You may observe we are gradually slicing out of our Specialty Chemical positions to re-allocate elsewhere. 

A key choice we need to make is whether to trim on valuation excesses or to let positions compound and accept incremental underperformance due to valuation de rating. 

Essentially, what game are we playing?

• Are we permanent owners of businesses?
• Are we allocators of Capital amongst companies we may want to own permanently?

As we intend to own 15-20 positions and act with rolling 5-year time horizons, we see ourselves as allocators of capital and not permanent owners of businesses.  We believe markets have emotions that vary from depression to euphoria.  We act to reduce portfolio risk when we encounter significant greed. 

“The riskiest moment is when you’re right. That’s when you’re in the most trouble, because you tend to overstay the good decisions” – Peter Bernstein

We believe individual sectors and companies follow a “Behavioural Cycle” (see chart below). 

• As a sector comes in favour, rising stock prices create more demand pushing prices higher.  A consensus view on prospects inevitably leads to Euphoria as analysts start building higher growth rates and dropping Cost of Capital assumptions to justify current prices.  The euphoric trend can sustain for quite some time.   Hence, one runs the risk of exiting early.
• However, when there is an Earnings surprise vs very high expectations, the trend reverses when supply overwhelms demand leading to steep time or price corrections. 
• Hence, as prices keep climbing away from fair value, the investment risk on the position keeps increasing, even due to factors beyond a company’s control.   This has played out in many companies in the last few years (Maruti, Eicher, Page Industries, Symphony, CERA, Blue Dart).   And this has recently played out in Sequent.

Our approach therefore is to have the bulk of the portfolio in “Early believer” or “Consensus” phase where one has a higher probability of benefitting from both Earnings growth and multiple expansion and start exiting gradually when valuations become “Euphoric”. 

Are valuations in Specialty Chemicals euphoric today? This answer will be known with certainty only in hindsight.  The valuations chart for the sector in aggregate (appended below) suggests we are deep in the greed zone.  And it is not appropriate for us to have 20% of the portfolio in this sector at these levels, when we can re-allocate elsewhere.  

Our approach means you don’t maximize returns on any one position, but achieve meaningful compounding on the portfolio with better risk management.