The recent correction in equities has brought into focus the importance of managing portfolio risk. Historical evidence shows that consistent alpha over benchmark returns can only be generated if the portfolio suffers lower corrections than relevant benchmark indices during a market downturn. There is no point in generating supernormal returns during a bull market only to squander it away during corrections.
Now, the key question is how to keep portfolio risk low. The obvious answers that usually get thrown up are maintaining a well-diversified portfolio, investing majorly or solely in large-cap companies or investing in companies that will deliver high growth in the near term and thus will suffer lower corrections. We believe that these are broad thumb rules and risk mitigation should be much more nuanced than blindly following these rules.
Proper diligence on businesses and management must to avoid portfolio mishaps
Firstly, the biggest risk in a portfolio is investment in companies with poor business fundamentals and corporate governance. Poor corporate governance of investee companies is the no. 1 reason that Indian equity investors end up losing even their invested capital. So, a significant amount of research and due diligence prior to investing needs to be done on evaluating any company’s historical track record of governance as well as the integrity, competence, and motivation of its management team.
Similarly, it’s crucial to evaluate the company’s business quality over the past 10-15 years and over multiple cycles to ensure it is fundamentally a high return on capital business with consistently strong cash generation and low to nil leverage.
High quality businesses run by stellar managements naturally have large market caps as they delivered consistent business execution and thus generated strong returns. However, it should not be construed that one should invest only in large cap companies to minimize risk. It is like interpreting the result as a cause because the large market cap of well-run businesses is the result of their exceptional execution and fundamentally superior business quality.
Just re-emphasizing, we believe the way to minimize portfolio risk is investing in high quality businesses run by honest and competent management. In India, there are several sector leaders with stellar execution records that are still small and mid-cap companies given the smaller size of our economy compared to the US and China.
From the top of mind, few such sector leading companies with less than Bn $ market cap are: Cera Sanitaryware (leading organised sanitaryware player), La Opala (leading organised opalware company), Suprajit Engineering (auto ancillary with leadership in automotive cables), etc. This is not a recommendation at all to invest in these companies but just to illustrate the fact that there are several niche sector leaders and well-run businesses in the small and mid-cap space.
So, the first and most important rule to minimize portfolio risk is to invest only in high quality businesses irrespective of their market caps. One should strictly avoid investing in companies with poor governance records and / or poor through cycle business quality no matter how much these may be trending currently or a narrative being created that their promoters have suddenly turned over a new leaf. All such stories and hype vanish quickly during a bear market.
Diversify across sectors, business types, and markets to reduce risk
Secondly, portfolio diversification is important but irrelevant beyond a point as statistically it is proven that over diversification does not lower volatility/ risk. Moreover, we believe it is important to diversify across different markets, sectors, nature of business (B2B or B2C), etc rather than just keep on adding more similar stocks to the portfolio like having 5-6 names from IT services, FMCG, banks, etc.
A key factor in lowering portfolio risk is to have a low correlation between the invested names. It is important to diversify across markets like having a good mix of domestic and export focused businesses, across sectors, across business nature like B2B or consumer facing, etc. to ensure headwinds during a downturn do not impact all portfolio companies in a similar fashion.
Moreover, once invested, it is very important to track each portfolio position to ensure that regulatory changes, tech disruptions, increasing competitive intensity especially from VC funded businesses, etc do not begin to challenge the initial investment thesis.
In a portfolio of 50+ companies, it is practically impossible to track each position effectively. We believe stringent portfolio tracking is more important than even an initial investment thesis as in India macros like regulation and competitive landscape change rapidly. So, the best way to minimize risk is to maintain a portfolio of 20-25 investments diversified across multiple dimensions.
Focus on long term prospects and never overpay
Lastly, there is a lot of focus on near term earnings prospects of companies as the belief is that companies that deliver good earnings growth will correct less during drawdowns. While earnings growth is a key factor in driving stock returns, the sustainability of that growth and entry valuation is more important.
We believe it is not a great strategy to continuously churn the portfolio in a lookout for the new fastest growing business. This is because there might be temporary factors like supply side disruptions, temporary regulatory factors, etc leading to short term outperformance.
These factors can revert in the medium to long-term causing the growth to fizzle out. So, the focus should be on identifying industries or businesses that are enjoying structural long-term tailwinds that can last several years or even decades and investing in them.
Also, one should be careful about entry valuations as that is the single biggest factor in our control. We are not suggesting buying the cheapest stocks as historical evidence suggests such stocks in India are generally value traps because of inherently poor quality or governance track record.
However, we do believe that one should consider factors like what are the inherent assumptions of growth and cash generation in the valuation of any stock and also what valuation has such sectors or businesses traded at historically in both emerging markets like China as well as developed markets like the US. One should make an informed decision and should only invest in businesses that are available at a reasonable to fair valuation.
Businesses with over stretched valuations can correct significantly if there is a slight change in their earnings prospects due to macro headwinds. This is visible in the significant correction in mid-tier IT services in the last 6 months as they were at decade high valuations back in Oct-Nov 2021. A slight change in prospects due to fear of a possible recession in the US led to an average 30%+ correction in their stock prices. So, just to sum up this last point, we believe to minimize portfolio risk one should only invest in long term growth stories with fair to reasonable valuations.
Summarizing, we believe risk mitigation is a continuous effort of doing proper diligence & research before investing, portfolio tracking, selling when valuations of portfolio position leave no room for further upside, etc. The bedrock of long term healthy portfolio return is lower drawdowns during market correction rather than in maximizing returns during a bull cycle.
Anubhav Mukherjee is the Co-Founder of Prescient Capital
