Coffee Can Investing

1. Create a financial plan aligned with life goals

Unless you do so, you will be shooting in the dark.

Goal categorization. Divide your financial goals into three categories: security (must-achieve), stability (lifestyle-related), and ambition (aspirational). This categorization helps prioritize goals and allows for adjustments if required returns are too aggressive.

Quantify and timeline goals. Assign specific monetary values and target dates to each goal. This process reveals the true cost of achieving your objectives and helps determine the required rate of return from your investments.

Consider inflation. Factor in the impact of inflation on future costs. For example, a goal that costs ₹70 lakh today may require ₹1.2 crore in 7 years, assuming an 8% inflation rate. This step ensures your financial plan accounts for the rising cost of living over time.

2. Harness the power of compounding through patient, long-term investing

The less frequently investors evaluate their portfolios, the more likely they are to see gains.

Compound growth. The power of compounding amplifies returns over time. For example, a 26% annual return results in a 10x increase in 10 years, 100x in 20 years, and 1000x in 30 years.

Patience premium. Longer holding periods generally lead to higher returns and lower volatility. Analysis of the BSE Sensex over 26 years shows:

• 1-year horizon: -56% to 256% range of returns
• 5-year horizon: -8% to 47% range of returns
• 10-year horizon: -3% to 21% range of returns, with highest median return of 13.1%

Reduce noise. Long-term investing minimizes the impact of short-term market fluctuations and emotional decision-making. This approach allows investors to benefit from the overall growth trajectory of high-quality companies.

3. Invest in high-quality companies using the Coffee Can Portfolio approach

The Coffee Can philosophy of investing is built to identify great companies that have the DNA to sustain their competitive advantages over ten to twenty years (or longer).

Selection criteria. The Coffee Can Portfolio (CCP) selects companies based on two filters:

1. 10% revenue growth for 10 consecutive years
2. 15% Return on Capital Employed (ROCE) for 10 consecutive years

Performance. Back-testing of the CCP from 1991 to 2017 shows consistent outperformance compared to the BSE Sensex:

• Median outperformance of 11.9 percentage points
• Lower volatility, especially during market stress periods

Hold for the long-term. Once selected, the CCP is left untouched for 10 years. This approach minimizes transaction costs and allows compounding to work its magic on high-quality companies.

4. Minimize investment costs and fees to maximize returns

Never forget that risk, return, and cost are the three sides of the eternal triangle of investing.

Impact of fees. High fees can significantly erode returns over time. For example:

• ₹1 lakh invested for 40 years at 15% annual return:
  • With 2.5% expense ratio: Final value ₹1.11 crore
  • With 0.1% expense ratio: Final value ₹2.58 crore

Choose low-cost options. Opt for:

• Exchange Traded Funds (ETFs) for large-cap exposure (expense ratio ~0.1%)
• Direct plans of mutual funds (0.5-1% lower expenses than regular plans)
• Low-cost index funds for passive investing

Advisory model. Consider paying a financial advisor directly (e.g., 1% of portfolio value annually) rather than relying on commission-based distributors. This aligns the advisor's interests with yours and promotes unbiased advice.

5. Diversify across asset classes, with a focus on equities for growth

The key was to quantify everything since reality is different from perception and hard numbers help differentiate one from the other.

Asset allocation. Divide investments between equity and debt based on your risk tolerance and return requirements. For example:

• Aggressive growth: 80-85% equity, 15-20% debt
• Balanced growth: 60-70% equity, 30-40% debt

Equity strategies. Within the equity allocation, consider:

• 20-25% in large-cap ETFs for stability
• 20-25% in a Coffee Can Portfolio for quality growth
• 20-25% in small/mid-cap funds for higher potential returns
• Remaining in other diversified equity funds

Debt allocation. Choose high-quality, short-term debt mutual funds for stability and tax efficiency. Avoid chasing higher yields at the cost of credit quality.

6. Consider small-cap stocks for potentially higher returns

Smaller companies have the potential to grow their profits much faster than large companies and, secondly, as small companies grow in size they are 'discovered' by the stock market.

Outperformance potential. Small-cap stocks have historically outperformed large-caps:

• BSE Small-cap index beat BSE 100 by 4.6% annually from 2009-2017
• Higher growth potential due to smaller base and market opportunities

Professional management. Invest in small-caps through professional managers due to:

• Higher company-specific risks
• Limited research coverage and information availability
• Need for thorough due diligence and monitoring

Allocation strategy. Consider allocating 20-25% of your equity portfolio to small/mid-cap funds, balancing the higher return potential with increased volatility.

7. Be cautious of real estate investments and their limitations

Adjusted for earnings, Indian property is easily among the most expensive in the world.

Limited returns. Contrary to popular belief, real estate often underperforms equities over long periods:

• US real estate: 0.4% annual return since 1900 (vs. 5% for Dow Jones)
• Indian rental yields: Among lowest globally at 2.4%

High costs. Real estate investments involve significant transaction costs:

• Stamp duty, registration, and other charges often exceed 10% of property value
• Long-term capital gains tax of 20%

Illiquidity. Real estate is highly illiquid compared to financial assets, making it difficult to exit or rebalance investments quickly.

8. Adapt your investment strategy as you approach retirement

Mr Talwar needs to invest in a manner which throws off adequate cash flows from the time he retires.

Shift focus. As retirement nears, transition from growth-oriented investing to income generation:

• Increase allocation to debt instruments for stability
• Consider dividend-paying equity funds for regular income

Cash flow planning. Project post-retirement expenses and ensure your portfolio can generate sufficient regular income to cover these costs.

Maintain growth component. While prioritizing income, maintain some exposure to growth assets to combat inflation over a potentially long retirement period.

9. Regularly review and rebalance your portfolio

Financial planning is a dynamic exercise and needs to be carried out periodically or whenever any significant change occurs in your cash flow, assets or goals.

Annual review. Conduct a thorough review of your financial plan and investments at least annually. Consider:

• Progress towards goals
• Changes in personal circumstances or financial situation
• Market conditions and economic outlook

Rebalancing. Realign your portfolio to maintain your target asset allocation. This process helps manage risk and can improve long-term returns by systematically selling high and buying low.

Stay flexible. Be prepared to adjust your strategy in response to major life events, significant market changes, or shifts in your goals and risk tolerance.

Last updated: August 23, 2024