Concentration and Public Markets Money Management – Series 1

Reviewing our portfolio at Itus over the last 4 months, an investor would view an increase in the number of portfolio companies today vs what they saw in our portfolios in 2022. As we stand towards the end of 2023 (CY), the number of portfolio companies stand at 27 vs 20 in early 2022. Multiple conversations with current and potential investors have gravitated around the need to concentrate vs diversify the portfolio and how one can potentially think about this. Over the next few series of articles, I aim to build a framework around what causes us at Itus to increase the number of investments, if there is a threshold above which we prefer not to go, and if concentration is truly a source of alpha in public money management.

As a public fund management company, at Itus, we believe our role is to minimize risk first, and maximise returns later (It is important to understand that one must choose one over the other and optimizing for both typically tends to not work overtime). When we as a fund manager choose to minimise risk, we measure ourselves around falling lesser in bear markets as a potential source of generating alpha over time – some of the aspects that drive this is investing in growth, paying attention to valuation discipline, avoiding overheated sectors and companies, and not getting carried away by narratives (apart from the core aspects of the business we look for – cash flows, promoter quality around how they reinvest and ability to protect margins). This also means that in a bull market, while we would do well, we would never be the highest return fund on any given year – put another way, we measure ourselves by the consistency of returns over long periods of time (as a function of outperformance over the index) rather than a few years of abnormally high returns which makes it harder to repeat over time.

Within this framework, one of the often-repeated aspects in investing is to build concentration into the portfolios and the analogy given is to invest in a few eggs and watch them closely. There are two aspects that this adage does not consider – concentration works well if investors do not benchmark your returns every quarter, semi-annual and annually (it is a well-known data point fact today that the average time an investor spends in a Mutual fund today is at 1.2 years). Secondly concentration works well if there is a lock-in where the fund manager is given a definitive 5 years to hold on in a cycle of underperformance too (There is no assurance that the portfolio constructed with concentration will outperform benchmarks every year, and the returns have a high probability of being lumpy rather than smooth even if the fund house has an uncanny art of picking the best investee companies).

While the fund industry and its structures do not lend itself into concentration, the aspect of investing in a few companies is also subject to a few extraneous factors which require cognisance and attention. In this series, we will look at breaking down each of these factors.

Visibility of growth – competitive landscape

Jeff Bezos wrote about a product led competitive advantage back in 2003, in one of his annual letters where he mentioned that a first mover advantage in product does not last over 2 years. With the benefit of history, AWS was one of the core products of Amazon which had a first mover advantage when it began to be scaled outside Amazon and this had a core advantage for 2 years as he spoke about.  Competition tends to do two things – lower prices for the end customer to gain market share and potentially lead to lower incremental returns on capital. This has a natural effect on lowering the certainty of growth (more importantly margins) in the future which typically is not taken well by the public equity markets in the way the companies are valued. There are 3 holy grails that public markets expect – growth in topline, growth in margins and minimal to no dilution.

It is important to understand as an investor where in a cycle we are to understand growth visibility and competition. As an example, though we are in the middle of a consumer inflection point in India (due to a rising middle class), the category of toothpaste is fairly well penetrated. Assuming a growth rate of more than a high single digits in this category may not be a prudent decision for an analyst, and deciding on the valuation to pay for such a modelled growth rate is the big decision a fund manager must make. Within this context, to concentrate a portfolio on such a sector may not be a wise decision as this can lead to underperformance over time.

However, the same growth in a less competitive space like jewellery retail where the category in India lends itself to repeat purchases for consumption and as an alternate for investment would need a different thought process on growth. Separately, very few brands have been able to come out of their local geographical presence and hence betting on a pan-India player who has a higher visibility of growth needs a slightly different thought process on concentration.

To conclude, one aspect of concentration that would have a materially positive convexity on portfolio construction is visibility of growth. While visibility of growth is always qualitative, placing an emphasis on growth visibility helps positioning portfolios towards concentration. Extending the same analogy to the other side, while investing in competitive areas, positioning portfolios with a more diversified risk exposures would tend to manage drawdowns better. In the next article, we would look at a slightly more tangential aspect of growth – pricing power, which can help concentration if appropriate.

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