Constructing a Compounding Portfolio

There are various kinds of portfolios that can be prepared in line with the risk appetite of investors. It could be a high-risk high return small/micro-cap portfolio, a medium risk-return midcap portfolio, a benchmark linked portfolio with large caps, a conservative portfolio which could comprise of dividend yield or MNC stocks or a compounding portfolio that is a true wealth builder, which could be a mixed cap portfolio. So, what is a compounding portfolio? It is a portfolio that keeps compounds wealth over a period of time. It is a winner over the longer term and is an investor’s delight. It comprises of Test match players rather than T20 players, to use cricketing parlance, in it’s portfolio. Such a portfolio may not give great returns during euphoric times but gives minimal heartaches, relatively, during times of corrections. It comfortably beats the benchmarks over longer periods of time and needs minimal tweaking across various cycles of the market. Risk of illiquidity reduces since the investment horizon is long term.  

So how does one construct such a portfolio?

While there is no fixed formula to prepare such a portfolio, we are making a small attempt to provide some guidelines of how it could be constructed. Readers are requested to do their own due diligence and not blindly follow these guidelines. The basic rules of investment of buying into stocks of companies with good managements, strong balance sheets, sustainable businesses, etc. remain. The guidelines are as follows:

• Decide your investment horizon: It is important to decide on an investment horizon for which you wish to have this portfolio, i.e. 5, 10 years, etc. Ideal time for the portfolio could be 5 years after which a review should be undertaken.

• Identify right businesses: It is important to identify the right businesses for investment. They could have the following characteristics, amongst others:
  • Non cyclicality
  • Unregulated or less regulated
  • Local market growth opportunities
  • Relative consistency of growth

• Identify stocks within these business segments: Once businesses have been identified, the best stocks in them should be identified. They could have the following characteristics, amongst others:
  • Leadership
  • Relative consistency of growth
  • Majority promoter holding
  • Clean corporate governance track record
  • Focus on local market
  • Believes largely in organic growth
  • Asset light
  • Above sectoral average CAGR returns over a 5-year period
  • Interesting valuations

• Check for volatility in stocks: A look at the charts can help us filter out stocks that swing wildly from those that move in a band. While we are not technical experts, we like stocks that move in a narrow upward trending channel on the weekly charts. One could also check the betas of these stocks, if accessible, else a chart check should suffice.

• Avoid sectoral concentration: Every business faces different kinds of risks. Hence, it is important to have an optimum basket of businesses to be able to address concentration risk.

• Construct an equal weighted portfolio: Once the best stocks have been identified, an equal weighted portfolio of a manageable number of stocks, could be constructed. It could be a portfolio of 5, 10, 15 stocks, depending on the size of the portfolio. A larger portfolio may be unwieldy and may also yield sub-optimal returns.

• Have conviction on the portfolio: Once a portfolio has been constructed after adequate diligence, it may take a while before the portfolio starts delivering. It is important for the investor to have patience. A compounding portfolio is meant for the long term and therefore short-term performance measurement, could impact this objective.

We hope these guidelines help our readers, in preparing their long-term compounding portfolios. Incase there are queries, kindly put them in the comment box or send us a mail at info@capitalportfolioadvisors.com.

Happy investing!

Disclaimer:

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