XC smallcase Portfolio: Decagon Alpha

Charlie Munger once said, “Waiting helps you as an investor and a lot of people just can’t stand to wait. If you didn’t get the deferred-gratification gene, you’ve got to work very hard to overcome that”. A lot of investors believe that equity investments provide a way to become rich instantly. They refer to it as ‘overnight success’ and believe that all it takes is a few hours of research to identify good investments. This is an absolutely absurd claim. What is more disturbing is that investors do not realize that along with time and patience, it takes plenty of effort to compound your wealth. Earning wealth through the stock market is not meat and drink and just because you remain invested for a long period of time (a long period of time in the stock market can be very vague but is usually considered to be for at least five years or more) does not mean that you would increase your wealth ten folds. It takes a lot of dedication, determination, and patience to be a successful investor.

Now that we have established that it takes hard work and effort along with being invested for several years to build and compound your wealth in the stock market, it is important to emphasize a few metrics. Just by looking at a few numbers and ratios over the last few quarters or years and picking stocks based on that is simply not going to bode well. Investors need to follow a set of guidelines and rules that are well defined and established in order to find repeated and continued success.

‘Decagon Alpha’ is a portfolio strategy constructed on the basis of screening stocks through certain criteria and holding those stocks for the next decade. The first criteria that every stock needs to pass through is a relatively simple one: have a market capitalization in excess of Rs. 100 crore. Those companies that meet this criteria will then pass through a couple more parameters. The first one is to have an average revenue growth of at least 10% over a ten-year period (2011–2020) and an average return on capital employed (ROCE) of at least 15% over a ten-year period. To put a slightly strict screener, companies were also required to have a ROCE of at least 12% every year over the 10-year period along with having an average of 15% over the time period. These filters were applicable for non-financial services companies.

For financial services companies, instead of revenue growth, loan book growth was used. To put it in simpler terms, loan book means the principal amount of all outstanding transferred customer loans as reported in the issuer’s balance sheet. An average loan book growth of 15% over the course of ten-years and an average return on equity (ROE) of 15% over the course were the criteria for financial services companies. The reason ROE was used instead of ROCE for financial services companies is because in calculating ROCE, both equity and debt is used and since most of the financial services firms (whether they are banks or non-banking financial institutions) tend to lend to their customers, the debt on their balance sheet is significantly higher and hence, using debt for calculations gives us a wrong impression.

Using the 2011–2020 time frame, there are 25 companies that meet the above requirements. However, the number of stocks was limited to 20, keeping in mind optimal portfolio performance, sector allocation, and diversification. This gives rise to the ‘Decagon Alpha’ portfolio. We will now track the price performance of this portfolio for the next ten years i.e. from the 30th of June 2021 until the 29th of June 2031. To do this, we will allocate an equal amount of money in each of these 20 stocks (5% to each stock). We compare our portfolio’s performance with the benchmark index, the Sensex, over the next ten years. To further assess the robustness of our research, we would stress-test the results for maximum drawdowns to evaluate the strength of the portfolio during times of market volatility. To do this, we would first calculate the returns of each of the stocks and the Sensex over the next ten years. Next, we need to compute the maximum drawdown for the portfolio. A drawdown in this context refers to the maximum drop in cumulative returns from the highest peak to the lowest subsequent trough. Last but not the least, we would calculate the risk-adjusted returns, i.e. returns in excess of the risk-free rate (currently 6% in India) divided by the maximum drawdown.

It is important to note that not all the companies included in this portfolio will do well over the course of the next decade. There might be four to five companies that would perform exceedingly well and similarly, three to four companies that would provide low or possibly negative returns. The remaining ten to twelve companies might just perform in line with the broader market. This is the nature of the Decagon Alpha portfolio. However, it is extremely likely that it will outperform the benchmark due to a few reasons.

First, as the time period increases, the probability of generating a positive return goes up. Based on historical evidence, the probability of generating positive returns goes up from approximately 70% in a one-year timeframe to almost a 100% if the time-frame is a decade. Second, over the long-term, the portfolio starts being dominated by winning stocks whilst losing stocks keep declining to eventually become insignificant. Hence, by the logic of simple mathematics, the positive performance of the winners will significantly outweigh the negative performance of losers to help compound the portfolio. Third, investing and holding for the long-term is the most effective way of staying away from short-term fluctuations and volatility that keep hitting the market.

Jack Bogle, a very well renowned investor, once said “”The idea that a bell rings to signal when to get into or out of the stock market is simply not credible. After nearly fifty years in this business, I don’t know anybody who has done it successfully and consistently. I don’t even know anybody who knows anybody who has”. As soon as investors try to time the market, there is a great deal of risk involved which can be easily avoided if fundamentals drive investment decisions. Last but not the least, by buying and holding stocks for a ten-year period, transaction costs are reduced as there is no churning that takes place. This, in turn, adds to the overall portfolio performance over the long-term.

There is a strong reason against churning the stocks in the portfolio. First of all, there is a higher probability of profits over the long-term. As known, equity markets are prone to extreme movements in the short-term, but as indicated earlier, over the long-term, the chances of success are drastically improved. Secondly, as indicated at the start, the power of compounding can only take place if a stock is given enough time to perform. Enough time could mean months to years, depending on the general market condition along with what is happening with that particular company. As mentioned above, the positive performance of winners would significantly outweigh the negative impact of losers. Next, timing the market is an extremely difficult skill that almost no one has had consistent success with. Being invested in the long term means that there is no focus on when to enter/exit and allows investors to solely focus on buying/selling based on fundamentals, which is unlikely to drastically change in the short-term. Furthermore, with no churning, the most obvious added advantage is that one would not incur any transaction costs. With constant chopping and changing, one would have to pay significant transaction costs on every trade being conducted but since this is a buy and hold strategy for a decade, investors would save a lot on transaction costs. Last but not the least, based on historical backtesting of this method, it is proven that constant rebalancing does not improve returns, but actually worsens them due to all the reasons mentioned above.

All in all, based on the above methodology, it is important to realize that the Decagon Alpha portfolio brings out a really important concept that is often overlooked and forgotten in today’s dynamic world filled with loads of information: the buy-and-hold strategy, where allowing the stocks to compound is a much more important factor when it comes to generating long-term returns rather than individual stock selection or timing. This is the philosophy on which the Decagon Alpha portfolio is constructed.

By Arhan Parikh (arhan.parikh@xumitcapital.com)

Xumit Capital is a boutique investment advisory firm that deals in equity & crypto portfolios and global & immigration investments.