The central theme of Investing is Risk Management. If we are able to manage the downside risk, then the underlying economic growth and entrepreneurship would provide the upside.

We see risk at three levels:

1. Market Risk
2. Portfolio Risk
3. Stock Risk

Most of us primarily look at stock level risk, but in our experience, looking at the other two is equally important – we should not miss the forest for the trees.

Let’s look at each risk in detail:

1. Market Risk: There are certain times when it’s so easy to lose money in the market, while other times, its so easy to make money in the market. The only question is the quantum of losses or gains. These times are irregular but periodic. Time in the market is most important, but approximately timing at the extremes is quite profitable and also helps in avoiding heart aches. Here, some basic valuations and news flow do provide ample indications, but what is more important is to understand market and your own psychology. One may not need to take drastic calls, but altering at the edges can help mitigate lot of the risk.

2. Portfolio Risk: At any given point of time, the portfolio composition is based on our own greed and fear metric. Some people (typically institutional) invest more in safe, stable bets and try to generate alpha through smaller but riskier bets. While others try to invest more in riskier stocks, which they track well, to jumpstart their portfolio. Though in bear markets, one can compromise less and can get safe bets at sane valuations and also allocate higher capital to them. Beyond looking at allocation to individual stocks and sectors, one can think of various macro and market led scenarios and how the portfolio is likely to fare under such scenarios. For example, in case of sudden market fall or prolonged market stagnation, mostly quality growth companies at fair valuations are likely to bounce back faster. Whereas when the market transitions from a bear to bull phase, value stocks are likely to generate maximum alpha. Other specific aspects could be looking at impact on sharp currency movements on the portfolio, geographical concentration etc.

3. Stock Risk: All stocks suffer from one or more of the following risks – business cycle, business model, management integrity, capital allocation, execution and valuation risk.

It’s difficult to mitigate these risks at a stock level through valuation alone – unless one is buying at the depth of a general bear market or the stock is totally undiscovered.

So investing at most times becomes an exercise in optimising between these risks, at all levels – the market, the portfolio and stock level.

Over a period of time, the portfolio returns becomes a function of how we manage these risks – avoiding deep market drawdowns, avoiding blow ups in large positions and yet make the most in stocks where we have high conviction.

At a stock level, the expected stock return is a function of = absolute expected return times (x) the probability of realizing that return.

The main mistake most of us make is to focus on the first – absolute expected return and not the second – probability of realizing the return. What reduces the probability are the above-mentioned risks, which often lead us to stocks which appear attractive optically but suffer from such risks. Also the mind focuses more on the absolute return potential since its easier to calculate compared to the probability part which is more nuanced.

Investing in low probability stocks is not bad per se – provided one can gauge the risk reward very well and these are limited to a certain proportion of the portfolio as a class and one knows when to cut losses/ up the game.

If we analyze the investment universe of companies in India, one can compartmentalize them into following categories:

1. Proven businesses which have very remote chance of blow-up. They have impeccable business quality, tested management, demonstrated ability to navigate across business cycles, minority shareholder friendly, high RoE, ability to garner market share, good growth visibility with a long runway and no major regulatory risk.
2. The second category is for companies where either you have good business strength but lower growth of mid-teens or good growth but a notch lower business strength.
3. Third is emerging businesses – showing promise but are still untested on one or more following metrics – Growth visibility, Management focus, Longer term execution, sustained RoE increase.
4. Perpetual hope plays, where one keeps on betting on future execution.
5. Cyclicals or commodity plays.
6. Laggards/ Turnarounds – both on industry themes and company specific. This also overlaps with cyclical and commodity plays and Perpetual Hope plays.

Once we bucket companies in this order, it becomes easier to view the portfolio in terms of risk and reward. It can also help in choosing the right pond to fish.

As a general rule,

1. It is much easier to allocate a larger percentage of capital in the upper buckets and the optimum allocation reduces as we go down the order.
2. The reinvestment risk increases as one goes down the order. The lower categories typically give one-time returns while the higher categories continue to give returns over a longer period of time.
3. Absolute probability of getting the investment right keeps reducing as we go down because
   1. The variables to track or even quantify are more in lower categories
   2. The volatility of variables is more in lower categories
   3. It’s easier for a business with positive momentum to continue to grow vs. turnarounds
   4. Timing can kill the returns in the lower categories (Even if the thesis works but takes much longer than anticipated)
4. The upper category stocks work across market cycles, though might underperform for short period of time.

Often the issue is of valuation in the first bucket. However, that should not be an issue if one has long term thinking and patience to wait out for opportunities. We just need to find a few ideas every year so it pays to keep the focus on these opportunities because if one is not prepared beforehand, then it is not easy to buy these companies when the opportunity presents itself.

We have tried to put the top 200 companies (by market cap – overall and in small-cap index) into the 6 buckets to see how the universe stacks up for each. As expected, top categories have a higher representation in the large caps than small caps – but small caps still provide opportunities to people wanting to go only for good sustainable businesses.

Obviously, this categorization is somewhat subjective as there is overlap between categories and also the companies do shift from one category to another based on various macro and micro factors.

Happy Investing.