How to assess business relevance?

In the previous story, we discussed the portfolio strategy of rebalancing and letting your winners run.

Here we address how to think about your holdings when they face a setback. You need to figure out whether or not they will come out stronger.

Trouble is a constant
All businesses face trouble at some point. If you invest with a long horizon, there will be times when your companies go through a rough patch. This is when your knowledge and temperament get tested. It is, therefore, important how you deal with it.

What kinds of problems would you encounter?
A competitor could have started a price war. There could be an irrational player entering the market. There could be a regulatory backlash.

The list could go on and on. You cannot predict when and what will hit you. But once the situation is known, it is important to figure out whether it is a passing storm or permanent damage.

How do you prepare for such things?
Keep track of your investments. Investing doesn't stop with creating a portfolio and forgetting about it. In fact, your understanding of a business usually deepens after making an investment.

Try to incorporate the mental model of inversion when you are conducting research on a company. Rather than thinking about how a company will become great, think about what may go wrong for this company to become a dud. You won't have an exhaustive list but you would be better prepared.

Another thing to note is that a company in trouble may script a turnaround. To decide whether to stick with it, consider your opportunity cost. If you can find something better, then choose that.

What factors should you look for?
Capital intensity and capital efficiency are two things that will help you decide whether or not a company will come out of the clouds. The former focuses on whether a business requires a high amount of capital (both fixed and working capital), while the latter focuses on a company's ability to generate a high return on the capital employed (high ROCE).

Capital-intensive businesses, by design, are debt hungry. So when trouble sprouts, it takes a lot to shake it off. The fixed nature of fixed capital makes it difficult to alter capital intensity quickly. However, companies that have been consistently capital-efficient are able to tackle it head-on. In fact, many use it as an opportunity to emerge stronger.

If you owned Idea Cellular (now Vodafone Idea) at the time of Reliance Jio's entry, to decide what to do, you should have considered Idea's high capital requirement, a debt-to-equity ratio of 1.73 (FY16) and a (then) 10-year average ROCE of only 11.6 per cent. Add to it Jio's free services and Reliance's financial backing, your best move would have been to sell the company.

There are many other qualitative and quantitative factors. It may change with the company in question. Also, this comes easier to the experienced than the novice.

Conclusion
Each company would face problems. Your returns would depend on how good the company and its management are. Keep abreast of events and look for signs of trouble. But you can still be caught off guard. Therefore, it is important for you to invest in companies that you understand. If you are doubtful about the next move, then sell it out.

Also in the series:
How many stocks should you own?
Which investing style is the best?
What is the right market-cap mix?
How should you research stocks?
What sort of businesses to prefer?
Should you invest in PSUs?
How much to own what?
When to buy and sell?
Should you churn your portfolio?