Markets will be volatile, to forecast short-term change in the mood of the market is difficult. However, as investors we must deal with volatility.
Let’s go back to the basics of what drives a stock. In very simplistic terms, performance of a stock price is an interplay of fundamentals i.e. earnings and a valuation multiple. Valuation multiple is nothing but a proxy to discounted future cashflows. Sometimes the market discounts far out in future and sometime the focus turns to near-term fundamentals leading to sharp corrections. Over the long-term earnings drive the stock performance, in the short-term sentiments can takeover fundamentals.

We can look at the same concept through a different lens. Let’s think about an individual stocks’ performance depending on three factors 1) opportunity to grow, 2) execution of the business model to generate returns and 3) capital allocation through organic or inorganic route to enhance opportunities for growth.

If there is a large runway for growth, the management is executing well and generating superior returns and allocating capital to sustain the growth at high returns you have a big winner on hand.

Sometimes the market is just focused on the opportunity and forgets about the execution and capital allocation.

Generally, in a bull market this happens with several stocks and whenever the markets focus changes back to fundamentals things end up in tears.

Keeping all the three factors in mind, helps us formulate our thesis on a stock. It helps us understand the fundamentals and what is being discounted in the price.

Let’s look at a few scenarios as to how this framework plays out in our portfolio. We would avoid situations where we are paying only for opportunity without any conviction on execution. There may be situations where the execution is strong, but the stock price is discounting far out opportunity. We may continue to hold the stock if we have not overpaid for the opportunity as our initial purchase price. We may buy stocks where there is a potential turnaround in execution or capital allocation and the opportunity remains reasonable. If the market turns, the biggest losers are likely to be stocks discounting opportunities far out with very little to show for execution.

We acknowledge that this is a simplistic framework and there are many more nuances to picking a stock but sometimes keeping things simple helps in dealing with more complex situations.

We take a closer look at the Auto Component sector and discuss Shriram Pistons a recent addition to our portfolio.