Portfolio Rebalancing
Two readers of this blog left couple of intelligent questions in comment section on some of the articles. Both of these questions relate to what I term as rebalancing the portfolio (or profit booking). I wanted to wait until I posted articles on TIPBlog portfolio update and risk analysis. I wanted to discuss these two questions in the context of TIPBlog portfolio. It will help better understand the re-balancing and profit booking processes.
You may have read earlier post that discusses risk analysis. I made a comment that the portfolio has overexposure on few stocks like ONGC, LNT, etc. I also mentioned that I will not be selling any partial shares to bring down allocation. Many use the term profit booking for partial selling.
When investors are using equity for long term wealth (instead of cash in and out and focusing short term) then it makes more sense to understand the concept of capital allocation. In the capital allocation approach, the simple aspect is expected rate of return on the capital. Re-balancing or selling partial shares should be based on how much return does one expect on allocated capital. The concept of “profit booking” applies to brokers/traders and individuals who have short term orientation and focus of trading. It is not applicable to any of the long term value or wealth building strategies. Let us discuss this in the context of TIPBlog portfolio. The table below shows three companies and its return characteristics as measured by YOC, XIRR, and Life-to-date returns.
Rebalancing
For all three stocks you may see that (1) YOC are higher than original yield; (2) Personal annualized rate of return, XIRR, has been more than 15%; (3) Lift to date returns are in order of magnitudes, instead of few percentages.
For the sake of this example, let us assume that I will sell partial position, or book my profits. What will I do? I would sell 50% shares and take that capital. Let us say, now I would have Rs 1,00,000 profits. What should I do with this profit? There are two things I could do which are:
- I could use it for personal use, expenses, buy something for my family, or go on exotic vacation. Basically, put it use for some expenses.
- If I do not need it for personal use, I will need to deploy it again in some form of investing. Where will I invest? I would like to invest in an asset (i.e. real estate, stocks, etc) that I have confidence will give me maximum possible return. What would be point of investing in asset that gives lower return! Right?
In my strategy, I will have to re-invest because I am not looking to use these profits for my personal use. I will need to find an idea that will provide me returns that are higher or at a minimum somewhat similar. I need another idea or stock that I believe will have potential to give increasing YOC; XIRR that is higher than 17%; LTD returns in excess of 100% in less than 5 years, etc. Unless I find another investment idea, it is always better to remain invested.
In another scenario, when I perform the yearly review, and I find some signs of trouble then I may reduce the holdings or completely sell the stock. By signs of trouble, I mean it does not meet the criterion I am investing for or change in company fundamentals, etc. The example of this is my recent selling of GE Shipping. I bought it early 2009. When I looked at fundamentals of the company, I was not ecstatic about it. I sold GE Shipping position completely. I allocated that “full capital” to stocks of Hawkins Cooker. Note I allocated full capital not standalone profits.
Now that you understand the strategy of re-balancing, you can read some of my analysis I have presented on this blog. In my analysis, I always attempt to understand the expected return. One may ask how sure you are about the expected return. Well, that is a whole different subject. There are many different ways to estimate expected returns. Some use intrinsic value based, some use margin of safety based, some use company’s growth projection vis-à-vis PE ratio, some use CAPM based, etc. In my view there is no fool proof method to estimate expected return. It is always perception of risk vs. expected return.
I do not claim that my expected return will always be right. However, I use a particular approach with very conservative expectations. I like to put my risk perception and expected return in numerical values. I avoid pure subjective explanation of risk and expected return because I find it difficult to make a comparative judgment. I am hoping that such an approach will facilitate my long term wealth building goals. So far signs are it is working.
asset allocation, expected return, GE Shipping, GESHIP, LNT, NTPC, ONGC, profit booking, rebalancing, risk perception in stocks, XIRR, YOC
Happy Diwali sir and also to everyone here..This blog has amazing collection of fundamental ideas which is very valuable.Hope the space continues with the same fervour for time to come…
Saif,
Thanks. Happy Diwali to you too.
Best Wishes,
happy Diwali to all. I agree with Saif, great must read stuff here. very thoughtful, very fundamental relevant and practical.
the parameter you discussed, like YOC, XIRR, they are increased over time. How do you include that in expected return. to calculate you will have to do that with some assumptions, correct?
I some how feel people like you and Rohit have lot of patience and confidence and guts to follow your own investment styles. It is really hard to ignore daily calls and brokers and not to trade. I wish I could do that.
Shikha,
You are correct, to calculate one needs to make certain assumptions. I do not estimate YOC and XIRR per se. Instead I calculate the expected returns for best cast and worst case scenarios, which more of less represent YOC or XIRR.
Happy Diwali to you.
Best Wishes,
Great Stuff.
I went through your XIRR article and how it is calculate. I think i understand it now. Right now the market has rebounded and hence it will make XIRR look good. If markets had not rebounded wouldn’t the XIRR drop significantly?
thank you
Biren
Hello Biren,
You have a point. Even if one assumes, say, 50% less than current valuation, even then XIRR is or the order of 15+%. Is is because of yearly dividends.
On the other hand, XIRR is for individual stocks which may or many not represent the drop in the market index.
Happy Diwali to you.
Best Wishes,
TIP Guy,
Thank you for the post. Wish you and others a very Happy Diwali.
I think still I have some confusion. I was mainly refering to the fact about market that it sometimes overvalue a stock and checking why not use that to our advantage. In such cases it will be definitely much higher than the fair value as per your calculation. So assuming that a stock is highly overvalued (much higher than fair value) wouldn’t it help to sell some stake and invest it in something else attractive and avaialble in fair range? Or keep in fixed income instrument till markets returns to sensible valuations. Because at high price even though YOC is high Yield on Current Price will be much low. So I was suggesting to use Yield on Current Price as basis for the sell decision, again only if markets are at crazy valuations, and redeply. I think that will be also give larger base to start afresh. Am I making some sense or missing here something grossly?
Welcome you thoughts!
Sachin
I think the difference is in approach and what method an individual is comfortable with.
In my view, the approach you are discussing is still something similar to profit booking. When it is overvalued on the basis of market pricing (as a function of fair valuation), you propose to sell. After selling you want to wait, until you find another idea (assuming none can be found at that point in time). Here, the decision is based on fair value vs. market pricing.
The method i am talking about is independent of market. I do not use current market pricing alone as my basis. I base my expected return (or continuity in returns) on company’s growth. I am looking for growth in company’s value or dividends. So when I like the company, I estimate its valuation and my expected returns (not the other way to check if market is overvaluing or undervaluing it). So for me to re-invest, I need to find another stock for which company’s growth in valuation or dividends are more than what I already have. Here the decision is based on company’s expected growth in value and dividends over long haul.
Having said that, I believe your approach is also good if one can execute it with confidence and consistent success. I do not use it because, it is just not possible for me to keep track of market or time it to figure out when it is overvalued. I do not have an aptitude to estimate expected return or valuation based on market movements.
BTW – In addition to price, stock’s current yield can drop if company reduces dividend in current year. So even if the market price of stock remains same, and company reduces the dividend in a given year, the current dividend yield may drop (irrespective of change in either stock price of company fundamentals). Dividends in India do fluctuate (and they are not like US where dividend cut can change market sentiment and market price can drop).
Thanks for comments. The discussion is enriching.
Best Wishes,
Hi dude
HAPPY DIWALI to you
Thank you for your response.
Cheers,
Sachin
Hi,
I want to know future of tata steel and your openion on tata steel,i already have shares and want to buy buy more share of tata steel.can you advise me…
Hello Chetan,
I missed this one, sorry. Tata Steel is a good company, but I haven’t looked at it for a while. I cannot comment at this point in time, but in future may be. At this point in time, world has overcapacity for steel. Chinese companies are 30%+ overcapacity. They will be dumping cheaper steel in the market. Accelor/Mittal is closing production for keeping with reduced demand.
Meanwhile, I would suggest make your decision based on allocation. If your portfolio already has tata steel upto 3% or more, then it is better to not buy. Use that capital for other opportunities. This way you are managing your risk.
Best Wishes,
Hi,
i am holding dena bank share from more than 1 year,and price is almost double,so it is good idea to sell them, and buy bluechip shares or i can hold them for long term,i have 2-3 years time to hold.
Thanx
Hello Chetan,
My apologies, I cannot help here.
Best Wishes,