Portfolio construction is one thing, but monitoring and making adjustments are equally important.
Chetan Phalke
Most investors spend a lot of energy on emerging themes and new stock ideas. But quite often, we spend less than the required time thinking and tracking their existing portfolio. For most investors, portfolio rebalancing is centered around price action alone. As stock prices move up, the conviction goes up  and the regret of not buying more creeps in. If stock prices tumble, it works the other way round.
Some theories suggest averaging of costs as stock prices and earnings move up, while some will emphasize the importance of buying more on declines and when earnings are uncertain. There is no one correct answer. You must work your way around based on your investment style.
We thought of doing it in a simpler way. We created a 2 x 2 matrix with investment hypothesis  and allocation as variables.
Investment Hypothesis
An investment hypothesis can be any metric or a combination of them based on investors’ assessment of the business. There are businesses with various characteristics, and we must arrive at key monitorable factors to see if the story is on track or not.
For growth companies, it could be market share gain, growth rates, quality of growth, cash flows etc. For a turnaround firm, it could be capacity utilization, working capital management, cash flow improvements, debt repayment, interest cost reduction and discount to replacement cost. If you are a management-driven investor, the execution track record of the promoter matters the most. If it’s a thematic bet, the monitoring the adoption of trends, efforts made by the management to reach out to consumers etc. becomes important.
Allocation
Allocations vary from investor to investor. Some investors, as a rule, will never go above 5 per cent in a single stock idea  and will keep trimming exposure whenever it crosses the threshold. For some, it doesn’t make sense to have less than 8-10 per cent in a single stock. Some investors work around sectoral allocations. Investment allocation is more of a personality driven decision.
We can divide a portfolio into four quadrants.
Q1 – Investment Hypothesis Is On Track  and Full Allocation
These are the anchor stocks in the portfolio. They must be held till the investment hypothesis is on track  and you have very high level of comfort in holding them. Even if the stock price hasn’t done well, these positions are not to be touched unless there is an over allocation issue. Unless the position becomes too large  and causes concern. That’s the time to take some money off the table.
Q2 – Investment Hypothesis Is On Track  and Low Allocation
As the business keeps performing, conviction level goes up. As you spend more time tracking the stock, you discover more  and can separate wheat from the chaff. Investors can narrow down on key monitorable parameters that matter the most. There comes a time when the valuations are right  and you are willing to scale up your position. Or, your understanding of the business is much better than the initial stage, and you are willing to pay a fair price/premium  and buy more. These are ideas that can move to Q1  and can become anchor stocks in the future.
Q3 – Investment Hypothesis Is Not On Track  and Low Allocation
These are the tracking positions. We can put them in the ‘ideas for the future’ bucket. They don’t have any impact on the portfolio even when they move, since the position size is too small to matter. This works in deep value, thematic or turnaround bets. You develop a reasonably good understanding of the business  and key parameters. Since you track these positions for a while, you can act quickly when it matters. When you see some symptoms of change, the ability to spot them well ahead of the market gives an advantage. These ideas can move to Q2 as and when things turn.
Q4 – Investment Hypothesis Is Not On Track  and High Allocation
These are obvious mistakes in the portfolio  and most difficult to tackle as our biases are involved. Most of us keep holding the stock, hoping for things to turn one day. Anchoring against the entry price is another factor. The stock is significantly lower than the highs we have seen, or it is way below entry price. It is important to be ruthless  and cut the positions or just move them to Q3. Ability to deal with this category is very crucial to have a sustainable performance over the long term.
None of us is immune to making mistakes. Our judgements will go wrong occasionally, and that’s completely acceptable. Investing is not a game of certainty, but of probability. You must keep that in mind  and act accordingly.
(The writer is the founder  and CIO at Alpha Invesco. Views are personal)
