But as we celebrate these gains, Diwali 2024 brings with it an important reminder: the need to re-evaluate and refresh our investment portfolios. No matter how successful the past has been, the spirit of Diwali encourages us to let go of the old, stale, and non-performing elementsโmaking room for a fresh start.
Diwali: A Time to Destroy the Old and Stale and Start Anew
Diwali, the festival celebrating Goddess Laxmi, the goddess of wealth, is not only a time for material prosperity but also a time to cleanse and renew. Just as we deep-clean our homes and remove the clutter, we should perform a similar โdeep cleaningโ of our investment portfolios. However, beware of the common traps most investors fall into when reviewing their holdings.
How Not to Clean the Portfolio
A common misconception among investors is to hold on to stocks that have performed well and discard those that havenโt. While this might work for a trader, itโs not the ideal approach for a long-term investor. Just because a stock has generated high returns doesn’t mean it remains a good investment, and conversely, poor past performance doesn’t always mean a stock lacks future potential.
Letโs examine the right way to clean your portfolio, the scientific investing way.
Deep Cleaning the Scientific Investing Way
Inspired by the Scientific Investing Framework at OmniScience Capital, letโs explore three critical pitfallsโCapital Destroyers, Capital Eroders, and Capital Implodersโthat can hold back your portfolio. Identifying and removing these โthree evilsโ can pave the way for a more robust and resilient portfolio.
The First Evil: Capital Destroyers
Capital Destroyers are companies that continuously generate losses or are burdened with unmanageable debt. While some sectors like infrastructure are exceptions, most businesses with consistently negative earnings or excessive leverage are harmful to your portfolio.
How to identify Capital Destroyers:
- EPS (Earnings Per Share) < 0 over the last 5 years
- Debt-Equity Ratio > 50%
- EBIT/Interest Ratio < 4
If you spot companies in your portfolio that meet these criteria (excluding sectors like finance or infrastructure), itโs time to consider eliminating them.
The Second Evil: Capital Eroders
Capital Eroders are companies with no sustainable competitive advantages, bad management, or consistently poor returns on capital. Persistent underperformance in terms of Return on Capital (RoC) or Return on Equity (RoE) can indicate poor long-term prospects.
How to identify Capital Eroders:
If a company consistently fails to meet these thresholds, it likely erodes value over time. Removing them from your portfolio helps prevent long-term drag on performance.
The Third Evil: Capital Imploders
Capital Imploders are the trickiest to identify because they often involve excellent companies that are overvalued. These businesses may have strong competitive advantages, but if the price you’re paying is far above the companyโs intrinsic value, youโre setting yourself up for disappointment. Overvaluation can lead to capital implosion, where investors face steep losses despite holding a great business.
How to identify Capital Imploders:
- PE Ratio > 50 (or >30-40 in some cases)
While exceptions exist (like a company having an anomalous low earnings year), itโs important to be cautious. If a stock appears grossly overvalued, even if it’s a household name or a great business, consider exiting the position.
What to Do After Eliminating the Evils?
Once you’ve weeded out the Capital Destroyers, Eroders, and Imploders, you’ll likely have freed up cash. The next step is to invest wisely in companies that donโt carry the same pitfalls. Again, using the Scientific Investing Framework, here are some guidelines for identifying robust companies:
- EPS > 0 over the last 5 years
- Debt-Equity < 50%
- EBIT/Interest > 4
- RoE > 15%
- RoC > 15%
- PE < 25
- Revenue Growth > 10% (CAGR over 5 years)
Create a diversified portfolio with 20-30 stocks spread across 4-6 sectors, ensuring that no recent developments have weakened these companies’ fundamentals.
Conclusion: Refreshing Your Portfolio for Diwali 2024
Diwali is not only a festival of light, but also a time for cleansing and renewalโboth in our homes and our investments. By eliminating the three evils of Capital Destroyers, Eroders, and Imploders, you can rebuild a stronger portfolio, setting yourself up for long-term success.
(The author Dr. Vikas Gupta is CEO and Chief Investment Strategist, OmniScience Capital. Views are own)
(Disclaimer: Recommendations, suggestions, views, and opinions given by experts are their own. These do not represent the views of the Economic Times)
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