A simplistic view taken by many analysts at present is that the Nifty is trading near its 10-year average valuation (see chart below) and hence, one should still be fully invested.

However, averages can be deceptive. Have you heard the story of the 6 feet tall man who drowned in a pool that was 4 feet deep on average?

Solidarity’s approach is to build concentrated portfolios in “quality” companies, i.e. companies demonstrating following characteristics:

• Strong moat with industry leadership
• Secular and structural growth tailwinds
• High Return on Invested Capital (ROIC)
• Good corporate governance

Further, we invest in these companies when they are available at fair valuations. While the Nifty seems to be trading at a fair valuation, our analysis shows that premium for quality companies has increased significantly over the last 4 years (see below charts)

Quality companies which were on average given a multiple similar to that of Nifty in FY11 are now quoting at a premium of ~47% over Nifty valuation.

This presents a dilemma on how one should build a portfolio at present. As the saying goes, “The best businesses are worst investments if bought at wrong prices”.

Here is what we would suggest:

• Take more concentrated bets on quality companies if they are available at a fair  price
  • These opportunities don’t come often and one must “load up” on them when available.  Some banking names come to mind.

• When facts change, one must be flexible: Be open to being unconstrained in pursuit of value
  • Some companies are available at a very deep discount to their intrinsic value due to extreme (and irrational) pessimism
    • For example, some opportunities in the power generation sector at present
  • Although these opportunities aren’t secular compounders or high ROIC businesses, one could consider them if the risk-reward ratio is largely in the investor’s favour. That is:
    • Probability of permanent downside is very low
    • Upside, if one is right, is exponential (much higher than steady 15-20% compounding that one seeks)
  • Ironically, these could be better bets than the richly valued quality companies given the lack of margin of safety in the latter
  • Borrowing from the legendary Howard Marks,  “Everything is triple-A at the right price”

• Consider opportunities in alternative asset classes
  • Given the scope for interest rate cuts, high quality long duration bonds could deliver respectable capital appreciation in addition to the coupon
  • People fully invested in equities or holding cash in bank accounts could consider some allocation in such bonds

• Keep a cash buffer
  • Global macro suggests volatility will continue and India will not be immune in the short-term
  • Valuation of many quality companies would correct if they do not deliver on the earnings

We should have some cash buffer to invest in quality companies when the above plays out