The tail can wag the dog too

Investors believe that it is their top holdings that matter the most. The top picks are expected to make all the difference to an investment portfolio. So, all energies get spent focussing on the top bets. Investors guard them possessively spending disproportionate time on detail and debate related to their top holdings. But, if one's largest holding is a HDFC bank or Coca Cola company, there isn't much to do really. One just needs to sit patiently and watch time pass by. Inactivity is what will make all the difference to outcomes. Yet, the moment an investor finds a new idea that excites him, he starts looking for capital to buy it. A natural outcome is that investors tend to sell his performing stocks. He simply lets go of a good bet just because it has done him good and he wants to move on. Often, as market cycles mature, investors sell marquee stocks which form the core of its portfolio to buy untested newbies. A classic example is the selling of FMCG blue-chips in 1999-2000 to buy untested IT and dot com newbies. A more recent example is the selling of FMCG blue-chips in 2008 to buy frothy infra and power stocks. Notice that in both instances, FMCG stocks were sold. Investors tire very easily of holding stocks that are predictable and unexciting. They tend to easily let go of them only to buy exciting stocks which carry high risk. lower long-term predictability and provide activity. Often, the excitement of doing newer things is the cause for investment decisions being taken sidestepping even the real merit of selling. Investors easily succumb to the fallacy that a richly valued stock can easily be bought back as it could be in the middle of a time correction. So, selling your core stocks when they are richly valued just so you could experiment with newer ideas is simply not the done thing. Remember, Buffett hasn't traded GEICO, WELLS FARGO or COKE every time they looked richly valued. Nor, has he considered selling them to buy newer ideas. The portfolio's core must be protected and its character kept consistent over time. Changes to the core must mandate very high conviction. 

But, an investor can't remain idle. He needs to find activity. So how can an investor do incrementally productive things, innovate and experiment with new ideas? How can he do it without messing up his existing investments? How does his search for ideas co-exist with the need to keep his strategy stable , contiguous and consistent? The continuing research and search for new ideas should be done in a way they don't invade existing portfolios. So, new research must be given their own space. 

The portfolio's tail is that place one should assign for newer ideas. Turning the tail into a portfolio driver is an interesting way of making portfolios breathe fresh ideas, creating newer drivers for returns and yet not upsetting the applecart too much. 

My prescription is simple. Separate your portfolio into two parts. The first part is your core portfolio that must have a limited number of stocks. The core will usually contain long-held stocks one intends to hold even longer. The second part , which i call the tail, is a  satellite portfolio that acts as your investment lab. In your satellite portfolio,  you experiment with newer ideas, buy stocks where your conviction is still evolving and carry stocks where your conviction is growing with the idea. A stock usually spends time in a satellite portfolio before it qualifies to become a part of your core portfolio. This phase is akin to a "Cooling period" or "Silent period" when you asks yourself a lot more questions. The cooling period helps you understand the counter arguments, answer them or decide they aren't serious enough to change your conviction. As conviction grows, you add to your existing positions in the stock. Gradually, you scale up your exposure to the stock and raise its portfolio weightage. Importantly, this scale up is strictly a function of rising conviction. Capital appreciation will also play its part in raising a stocks weightage and taking it up in your allocation. A stock earns its position in a portfolio. I am a firm believer in that principle. If we identify a stock's merit correctly, we must reward the stock with a higher position in our portfolio and the stock subsequently lives up to its promise. Then, the stock will gradually rise from the tail to the core of a portfolio. 

My top holdings of today were the tail stocks of my portfolio a decade ago. I held them long years to build conviction. As my conviction grew and became stoic and unshakeable, I helped myself to own more shares of them. My hunger to own more shares grew naturally. It is important that that a stock gets more attention only when this happens naturally. Over a decade, what was the tail of my portfolio became the driver and enjoys the bulk of the credit for my investment performance. 

My portfolio has a long tail. The bottom 30% is my investment lab. That is where i experiment and give room for my investment hypotheses to be validated. Some of these ideas move very fast in very short bursts of time earning their place in the portfolio's core. The others spend more time forcing me to fine-tune my understanding and question my own investment theses more critically.  The tail of an investment portfolio is no more a doghouse. One can ill afford to think " Oh but I don't really own much of it. So why bother?"  If one own's very little of a stock, the question to ask is " Why is this not good enough to grow as a position?". If one manages the tail of a portfolio well, it could well make all the difference your portfolio needs. 

The tail can wag the dog too. 

My tribute to Parag Parikh

The passing of Shri.Parag Parikh, one of the finest investors and investment professionals of our times stunned the value investing community in India. Paragbhai, as he was affectionately called, was deeply admired by the value investing community for many reasons. Being an astute value investor was definitely a strong reason. But, there were other reasons beyond just his accomplishments as an investor. Firstly, he was much more than an investor. He worked with unmatched zeal to promote value investing at a time when few had even heard of the discipline. He was a mentor to so many young investors, a teacher to many through his writings on behavioural finance and a role model in keeping the highest professional values and ethics. He carried his achievements lightly, talked about his past learnings with utmost humility and made every person who met him carry meaningful insights about life in investing.He was the most gentle teacher and would always be ready to travel to speak to our investors. TIA had the privilege of hearing Paragbhai several times and he would always come from Mumbai on his own and generously support our efforts to educate our investors. I am sharing a few things that I observed. Parag's sense of integrity and ethics is well known in the investing community. He was a man who took tough decisions even when there was no systemic need to do so. The reason was that he felt strongly about the need to do so. He shut both his lucrative stockbroking business and later his PMS business when he started a mutual fund. The reason - he believed that there should not be conflict of interest. This was at a time when most of his peers had operations in all three businesses and the system allowed them to do so. Parag felt that he should not be in all three as there could be potential conflict. So, he stuck to just one business- mutual funds. His entry into mutual funds was hardly easy. The regulations to raise the capital adequacy only made things more difficult for smaller & newer players. He remarked jokingly that the new regulation made him a poor allocator of capital. He did not flinch to speak the truth and that is something unusual in an industry that thinks one thing and is too fearful to say it. Talking about the mutual funds business , he said " this is a knowledge business. You don't need too much capital. By raising the capital adequacy, we are making it a capital intensive business. Those with the requisite knowledge and integrity may never be able to put together Rs.50 crores. Is that really good for the investor? Are we not closing the doors to the smartest minds to come into this business?" This was when he was able to comfortably comply with the new regulations. He was able to think beyond himself and talk like a statesman rather than a businessman. He did this with a rare candour that never hurt anyone and yet did not flinch in saying what he intended to. Parag's views on mutual funds paying dividends is another vignette of his brutally honest personality. He was against the practise of mutual funds paying out dividends. He stated upfront that his funds will never pay a dividend. If any other fund manager would do such a thing at his fund launch, that would become nightmare for marketing the fund to investors? It was unthinkable for investors to accept a fund that would not give a dividend. "How can a fund refuse dividends to its investors ?" Parag had a simple answer. " You are giving me money to manage. If you want some money out of it, you are free to take it. An investor should decide for himself. The fund should not give investors money and work against the principle of compounding." Parag was clear that genuine long term investors may not need the money most of the time and when they need it, they are free to take as much as they decide out of the fund. And, that was how he ran his fund. His contribution to the value investing community was immense. He was accessible, helpful and kind to so many budding investors. He gave encouragement, ideas and moral support in the phase of life when a budding investor was building his self-belief. Parag was a master in teaching people to learn and grow. The glowing tributes by accomplished value investors and thought leaders to Parag recognises his contribution to building a community. First, he helped so many young aspirants to evolve as value investors. Then, he put together a community through his annual event Octoberquest. It was a one day conference he personally hosted. He carefully chose the speakers, the invitees and even the menu for the lunch. He loved every moment of that day and made sure he spoke personally to every participant at the meeting. The meeting worked to a clear well planned agenda, the confirmations had to be done well in advance. He was absolutely punctual in starting the proceedings ( an unusual trait in Mumbai). He always was looking to make the event better, more focussed and useful to those coming in with great expectations. At the last meeting in October, he was telling me after the meeting " We must have more interactions . We must change the format from individual speakers and have a panel.You should participate in making a different Octoberquest in 2015". Any other host will want to hear you tell the nicest things about an event he so graciously hosted. But, that was Parag Parikh. The man had a plan to make everything better. The almighty had made other plans to take him to a better place.