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Risk Management Framework

Investing is all about constantly dealing with uncertainties which implies the outcomes are probabilistic in nature. In the light of above, we strive to maximize our odds of earning reasonable returns while minimizing risk. We don’t define risk as ‘volatility’; we don’t get scared even if our stocks go down 30% as long as thesis is intact. Rather, for us the term ‘risk’ only implies a permanent loss of capital - where stocks crash permanently with no hope of recovering capital (think Reliance Power, Kingfisher Airlines, JP Associates or Unitech). Stalwart Advisors’ team has a cumulative experience of over two decades augmented by a sound advisory board comprising of veteran investors. This has helped us develop a strong risk management framework.

 This involves stringent due diligence on prospective companies including:
  • Forensic Accounting: We give much more weightage to balance sheet and cash flow analysis, over Profit & Loss statement, to identify manipulation and misrepresentation in reported financial information. We have developed a proprietary checklist which we run for each company to spot fudging in accounts.
  • Scuttlebutt: We try to get independent views from channel partners (dealers & distributors) and physically inspect plants and offices. In India corporate scams and siphoning of public money is very common. For us avoiding these landmines is of prime importance which is why downside protection takes precedence over upside.
  • Debt (Death): We avoid companies which have high debt as that’s the single biggest reason for corporate bankruptcy.
  • Political Connection: We stay away from companies, no matter how attractive, if they are promoted by politicians or individuals who are affiliated to any political party.
  • Integrity & Transparency: We analyze corporate governance history and assess how management has treated minority shareholders in the past. We rule out companies which are run by some desi lala as his private company.
  • Skin-in-the-game: We avoid companies run by management teams or promoters without having enough skin-in-the-game. Such folks share all the upside with shareholders but no downside; a perfect setup to encourage taking undue risks. This is the prime reason we prefer to stay away from public sector enterprises (PSUs). This rule also helps us avoid companies where promoters have pledged their holding or have interests in similar line of business through private entities outside of the listed company. This is a crucial information which may not always reflect in related party transactions disclosure.
  • Capital Allocation: We assess the track record over the last decade, management’s willingness and competence to deploy incremental capital in a sensible manner keeping in mind the interests of all stakeholders.
  • Fragile Business Model: We filter out businesses having high customer concentration, lack of control on raw material sourcing/pricing, fixed-price or long-duration rigid contracts, are highly regulated, face Chinese and global competition, are fads and sell products/services which are fast getting disrupted due to e-commerce and other technological advancements.
  • Value Investing & GARP: We steer clear of fancied stocks trading at very high valuation even if everything is rosy from a business standpoint. We prefer to enter good quality businesses but at reasonable valuations. This strategy is popularly called GARP - Growth at Reasonable Price.
  • Circle of competence: Nobody can understand all the businesses and sectors given India has over 5,000 publicly traded companies from a myriad of industries. We aim to stay within our circle of competence and invest only in things we understand. Even when we try something new, it is always a minute allocation (3-4%) and overall such positions never cross 10% of the portfolio. This tail end motivates us to keep learning more about newer industries without risking meaningful capital. However, we never violate our other principles even while venturing this way

No matter how much analysis one does, there are always unknowns and subsequent developments which could dilute or negate the original investment thesis.

 We manage those risks at portfolio level in the following manner:
  • Diversification: We diversify portfolio across 15-25 stocks in order to reduce concentration risk. We have selected this range as it is neither too diversified nor too concentrated. This strategy diversifies company-specific risk to a great extent and minimize the effect of a few failed positions on the portfolio.
  • Allocation: There is a lot of thought and analysis that goes into deciding what proportion of capital get deployed in a particular stock idea. We allocate based on risk-reward ratio and it could range between 3% to 10%. We never allocate more than 10% to any single stock. Ultimately, what matters is how much absolute profits we make when we get the thesis right and how much we lose when we get it wrong.
  • Sectoral Caps: A portfolio of 15-25 stocks optically might look diversified but if it's the same factors that affect the fundamentals of the majority of the portfolio companies, the overall risk could still be very high in an adverse environment. Cognizant of this fact, we ensure we restrict sector-wise exposure to a maximum of 25% of the portfolio.
  • Optimizing Other Risks: There could be various other sources of risk in the form of geographic concentration (plants or sales in similar geography) or currency exposure (import/export getting affected by Rupee depreciation/appreciation with respect to USD). Before a new stock enters portfolio, we analyse it from various lens and ensure post addition of this stock, portfolio level risk-thresholds are not breached.
  • Volatility (Market Risk): We never invest based on event-driven spikes or for short spurts. When we analyse a prospective investment we strive to think 3-5 years out which immunes us from daily volatility. In the short-term, markets are driven by sentiment and can be irrational. However, in the long run stock prices always follow the earnings trajectory and valuation multiples reflect the true nature of business model.

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