WF: The 21st edition of your Wealth Creation Study is truly fascinating - it explores a dimension that, as the study rightly points out, is under-researched yet needs lot more focus. Can you please explain the Payoff - Edge decision matrix and its implications on portfolio construction?
Aashish: The learning and findings from the series of 21 Wealth Creation Studies by our Chairman Raamdeo Agrawal is what has gone into developing our investing style and philosophy; managing focused portfolios that buy and hold into high quality high growth companies possessing distinct competitive advantage.
There is a lot of research on which companies to buy but not enough on how to allocate once you like a company. And there is enough evidence to say that with the same portfolio constituents, different allocations can create totally divergent outcomes as demonstrated below.
The payoff edge decision matrix which is a key development out of the latest study on Focused Investing is as below:
As is evident this 2x2 matrix suggests that the size of allocation in a company should be in direct correlation with the kind of edge - depth and superiority of understanding about the business and its prospects that we possess - and the size of payoff it can have if the investment thesis plays out as expected. The edge determines how strong the hypothesis is and the payoff determines the reward that our investors will receive if the hypothesis plays out as expected. The confluence of these two can result in wealth creation for our investors.
WF: It is quite possible that the "edge" is likely to be found by fund managers more in the small and midcaps spaces, and payoffs are also likely to be usually higher in select picks in these spaces. Following the "big bets" philosophy of your matrix could therefore mean a few large bets in a handful of mid and small cap names, with much smaller bets, or none at all in index heavyweights. The conventional view of such a portfolio is a high-risk portfolio, to be advised only for aggressive investors. Is this time for us to reflect and review this thinking in your view?
Aashish: What you are saying may seem obvious but let's see where "edge" can come from:
Researching the under-researched - which is where your point on mid and small caps bears out. But hold on; the next point is linked to this first point for outsized payoffs
Understanding growth and longevity better than the market - many investors are great at identifying mid and small caps, developing an edge but that needs to be extended to build conviction and hold on in face of market developments for outsized returns. There is no fun in identifying mid and small caps and then not knowing enough to hold on to them.
Buying cheap or contrarian or against the market - needs conviction and patience and in most cases also edge of understanding macro environment other than just the company.
In our experience market consistently goes wrong in understanding rate of growth of companies and the length of growth of companies and this the market fails to capture in all kinds of market capitalization companies. This is the reason why great companies like HDFC Bank, Asian Paints, Hero Motors, are perpetually thought to be expensive - in other words people assume there is nothing left to understand in these companies and there is no source of edge. Well, understanding rate of growth and length of growth and willingness to stay the course can be a source of edge too - irrespective of market capitalization.
On your point on large and midcaps in general - while we have to work on developing an edge and bet sizing in line with payoffs - in general I suggest that our IFA friends and investors must understand the below matrix very carefully. Clearly the payoff in mid and small cap is very high but probability of success if low - that's where carefully selected high conviction bets are ideal. On the other hand with large caps while payoffs may be lower, the probability of success is very high.
WF: Your study makes a very important point on the dominance of well diversified portfolios in industry equity AuM and the relatively small niche occupied by focused investing. Why is this happening in your view? Is it time to change our approach towards focused portfolios?
Aashish: I don't think there is any intent on our part to profess that one style is better over the other. Focused Investing produces good results for investors who focus on the right investments. It's a function of style and philosophy. It suits us because we are totally fundamental driven bottom up investors and we do deep work on whatever companies we own plus we buy them from a perspective of holding preferably forever. We believe in putting our conviction on few ideas that we think we understand deeply.
Finance text books clearly say that anything over 20-25 stocks doesn't reduce risk in fact it is likely to dilute returns. My own guess about widely diversified portfolios with 50-60 stocks is that it's generally not deliberate. We notice quite often that when NFOs are launched funds start with 20-30 stocks but as time passes and fund size grows the number of stocks keep growing. A lot of marginal positions are positions which were commenced but never built, or stocks which have seen depreciation - absolute or relative - just that they haven't been sold out of. Otherwise there cant be a conscious justification of having nothing positions ranging from 0.1% to 0.2% or 0.5% of the portfolio.
That said, on the second part of your question, there is a totally different reason why I have been saying that focused portfolios should be considered seriously by distributors and advisors.
That's because anecdotally we know that most investors have 7-8 equity funds in their portfolios.
In that context, see the above data. Just make a note: BSE 200 is 82% of total market capitalization. Always remember this number. Why? On an average equity mutual fund schemes have anywhere between 40 to 70 stocks in their portfolios. Even if one assumes an average around 50 stocks per fund, 7 equity funds would end up holding 350 stocks. If you de-duplicate for common holdings, one would still end up owning in excess of 200 stocks. If you buy the market you cannot beat the market. Owning 7-8 widely diversified equity funds is a very expensive way of trying to beat the market by pretty much owning most of it. With this kind of diversification I am pretty sure investors will end up getting index plus a few percentage points at best. But the benefit of stock selection and serious alpha generation definitely cannot flow to you if you own almost everything that's trading in the market.
We are clear that our business is B2B, we are opaque to what's happening in the end client's portfolio, if the end clients portfolio is over diversified with 7-8 equity funds, then it's even better that we are focused in what we buy. We have to deliver alpha in the end investor's portfolio, not just in our factsheets! Advisors and distributors need to be cognizant of this, and if they are going to end up buying 7-8 equity funds for their clients, might as well buy a broad based index fund. We are all paid to stick our neck out not to "spray and pray"!
WF: Is there evidence suggesting higher alpha from focused portfolios? Is there evidence suggesting that risk from focused portfolios is not materially higher than diversified portfolios?
Aashish: In fact we have been managing highly focused portfolios since last 14 years in our PMS and since last 3 years in our MFs, I am usually told that focused portfolios are more risky or aggressive. I do not agree with this perception at all. It just calls for better research and higher conviction on your holdings. On the other hand, with diversified funds to say the least, you are definitely restricting your payoffs and hence potential upside. Let me elaborate further.
Being focused is just one attribute which needs to fit into a coherent style. We are buy and hold investors so it is better we are focused on a select set of high quality high growth companies with competitive advantage that lends sustainability to growth. We can't buy and hold in a portfolio of 50-60-70 companies. Also, I don't think it is humanly possible to do bottom up investing in 50-60-70 stock portfolios. Most often I don't understand why a stock would be say 0.1% or 0.5% or 1% of any portfolio? Even if the hypothesis is perfect and indeed there is a demonstrated edge out there, and the stock quadruples, what will it deliver to the end investor? The point is, are we giving our investment research and stock picking ability an opportunity to create wealth for our investors?
I am not making any case that focused funds will always do better than diversified funds. After all focused funds will also produce results if one is "focused" on the right stocks where some deep work has gone into developing the edge and the edge is available in stocks with significant payoffs. When both these dimensions are available and appropriate bet size is allocated, only then focused funds can deliver.
WF: One conclusion that can be drawn from this study is that advisors should consider low cost index funds and focused portfolios - the first where market beta is to be delivered into client portfolios and the second where the aspiration is for healthy alpha. A combination of both can deliver an optimal outcome - in terms of returns as well as costs, rather than going in for actively managed well diversified portfolios. Is this a fair conclusion?
Aashish: Yes, I do agree with this thought process. Even in developed markets the experience is that people are moving towards index funds or alpha shops. The widely diversified actively managed funds which are managed to largely track the index and beat them by a few percentage points are falling out of favour because they don't stack up on the cost benefit analysis. Some of them are even alleged to be closet-indexers. Its early days in India, but I won't be surprised if that trend emerges. The other evil is holding 7-8 equity funds in client portfolios, because in that case too quite unintentionally you are tracking a broadmarket benchmark with minor variation.
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