold / sell the stock at the time of publishing this report.
• The securities quoted are for illustration purpose only and are not recommendatory
• RC Capital Management may hold position in any of the companies mentioned in the report at the time of publishing the same. Its partners may hold a position in this company in their individual capacity at the time of publishing.
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We posted the following to our subscribers recently. Thought of sharing it with a wider audience

There was a question from one of the subscribers to which we responded via email. we wanted to share the communication with all of you. We have slightly edited the conversation and added to it

Question:  

I am fully invested into the model portfolio stocks currently, will I get any panic alert to liquidate portfolio and raise cash and wait for a dip again. Is that how your investing style works or I stay put and be invested at all times. Asking this as, most stocks are trading at all time highs. Is it possible to buy cheap and sell high!?

Our response

We think the underlying question is about timing the market and if we cannot time it, then what will be our course of action? Will we sell in panic to raise cash or just stay put and live through the rollercoaster ride

For starters, we cannot predict the stock market and so can no one else. We have spent 25 years looking at all kinds of systems and approaches and there is none which can predict the market. Some approaches can alert you to the possibility, but there is no fool proof system. If one exists, it is unlikely the practioner will ever share it.

The second part of the question is about a sudden crash and panic selling in response to it. The only scenario where everything just collapses and requires us to liquidate the full portfolio is if a major global catastrophe occurs. Unfortunately, no one can predict or prepare for it.

We have never seen a market where everything collapses suddenly. The worst case was covid which took close to a month to play out.

So how should we navigate this risk if we cannot predict.

We have a defined process to manage risk at the portfolio level and at the risk of repetition, let’s go over it again.

1. Being diversified: We have 20+ positions in our portfolio with no position exceeding 7% and sector allocation capped below 15%. A collapse in a stock or a sector will hurt us, but not wipe us out
2. Avoid leverage in the portfolio including F&O: No one can force us to sell
3. Have sufficient cash: This is not part of our advisory, but 101 of personal finance which all of you should practice. Have proper equity allocation based on your age, and risk tolerance and enough cash to cover personal expenses for 6 months
4. Stop loss on all positions: This acts as a circuit breaker at the stock and portfolio level. If the stop loss is hit for a stock due to company, sector or market related reason we will exit from a risk management standpoint. We will cap our losses and look for reasons at a later point. These stop losses are reviewed monthly and in advance so that we don’t have to make decisions in the heat of the moment

Our approach is to buy and hold each position till either of these conditions are met.

• Stock becomes extremely overvalued, and we decide to cut position size to manage risk.
• Company level issues occur and causes me to lose confidence.
• Stop loss gets hit for obvious or unknown reasons.
• A better idea comes along.

In summary we have a process laid out to manage risk level in the portfolio via diversification, position size and finally stop loss so that we don’t have to predict what will happen. As we cannot predict, our only option is to react to what is happening and if a dire situation occurs, we will do what needs to be done

Following is from a note published to subscribers. Hope you find it useful

It may appear that our outperformance is from how well we do in an upcycle. That is not entirely true. let me share some stats

Losing less than the indices

I have no preference for any particular market cap but tend to avoid the smallest companies from a risk and liquidity standpoint. Outside of that, any company is fair game for our portfolio

If you look at the table above, one period of outperformance stands out. In 2018 and 2019, when the market went south, we lost much lesser than the market

We were outperforming when it did not appear that way. Losing less than the market in bear markets is also an achievement, even though it may not appear to be. Some of the subscribers who joined us during this period, threw in the towel before the market turned as they did not agree with that notion.

The period of 2018-2020 was not an easy one. I made some of the worst mistakes of my investing career –  Shemaroo, Edelwiess Financial services and Thomas cook (sat on it for too long). These losses are seared into my memory. When you lose your own money and that of your family, it is not easy to forget

In spite of these mistakes, we lost much lesser than the indices. The key was to keep our heads down, keep working and wait for the tide to turn. It was also important to have some extra cash in place

Regular theme

The last few years are NOT an aberration. This has occurred regularly, and it will occur again. You can take the following as a given

• We will lose money from time to time, at individual stock and portfolio level, even though I am focused on not losing money, which includes my own
• There will be long stretches of underperformance with sudden spurts of outperformance
• Returns will be lumpy and unpredictable
• If you do not have the patience to stick around, you may exit at the wrong time

Let me share another metric to underscore my point

The model portfolio is up around 50% from 15^th Jan 2018 to 30 Jun 2021. What is special about these two dates? The small cap index peaked on first and then went into downturn. It regained this peak again this year.

We are up 50% from peak to peak

The key is to evaluate performance is to do it over a cycle and not from the bottom to the top of a cycle (when everyone looks like a genius) or from top of a cycle to the bottom, when any outperformance is hidden

From my recent note to subscribers

I have spent the last 9-12 months digging deeper into other approaches to investing. I have read up on the momentum style, technical analysis, trading, options and more. The reason was to understand how other investors think

It is easy to become dogmatic about your approach and think only you have access to the ultimate truth. I have been guilty of that. I have seen a few value investors (including friends) talk about these other approaches and that intrigued me to dive deeper.

It has given me a better appreciation of these other styles and understand (NOT predict) the price movement in stocks much better.

I have defined my approach as value investing – buying companies for less than their intrinsic value and then holding them for the long term (2-3 years).  This approach involves deep analysis of the business and its prospects. However an under-appreciated aspect of value investing is the time horizon.

Value investing or in other words convergence of price to value of a company, usually happens in 2+ years. In the short term markets are quite efficient and tend to price the near term quite well. The gap (if there is any) usually closes over the long run.

The approach is sound and has worked for a long time. What has changed ofcourse is the definition of value. If you still follow the traditional approaches of PE, P/B ratios and so on, then you will not do well as markets and economies have evolved a lot in the last 15-20 years.

In comparison, other approaches such as Momentum (where you buy stocks which have done well recently in terms of price performance) have worked quite well in the recent past. This approach is practiced more widely in India and there are a lot of very successful practitioners. The difference however extends beyond just the approach. It also involves a shorter time horizon and a difference in temperament.

Although the upside is good, this approach comes with its own risk in the form of momentum crashes. Investors who practice this form of investing have a methodology (rules based or otherwise) to exit their positions when the momentum turns to reduce the downside.

This often means changing your view and portfolio positions overnight. It is important to recognize which approach fits your temperament and which positions make sense for it. The worst thing to do is to buy a momentum stock with a value investing framework.

The momentum mindset

Even though I am not picking stocks based on momentum (yet), I want to build that mindset into my decision making process. The trading or momentum mindset is more rational, even more so when it is rules based.

Investors who follow the non-discretionary approach in momentum or trading, exit their positions when their system gives the signal to do so. Their effort is to back test the system and validate it. However once that confidence is developed, it is followed with discipline.

On the contrary investors like me, tend to get wrapped up too much with our narratives (or stories). As result, even when external conditions change, we tend to stick to our outdated stories and refuse to exit the position.

I have been guilty of this and even when I do change my mind, tend to get emails accusing me of abandoning a stock as if we should remain married to it forever.

I have been re-thinking my approach and you could see a higher turnover or exits even where I was optimistic or positive earlier. Some of you will hate me for taking small losses when I am wrong. I will treat that as an occupation hazard.

It is far better to take a small loss initially than lose much more later.