I wrote earlier about a Darwinian approach to portfolio construction. This approach involves the ranking all the stocks in a descending order and replacing the last position with a better stock/ idea. The key concept behind this idea is to replace the weakest position with a stronger one and thus improve the portfolio quality.
I did not discuss about how to rank the various stocks in the portfolio. I will discuss the business aspect of the ranking in a future post. Let me share some thoughts on how to consider valuation when doing this exercise.
A 2X in 3 years
As the title suggests, I have now started asking a question for each position (at the time of quarterly and annual results) – Does this position have the potential to double in 3 years ?
Note the use of the word – potential. One can never be sure if the stock would double.
How does one look at the potential ? There are two variable driving the stock price – earnings growth and valuation. Lets say the stock is selling at intrinsic value and the earnings are growing at around 24% per annum. At the risk of over simplifying (and not stating some additional factors), we can expect the stock to increase at roughly the same rate and thus double in 2 years.
If however the stock is selling below fair value, then we may get an additional bump from an increase in the PE ratio. However I would prefer to place a higher wieghtage on the earnings growth than the valuation – which depends more on the whims of the market.
Not a scientific exercise
One can easily find a lot of flaws in the above thought process. You can argue that, no one knows the market situation three years from now. In addition, the company performance may turn out to be much lower than expected, thus negating the entire exercise.
All the above points are true and I could add more. However the point of the entire exercise is to look at the potential of each stock (atleast annually) and assess its attractiveness based on new information. It is easy to fall in love with a position (especially in my case) and hang on to an old thesis, whereas the world around the company has changed completely.
What do to with such cases
Lets say you identify a stock where the potential return is unlikely to be 2X in 3 years. What now ? do you sell and buy another stock ? What if you don’t have another idea ?
Lets bring in the concept of opportunity cost. Lets say you dont have a better idea. Then the alternative is to sell and invest it in a fixed income instrument. Is the opportunity cost around 9% then? .
I don’t think so. I would say the opportunity cost is the average returns you have made over the long term. Lets assume that your portfolio has returned 15% per annum on average in the last 10 years. I would say that this is your opportunity cost and the existing position has to be above this threshold to remain in the portfolio
Why is this your opportunity cost ? The reason is simple – you have been able to make this return in the past on average and if you sell the existing position and hold cash, something will surely come up in time to deliver this kind of return. You may not make this return the next month or next quarter, but can expect to make it over the next few years.
So the question to ask is – does this position meet my opportunity cost threshold? If yes, hold on to it till you can find a better idea – preferably a 2X or 3X in the next few years.