It is not about selection but about allocation: Nooresh Merani

In 2014 you had two choices – either you discuss politics or accept the fact and get on with it. By February 2014 small-cap indices had broken out (made a new high) and the benchmark indices did that in March-April 2014. During this time there was no earnings, etc that one would look out for.

Similarly in 2016 textiles were turning up, although the numbers were not in place. But the stocks were giving a breakout through the overall markets were declining. So for me, all I need to do is to check if there is no major problem in the sector if I go wrong.

This is necessary because I trade mid-caps where it is easy to enter but not that easy to exit. So if the stop loss is said 15 percent away from the current price, by the time you are able to exit your position it will go down by 20 percent.

Also read: How a software engineer traded his way to financial freedom

Also read: Key learning from 2008 crisis was to cut down on my leverage: Nooresh Merani

For how long do you hold on to your position?

I have stocks that I have held anywhere between 1-3 years because the trend has never stopped. I am a classical Dow Theory follower, higher tops, and higher bottoms. Till this condition exists I hold on to my stocks.

But do you have a sector limit

We consider a 20 percent allocation to a sector. We do not know which of the six stocks in the sector will be the biggest gainer. But we look at the sector as one stock. The top two might be 12 percent of the portfolio the next two around 5-6 percent and the last two will be around 1 percent. The smaller ones really have to go up to three times to really make a difference.

Do you add to your original position?

Yes adding is the more important part. So when the stock touches a new 52 week high, that’s when the move starts. After that there would be a period of consolidation and if it breaks that you add more. And if in that period the Nifty has not performed but the stock still continues to make a new high it adds more conviction.

So we started buying textiles sometime in 2014 and in 2015 when the Nifty went down by 5-10 odd percent and this sector made a new high we added more. Then in February 2016 when textiles and chemical sectors did not break new lows we added more. That’s the way I like to add to my position.

In this strategy, you may go wrong occasionally, but the one trade where you catch right will make the difference.

Incidentally, the textile and chemical sectors were up 50 percent when the Nifty was down by 20 percent.

What about exits, where are your stop losses placed?

We look at intermediate lows, it may be weekly, monthly or consolidation range low. We normally have a time stop loss and price loss. So if a stock is not doing anything say for three or six months we take a call and exit from the position.

How important is the psychology in your strategy?

As I say in my training programs to succeed only 10-20 percent is analysis next is psychology and the final frontier is knowing yourself. Trading or investing is always a personal journey. How much can you contain your psychology? So if your instincts are aggressive you can’t have a 10-year portfolio. So you need to understand if you can digest the food. But it takes a few years to understand what works for you trading, that too on what time frames or if you are comfortable in investing.

Coming back to your strategy if you are already invested in some sectors how will you accommodate a new sector that is touching showing up on your radar?

That is the tough part. We have a checklist to see a reason to trade, conviction, etc, the last one is an opportunity cost. For that reason in my tracking sheet, I do not have the cost price of the stocks where I have entered, so I do not have any bias among the existing ones and the new ones that come up.

I generally am not holding more than two sectoral bets, there may be stock specific bets but on a sector level, there are generally two sectors. Then I look at stocks based on the conviction and invest in the ones where the conviction is high.

And when and how do you decide to cut down your allocations or sit on cash?

We have a system which is very simple. Until the time Nifty is making higher tops and higher bottoms we will ride with the entire position or even with the small leverage that we occasionally take. The moment it starts breaking the bottoms, we cut down to 80 percent or even 60 percent if the need be.

For example, pre-demonetisation the big event was the US elections. We look at the BSE Sensex, Nifty, and the small-cap index to see froth. That is one indicator to take cash out. Second is if they are breaking lows. By November 4th, 2016 we had broken the previous low, so it was very clear that the trend has changed.

In the same period when Nifty had gone down from 8960 to 8550, the BSE Small Cap indices made two new highs. That is what we signal as a froth. It’s a typical Dow theory at play where the rule says that indices should not diverge. If there is divergence there is froth. So this is the time we generally tighten our stop losses and cut down the leverage immediately.

At a time how many positions are you comfortable keeping open?

It is generally not more than 15-20 companies. My view is you can have a 50 stock portfolio but how many will you remember. If you can remember them then you should. In my case, I have sectoral baskets which I consider as one stock for each basket, so the actual number of stock can go up. My view is 25-30 stock max, including the stocks in the sector baskets.

Since you have a techno-funda approach how important is timing?

We made more returns not by selection of stocks but by timing our entries. How much we invested in in February 2016 decided the return for the next one year and how much we pulled out pre-demonetisation decided the return for the next year.

In investing based bets, where the stock is on the radar before it shows up on the technical filter of new highs, we are cautious and prefer to buy stocks cheap. I believe I can make mistakes. Your capital loss and mistakes can be controlled by not buying something expensive.

For example, presently we like hotel stocks which are not too expensive. So even if we get the cycle wrong we will not lose 50 percent of the capital.

Take another example. The market made a low on around February 12th, 2016. Nifty made a new low but other indicators were showing divergences. By February 20th, 2016 when the budget was there we had all the discussions about the recession and long-term capital gains would be announced. During this two weeks, Dow Jones indices and other markets had all moved up 5 percent from the bottom.

These divergences told us that markets had bottomed out. In India, it touched a low only because of the budget event taking place.

Your investing strategy takes a lot of inputs apart from simple 52-week breakouts.

One way of trading is doing automated but with new inputs, you may need to tweak it. My view is how do we become a better trader. It is by processing new data subconsciously so that it becomes intuitive. That’s why we look at so much data in order to make it intuitive and decision making is easier.

For example, we even look at mutual fund inflows. We found that how inflows have surprised, we now have more mutual fund investors than direct investors. This has only changed in the last one year. So this gives us the conviction that the trend is up and to remain leveraged till the trend is up.

We take up other data crunching exercises. Like we have done an exercise to find companies which were doing badly on account of governance over the years have changed. Most of these companies started in the nineties when the promoters were in the age bracket of around forties. Now the next generation has taken over.

Back in the 1990s taxes were high and companies adopted various ways to ‘save’ it. But with a generation change governance changed. So we identified these companies and traded them. We have nearly 60 percent, it could even be 80 percent, of the companies that were in the nineties. Post demonetisation many more companies was compelled to do the exercise.

We also look at other correlations. Like just now we see the Nifty touching a new high in dollar terms. If we sustain this over three months the flows can reverse. We look at parameters that is very clear.

Right now we have been working on a PE (private equity) selling and promoter buying as a strategy to invest. For example, you have Jamna Auto, Sinclairs Hotel, Minda Corp, Lancor Holding are all where the PE sold. We buy when the stock changes hands.

We mix all these criteria but use technical analysis because they help us remove all our biases.

What was your Eureka moment when your strategy was clear?

Originally we were only looking at technicals. Between 2009 and 2012, we met a lot of successful investors and realised the amount of effort a successful investor makes. During this time we did a random portfolio study. For us, the Eureka moment was when we found out that it is not about selection but about allocation.

Your returns are going to be defined by cash allocation or equity allocation. Second is the sectoral allocation. If you get the first one right the second one you are still okay with. And if you get both of them right you will get superior returns.

And your best trade

One was Hexaware, the stock was at 15 year high. Promoters had bought from the market and there was a management change. It was one of the two stocks to have crossed their 2000 high. Stock went up only Rs 150 to Rs 270 but we had 20 percent allocation.

Then it was technical textiles — Garware Wallropes and KPR Mills. Both these stocks crossed multi-year highs.