In the wake of the recent stock market drop, the significance of managing portfolio risk has been pushed to the forefront. Consistent alpha above benchmark returns can only be created if the portfolio experiences fewer corrections than comparable benchmarks in times of downturns. After a bull market, it is pointless to generate abnormal gains just to lose them during a drop.
Now, the most pressing issue is reducing the overall risk of the portfolio. Maintaining a well-diversified portfolio, investing mostly or exclusively in large-cap businesses, or investing in companies that will generate significant growth in the short future and so suffer fewer declines are the most common replies. There should be more complexity in risk reduction than just following these general guidelines, in our opinion.
Portfolio errors can be avoided with proper due diligence on firms and their managers-
To begin with, the greatest danger to a portfolio is the inclusion of investments in firms with weak financial health and ineffective governance. Investee businesses' poor corporate governance is the most common reason that Indian stock investors lose all of their money. Prior to making an investment, it is crucial to conduct thorough research and due diligence to determine the integrity, competency, and motivation of a company's leadership team.
When looking at how well a firm has performed in recent years and throughout several cycles, it's critical to determine whether or not it is essentially a high return on capital business with constant good cash production and low to zero leverage..
The market capitalization of high-quality, well-managed enterprises is a byproduct of their continuous business execution and great returns. However, this does not imply that investors should solely put their money into large-cap firms in order to reduce their exposure to risk. As a result of their great execution and fundamentally superior company quality, well-run organizations have a substantial market cap.
To reiterate, we believe that the best strategy to reduce portfolio risk is to invest in high-quality companies with honest and capable management. As a result of our country's smaller size compared to the US and China, numerous industry leaders in India have exceptional track records of performance.
There are a few examples of firms with less than a billion dollars in market capital that lead their respective industries: Cera Sanitaryware, La Opala, Suprajit Engineering, and others, all of which are leaders in their respective industries. Aside from the fact that there are a number of specialty industry leaders and well-run small and mid-cap enterprises, this is not an advice to buy into these companies.
You may limit your portfolio risk by exclusively investing in high-quality firms, regardless of their market capitalizations. Investors should stay away from firms with a bad track record of corporate governance and/or poor overall company quality, regardless of how popular they may be right now or how convincing the story is that their promoters have suddenly changed their tune. During a bear market, all of this hoopla and publicity suddenly fades away.
Avoid becoming overly reliant on any one market or type of business by being broadly diversified-
Secondly, portfolio diversity is necessary but irrelevant beyond a certain point since empirically it has been established that over-diversification does not reduce volatility/risk. The importance of diversification cannot be overstated. We think that it is critical to have a diverse portfolio that includes a wide range of companies from different industries and markets, as well as different types of businesses (B2B or B2C).
When it comes to reducing portfolio risk, having a low correlation between the stocks in your portfolio is an important consideration. For portfolio firms to avoid being hit equally by headwinds during a recession, it is critical to diversify across markets, such as having a solid balance of domestic and export-focused businesses, across industries, and between company types such as B2B or consumer facing.
The initial investment thesis should not be challenged by legislative changes, technological disruptions, an increase in the competition intensity, notably from VC-funded enterprises, or any other factors after the money has been spent.
In a portfolio of more than 50 firms, it is nearly hard to keep track of each one. In India, where factors like legislation and the competitive environment change swiftly, we feel that tight portfolio tracking is more crucial than any initial investment idea. Maintaining a diverse portfolio of 20-25 investments is the best strategy to limit risk.
Focus on the long-term and never overpay for anything-
It's also widely believed that companies with high profits growth are less likely to correct during market downturns than those with low earnings growth. Despite the importance of profits growth, the long-term viability of that growth and the company's entry price are more critical.
We don't think it's a good idea to keep rebalancing your portfolio in search of the newest, fastest-growing companies. Short-term outperformance may be due to transient causes like supply side problems or brief regulatory issues.
To put it another way, these variables can reverse in the medium to long term. As a result, the emphasis should be placed on locating and investing in organizations or industries that are experiencing substantial long-term tailwinds that can last for years or decades.
Entry values should also be taken into consideration, since it is the single most important aspect within our power to influence. As a rule of thumb, we don't recommend buying the cheapest stocks since they tend to be value traps because of their low quality or governance track record in India.
However, we feel that when valuing any company, it is important to take into account aspects such as the underlying assumptions of growth and cash creation, as well as past valuations for similar sectors or firms in established markets like the US and emerging markets like China. It is important to make an educated selection and only invest in firms that are priced fairly.
Businesses with overvalued values are vulnerable to large corrections if their profit expectations alter even slightly owing to macroeconomic challenges. Mid-tier IT services have had a considerable correction in the recent six months, since they were valued at decade highs in October-November 2021. Stock prices fell by an average of 30 percent or more owing to the concern of a U.S. economic recession. This third premise may be summarized as follows: we believe that investing in long-term growth stories with fair to acceptable prices is the best way to limit portfolio risk.
We think that risk reduction is a continual effort to conduct adequate due diligence and study before investing, watch your portfolio, sell when the values of your portfolio position allow little opportunity for additional upside, etc. Lower drawdowns during market corrections rather than maximum gains during a bull cycle are the foundation of long term healthy portfolio performance.
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