Growth Mindset: The key to multiplying your wealth.

At the outset, I must share that this blog is a bit long and in parts could get a bit technical. Do read it when you have a few moments of quiet and I assure you that you will find it interesting and useful.

2019 was an amazing year for me. I spent a lot of my time thinking about the future I want to build for myself. One of the books that had a huge impact on me was a book titled “Mindset – Changing the way you think to fulfil your potential” by Dr Carol Dweck. She is the Louis and Virginia Professor of Psychology at Stanford University and is widely regarded as one of the leading researchers in the field of personality, social psychology and development psychology.

The basic argument of the book is that basis our belief system we display two kinds of mindsets – The Fixed Mindset or The Growth Mindset. If you have a fixed mindset, you believe that your qualities are carved in stone and cannot be changed. If you have a growth mindset, you believe that your basic qualities are things you can cultivate through your efforts, your strategies and help from others.

This blog is my commitment to applying the Growth Mindset to my personal finances. At the outset, I must also clarify that this is an experiment that I am doing with my personal money by applying the principles of the Growth mindset. Stock and portfolio ideas discussed herein are included to illustrate the application of certain principles and are not a recommendation to either buy or sell a stock.

Is it a great idea to invest in Index Funds?

When it comes to managing money, there is a belief that it is difficult, if not impossible to beat markets in the long run. If you look at the performances of the professional fund managers, there is a growing trend of mutual fund schemes underperforming the benchmark returns. A Fixed Mindset would lead us to buying index funds and confining us to a lifetime of mediocrity in investing. A Growth Mindset would encourage us to put efforts, strategies and methods in place that can help us beat the market indices significantly. Imagine the concomitant rewards of accomplishing significant outperformance to stock indices!

I do not expect this journey to be easy. I do expect disappointments and failures. There will be a lot of criticism as well. The eventual outcome will be decided on how I react to all the negativity that is associated with my mission. A growth mindset is not about outcomes. It is about progress. If I can demonstrate progress, however small it may be, I know that I will eventually deliver something substantial.

The next logical step was to put a strategy, a process and a method in place that could help me achieve the desired outcomes. I started researching the subject of investing with a renewed vigour and focus. I was clear in my mind that I need significant outperformance to market indices as a reward for my efforts. I read about strategies adopted by legendary investors like Warren Buffet and Peter Lynch. What I was looking for is a strategy that would suit me!

The authors basically argue that if you pick up quality stocks and hold it (without churning it) for 10 years, the results of the strategy deliver significant outperformance with lower level of risk than the market indices itself. The authors use a) Revenue Growth of 10 percent and Return on Capital Employed (ROCE) of 15 percent every year for non financial services companies and b) Loan book growth of 15% and Return on Equity (ROE) of 15 percent every year for the preceding 10 years.

You shortlist companies basis the above parameters every year and cast and equal weighted stock portfolio. Once the portfolio is cast you do nothing! You stay invested for a period of 10 years. Over time, some stocks fall by the wayside but the ones that do well are able to not only compensate for the non-performers but deliver superior results. The overall portfolio created on this basis has provided significant outperformance to the markets and with lower volatility than the market.

The second one was basis a book titled, “ The Little Book That Still Beats The Market” by Joel Greenblatt. Here the core belief of the author is that the two key factors that matter while investing are “Investing in Quality companies” and buying them when these companies are available at reasonable valuations.

The author uses “Return on Capital Employed” (Earnings before Interest and Taxes divided by Net Fixed Assets +Net Working Capital) as the single metric for Quality and “Earnings Yield” (Earnings before Interest and Taxes divided by Enterprise Value) as the single metric for Valuations.

Step 1 – you rank the companies basis Quality (ROCE). The company with the highest ROCE is Ranked 1 and next highest ROCE as Rank 2 and so on.

Step 2 – you rank the companies basis Valuations (Earnings Yield). The company with the highest earning yield is Ranked No 1, the next highest earning yield is Ranked No 2 and so on.

Step 3 – you add the two ranks and create a list in ascending order of their combined ranks. You give equal weightage to Quality and Valuations while computing the combined rank. The company with the least combined score is Ranked No. 1 and the next lowest score company is ranked No. 2 and so on.

Step 4 – You pick the top 30 stocks and create a portfolio. Each stock has an equal weight in the portfolio.

Step 5 – You hold the portfolio for a year.

Step 6: You repeat the process at the end of the year and recast the portfolio basis the new set of data.

The author terms the above process as the “Magic Formula” and ranks 3500 listed companies in USA as per the above formula. The investment results of the Magic Formula are astounding as it ends up delivering significant outperformance over large cap indices in the long run.

Coffee Can portfolios vs the Magic Formula

As you would notice the two approaches are very distinct. The Coffee Can approach is one of buy and hold. The portfolio is generally concentrated as the number of companies are shortlisted based a stringent criteria of quality. The markets too recognise good quality and hence the shortlisted stocks would have to be bought at a significant premium. Some stocks in the portfolio do fail, but the ones that survive make up for these failures. Some of the stocks are real winners and end up forming a very significant chunk of your investment portfolio. It is a one time effort to put this portfolio together but once done, you just invest and forget! The low transaction costs are a great plus as well that works in favour of this strategy. Patience pays!

The portfolio that is cast by using “the Magic Formula” is a well diversified portfolio as the author recommends investing in a 30 stock portfolio. All investors like to buy high quality companies at reasonable valuations and hence there is an intuitive liking for this strategy. We all think that we must book our profits at some stage, so the annual review and revision process also is very appealing. The real challenge, however, is due to the annual churn that can potentially eat significantly into our returns due to its associated transaction costs and taxation.

I decided to cast portfolios basis “Coffee Can investing” and “the Magic Formula”. Though personally I find the Coffee Can approach more appealing, it needs a lot more work to genuinely cast “Buy & Hold” portfolio specially when I know upfront that I will not be able to churn the portfolio for a period of 10 years. Hence I decided that I would give “the magic formula” a try this year.

“The Magic Formula” Portfolio for Indian Markets

There are over 4,000 listed companies in India. However, there are only 222 companies with market cap of over Rs 10,000 Crore. There are another 445 companies with Market Capitalisation between Rs 1,000 Cr and Rs 10,000 Cr. I decided to stick with these 667 companies as my stock universe from where I would select my portfolio.

I also decided to create two distinct portfolios basis – (a) A large&mid cap portfolio and (b) a small cap portfolio.

The Large&mid cap portfolio was cast out of the 222 companies that had a Market Captialisation of greater than Rs 10,000 Cr. The small cap portfolio was cast out of the 445 companies that had a market capitalisation between Rs. 1000 Cr and Rs 10,000 Cr.

Using the Magic Formula, I ranked the 222 companies and picked the top 20 companies for my portfolio. I ran a similar process on the Small Cap stock universe of 445 companies and picked the top 20 small cap stocks for my portfolio.

I made a couple of minor changes to the Magic Formula while adapting it to the small cap portfolio. The emphasis of the methodology is on quality and hence I added another filter which the stocks shortlisted must pass through to be a part of the final portfolio. The companies must have a positive Cash Flow from operations for the last 3 years. The final short list that I have obtained is as follows:

The stocks in the above portfolios have equal weights. The total number of stocks that I own are 40 (20 Large/Mid Cap and 20 Small Cap).

Conclusion

This is a personal experiment. I do not know whether I will be successful or not but I know for sure that I will be gaining a lot more investment insights.

I would like to reiterate that I am not recommending any stocks for buying or selling. All I want you to take from this blog is that you must build a growth mindset and attempt to do better with your investments. People with growth mindsets are willing to put in the desired efforts, build strategies and methods and are willing to take help from others. They are not seeking outcomes but they are seeking progress.

I look forward to share the results of the above portfolio next year. I hope that I will have some good news to share in January 2021.

I wish you all the very best for the coming year and decade! May God bless you all with a growth mindset!