The MoneyWiseSmart 5-Step Investment Portfolio Review for Long-Term Success

The ‘second best’ long term performer is usually the investor who has forgotten the brokerage account password. The above anecdote brings forward the obvious question: who is the best performer then?

Well, it is the investor who is no longer alive.

These may sound like trivialising the matter, but it is quite true unfortunately. The aspect of investing these anecdotes highlight is that of ‘inaction’ and the time-tested wisdom behind it. We have discussed the matter in this short blog article called “The Art of Doing Very Little.”

While the common narrative (understandably popularised by the financial experts, advisors and private-banking communities) includes terms like ‘quarterly review’, ‘half yearly review’ and all these frequent ‘reviews’, these practices are often detrimental to investors.

In fact, these reviews simply result in increased churn for the portfolio, generating higher fees and commissions for those experts who suggest such reviews. Don’t even get me started on the additional ‘tax bill’ arising out of such frequent reviews…

This is why we have no hesitation in making a blanket statement: 

“The frequency of portfolio reviews is inversely proportional to the long term portfolio performance”.

Having said that, there are some sensible ways to review one’s portfolio on an ongoing basis. Here are the five steps for a portfolio review using our MoneyWiseSmart principles and strategies.

• Step 1: Define your investment strategy. There is no one single good way to invest, so you need to first define your style based on your needs. At MoneyWiseSmart, we focus on investing in high-quality businesses that compound our wealth over the long term. During a portfolio review, we focus on ensuring this compounding is not unnecessarily interrupted.

  
  

• Step 2: Evaluate the business performance. Look at the financials and growth drivers of the companies in your portfolio. Are they on track to delivering on the original promise?
  

• Step 3: Assess the CEO’s capital allocation record. While financial statements show how a company has performed operationally, how the CEO allocates capital is the best gauge of long term performance. This does not usually show up in the financial statements of just one year and requires a bit of work, but we show our subscribers how to go about this step.
  

• Step 4: Add, maintain (or reduce) positions. Based on how the business has performed (relative to the initial thesis) or current valuations, investors can add to/hold their portfolio allocations. We hardly reduce or rebalance our portfolio holdings unless there is any fundamental issue with the businesses we own, or we come across other opportunities that are significantly superior fundamentally than something we own. We prefer to let the process of compounding do the rebalancing for us and avoid tinkering with our portfolios and incurring costs. Of course, if we need to raise some cash we sometimes sell, but we would prefer to sell the weakest holdings, leaving the stars untouched.
  

• Step 5: Generate ongoing cash flow using options. If we discover high-quality businesses at attractive prices, the next step is to invest more capital into these businesses. Our option strategies ensure that we enjoy a steady cash inflow, to take advantage of undervalued opportunities that Mr. Market often presents us with.

Step 1: Define Your Investment Strategy

What we try to achieve in a portfolio review would depend on the investment strategy. A portfolio review of a deep value (Ben Graham style) investor would look very different from that of an average MWS member, who is focussed on long term compounding through holding some high quality businesses.

We are not suggesting that we should just invest in a portfolio and go off in hibernation mode. In fact, we should keep a close watch on the quality of our businesses to look out for any deterioration in fundamentals of the business, or any red flags. 

What we want to avoid is the ‘action bias’ based on short term price movements. This is what very few investors are immune from, and is the biggest cause of underperformance for most portfolios.

As Charlie Munger has famously pointed out, the long term performance of an investment cannot be too different from the ‘Return on Capital’ the underlying business generates. In the short term, the market value of our investment portfolio would be fluctuating wildly with mood swings of Mr. Market. 

However, the longer we hold our investments (assuming we have exercised the basic care to not invest in absolute duds), the closer the results merge with the fundamental performance of the underlying businesses in our portfolio. This is irrespective of the expensive or cheap price we initially purchase our shares for.

A Miracle of Long-Term Compounding

We would like to share a story of this lady, whom our co-founders recently met at an investors’ program in India. She comes from a Gujarati (the community that boasts of some of the smartest business people in India) family.

Several decades back, her grandfather-in-law had entrusted her (as she had the necessary qualifications, background and interest) with three bags full of share certificates of different companies that the family had owned. It was her responsibility to liaise with the respective companies and get those certificates converted into dematerialised form.

Fast forward to 2023, many of those companies don’t even exist any longer and the value of the shares have gone down to ZERO. However, as luck (that’s what she humbly calls it) would have it, the bunch also contained some Asian Paints shares since the first IPO in 1982 (> 40 years back). 

The family didn’t sell a single of those shares in the last 4 decades. From publicly available information we can see that Asian Paints Shares price in the year 1990 was ₹2.99. If you had invested INR 10,000 in Asian Paints Shares in 1990, in 33 years, your investment would have grown to INR 11.1M by the end of 2023.

Here is a picture of the data that was easily available since 2000.

Imagine the amount of ‘portfolio review’ temptations and ‘portfolio rebalancing advice’ from ‘advisors’ this lady had to resist to be able to achieve this > 1000 bagger. Now hindsight is always 20/20, but think of the number of times the portfolio would have gone into drawdowns because of the price fluctuations. Imagine how difficult it would have been for her to completely shut out the noise and just hold on.

However, if someone managed to stay focussed (like our lady did) purely on the business performance and not the price action, as if it is a private business, then they would have noticed that the business continued to deliver it’s best-in-class performance year after year, decade after decade, along with a steadily growing dividend stream. 

Any kind of interim price action based portfolio review, would have only done a disservice to the family. She had defined her investment strategy and stuck to it through the decades.

Step 2: Evaluate The Business Performance

Here is a long term ‘business owner’ perspective…

In our humble opinion, the portfolio review should be restricted to evaluating the fundamentals of the business alone. A possible exception would arise when a business becomes ridiculously overvalued, and offers sensible opportunities to switch to some alternatives which promise significantly higher expected future returns.

The fundamental review of a business needs to be done periodically (once a year or a couple of years is frequent enough). If nothing has changed in the fundamentals, and the business remains among the top performers (not share price wise but fundamentally) then we would typically look for opportunities to add more … as and when we find the stock available below its intrinsic value.

However, there are some good reasons for us to trim/sell our holdings at times, when the factors discussed below show up:

Reason #1: The business fundamentals have permanently deteriorated 

Investors can consider selling their holdings if they notice that the fundamentals of the business have permanently deteriorated. Some of the pointers towards that premise include:

• The balance sheet has become significantly more leveraged…and the interest cover of the business has shrunk to dangerously low levels
  

• The moat of the business has eroded and the business has been losing market share to competitors
  

• The gross margin has been shrinking demonstrating competitive pressures and inability of the business to pass on price increases (effects of inflation) to customers…lack of pricing power
  

• Shrinking operating margins…demonstrating drop in efficiency or negative effect of operating leverage
  

• Shrinking Returns on Capital Employed…due to lower margins or asset turns
  

• Significant drop in working capital efficiency viz. Significant increase in inventory days or debtor days etc
  

• Repeated poor capital allocation – sometimes even maintaining a good operating performance is not good enough for us to stay invested, if we notice that the capital allocation track record of the CEO is deteriorating. These are early signs which can severely compromise on the long term returns for shareholders. We have discussed this issue in a fair amount of detail along with several examples in our Multibagger Research Series program.

  
  

These examples are not meant to form an exhaustive list. We cover the exhaustive list with case studies in our Investment Fundamentals program here.

Reason #2: We identify new red flags

As we monitor the company’s updates, we might identify some new red flags or some corporate governance issues. 

As the saying goes, there is never just one cockroach in the kitchen. We are usually quite unforgiving when we notice the first proverbial ‘cockroach’ in the form of some corporate governance issues or other serious red flags.

Reason #3: Extreme cases of overvaluation

While we do not think of selling or trimming our position in every instance of overvaluation (long term business owners’ perspective), as long as the fundamentals have not changed, sometimes extreme cases of overvaluation offer us the opportunity to switch sensibly.

For example, if a business becomes so overvalued that our future expected returns diminish well below our required rate (~15% p.a.), then it would make sense to look for other attractive alternatives that promise an expected return above our target (with similar level of certainties). This can be explained with the example below:

Let’s say a business is available at a market cap of $1B, which is also more or less the intrinsic value of the business. Now we expect the business to grow its earnings and intrinsic value @15% p.a. over the next decade. This would translate into an intrinsic value of ~$4B in 10 years’ time.

Now if for some reason the share price shoots up by 30% in the first 6 months and pushes the market cap of the business to $1.3B, we would not think of exiting the business. Though in this scenario, our expected future returns for the remaining 9.5 years from that point onwards, would drop to 12.7% instead of 15%.

However if the overvaluation is very extreme, and let’s say for some bizarre reason the share price shoots up to 3X over the 6 month period after purchase, translating into a market cap of $3B…this would bring down the expected future returns over the remaining 9.5 years to only ~3.2% (assuming the business fundamentals and prospects have not changed significantly). 

In this scenario, it just does not make sense to stay invested in this business, as we can easily find other opportunities that would offer us a better expected return than the ~3.2% p.a.

Reason #4: The moat of the company is shrinking

Short term financials can fluctuate a lot and can be hard to predict. However, the economic moats controlled by a business are less volatile. In fact, the moat is very often the factor determining the long term ROC that a business can achieve, so it is more important to evaluate whether the moat is still protected, as opposed to short term financial fluctuations. As we review our portfolio, we take careful note of whether the moat of the company is intact, widening or shrinking.

Reason #5: Replacing laggards with better opportunities

Another good reason to review the portfolio can be to find laggards and replace them with other better alternatives that would promise us a significantly higher future return. 

Let’s say we have a portfolio of 10 businesses and the lowest (10th) performer in the portfolio is generating an RoCE of ~10%, (assume no debt). This business pays no dividends and reinvests 100% of the earnings every year. In this scenario the business would not be able to grow earnings and intrinsic value at anything more than the 10%…so even if the business is able to fend away competitive pressures and maintain the same Returns on Capital over time, the long term shareholder returns would also be somewhat similar to the 10%. In such a situation, it would be wise to look for alternative opportunities where we could reasonably expect a higher return.

This is exactly what we practise in our MRS Portfolio, thus ensuring that over time (and not overnight) we steadily enhance the quality of our portfolio. We identify and take a closer look at our businesses with low returns as we have done in the picture below, and evaluate other alternatives relative to them.

Step 3: Assess The CEO’s Capital Allocation 

Efficient allocation of capital is a critical skill that sets exceptional CEOs apart. These leaders possess a deep understanding of how to deploy financial resources in the most productive and profitable manner. 

A CEO’s capital allocation decisions directly impact shareholder returns over the long term. By efficiently deploying capital and generating sustainable returns on that capital, they enhance earnings per share and increase the company’s overall valuation.

Understanding a CEO’s approach to capital allocation provides valuable insights into their strategic thinking, financial acumen, and ability to create value for shareholders. It is a crucial aspect to consider when evaluating a company’s management and assessing its long-term potential.

We’ve extracted two examples of capital allocation from our Multibagger Research Series. While the analysis below uses financials up to FY2021, the principles remain fully applicable for our current portfolio holdings.

Case Study #1: Adobe

“Adobe is a very capital-light business and is highly free cash flow generative. Out of the ~$32B of Cash Flow from Operations generated over the last 10 years, the business guzzled less than $3B (i.e. <10%) of Capex. 

This also makes the business fairly inflation resistant (something very relevant these days). Over the last 10 years, out of the ~$29B of FCF generated (before deducting SBC), about $16.7B (~60%) was returned to shareholders in the form of buybacks, and about $11.5B (~40%) was spent on acquisitions (net of cash acquired).

For the ~60% funds spent on buybacks, they have generated a healthy IRR of ~23%, considering the share price of US$388 as of 19 July 2022 (much higher now as of time of writing in July 2023). However, if we consider the intrinsic value of the business, we believe the IRR would be higher.

For the ~40% funds spent on acquisitions, Adobe’s acquisitions and subsequent integration of them into its core business over the past two decades have been reasonably successful, and it had not had any goodwill impairment since 2011 which suggests that the acquisitions have not gone materially wrong. This strong track record provides comfort that it could also acquire well in the future as and when the opportunity arises.

Here’s a non-exhaustive list of some of Adobe’s past acquisitions and the amount paid:

• Frame.io (Aug 2021) – $1.18B

• Workfront (Nov 2020) – $1.52B

• Allegorithmic (Jan 2019) – $106M

• Marketo (Sep 2018) – $4.74B

• Magento (May 2018) – $1.64B

• TubeMogul (Nov 2016) – $561M (cash)

• Fotolia (2014) – $800M (cash)

• Neolane (2013) – $600M

• Auditude (2011) – $120M (mostly cash)

• Efficient Frontier (2011) – $400M

• Day Software (2010) – $240M (cash)

• Omniture (2009) – $1.8B

• Macromedia (2005) – $3.4B (Fireworks and Dreamweaver)

• Aldus (1994) – $450M (InDesign and PageMaker)

  
  

Overall, Adobe has grown its ROCE to a very healthy 28.6% over the years, demonstrating how efficiently the business deploys capital. Five years back, the ROCE stood at ~15%. Both operating leverage and ‘capital employed turnover’ played a role in this steady increase.”

Case Study #2: JD.com

The following data was extracted from our July 2022 update for JD.com. However, these diagrams present a clear view of JD’s capital allocation. While the business is firing on all cylinders operationally, the significant cash accumulation on the balance sheet is not ideal for shareholders.

Step 4: Letting ‘Compounding Do The Rebalancing’

You would have noticed that in the Point 1 under Step 2 above, we have highlighted the word ‘permanently’. While the above factors can be justifiable reasons to review and rebalance our portfolios, a very common source of ‘error by commission’ is often acting in haste to rebalance the portfolio at the earliest indication of a fundamental problem…and it turning out to be a false alarm. 

Once we have researched a business and the management carefully, we need to put some faith in the management’s experience. We need to give them some leeway to be able to notice the fundamental issues themselves and work out corrective measures internally. 

In a fundamentally high quality business, run by an able CEO & management team, the chances of this happening are far greater than what our knee-jerk action can achieve in the form of finding superior alternatives, every single time. Moreover, our action bias also incurs huge transaction and tax expenses which can have a devastating (often unnoticed over long periods) effect on our portfolios.

In any case, the ‘principle of compounding’ is the best rebalancer. If at all a business in our portfolio develops a fundamental problem that goes unnoticed, the very fact that the other businesses are compounding at a higher rate, would ensure the problematic business becomes a relatively lesser portion of our total portfolio (and hence less of a worry over time). This concept is far less appreciated than what it should be. 

The elegance of this idea lies in the fact that if over time the problem in our laggard gets rectified, then we still get to enjoy the upside from this rejuvenated business…which we would have missed had we exited. Microsoft under Steve Balmer and then Satya Nadela provides the perfect example of this concept.

However, while this is how we would like to approach our portfolio review in a slow and business-like manner (as we internalised Mr. Buffett’s teachings), there might be other ways of approaching the same. We do not claim that this is the only ‘good way’. After all, ‘the opposite of a good idea can also be a good idea’.

Step 5: Generate More Cash Flow Through Options

Once the businesses in our portfolio are rigorously analysed so that only high-quality businesses remain, we can reasonably expect their high return on capital employed (RoCE) to be maintained for a long period. As a result, we can expect their share price to increase to eventually match the growth in intrinsic value of the company.

At that point, can you guess what our next priority should be? If we have built a portfolio that has a high expectation of compounding our wealth, our focus then shifts into adding more capital into this portfolio.

This is the exact challenge many of our subscribers have…and our solution involves using options in the same way Buffett uses them to generate “float” for Berkshire Hathaway. We must emphasise this does NOT involve trading or trying to catch outsized returns overnight.

We discuss our unconventional approach towards using options in this Option Series Review article here.

Conclusion: Key Takeaways from Your Investment Portfolio Review

While our approach to portfolio reviews might be contrarian, they are based on time-tested and proven principles of value investing. Using the five steps discussed, investors have a good chance of compounding their wealth over the long term.

If you’d like to dive deeper into the MoneyWiseSmart approach to investing, you can enrol into our FREE courses here:

• Option Series Preview

• Research Series Preview

  
  

These previews provide a sneak peek into our paid subscriptions where we delve into great detail about investing in high-quality businesses. However, we are confident that the value you receive from our previews will already exceed what other financial education providers teach in their paid courses.

Download the FREE preview courses above, join our MoneyWiseSmart community and bring yourself closer to achieving financial independence.