Factors That Matter: How Windmill Capital creates Model-based smallcases

We get a lot of questions from our investors on the selection, addition, and deletion of stocks in our model smallcases as they see churn in every rebalance cycle. In this blog, we will explain the core philosophy of the underlying construction methodology of our model smallcases by taking an example of Dividend Stars smallcase and then also address some of the regular questions we keep getting around our model smallcases.

We hosted a LIVE AMA on 30th April where we spoke at length about Model smallcases

How does Windmill Capital create Model smallcases?

The core logic remains pretty much the same, whether it’s a thematic or a model smallcase. Just like there is an underlying theme for a thematic smallcase (brand equity for Brand Value smallcase), there is a combination of factors (for example – value + momentum) that drive the formation of model smallcases. Now, you must be wondering what factors mean.

Factors are company-specific/macro quantifiable data points that affect the performance of the stock. There are two key types of factors – macroeconomics and style. Windmill Capital primarily uses style factors, which is a combination of fundamental and technical criteria, to build model smallcases.

To give an example, volatility is a style factor. This is a risk indicator, that measures the price movement of a given stock. The more drastic the price movements, the higher the volatility. Value is a style factor that strives to pick companies that are undervalued and are trading below their industry peers. Yield, basically dividend, is also a type of style factor. High dividend-paying companies that are undervalued and have demonstrated a good track record of dividend payouts usually qualify for this factor. Fundamental factors usually revolve around profitability, cash flows and business stability. While technical factors help us in gauging the trends in the securities.

In order to give you a better sense of the factors we use and the process we follow, let’s deep-dive into one of the smallcases:

Case Study: Dividend Stars

There are 4 key elements which play their respective roles in the formation of the Dividend Stars smallcase – selection criteria, sorting criteria, buffer rules, and red flags.

Selection criteria: This basically filters the relevant stocks from the universe of the top 700 companies listed on the NSE. This makes the strategy multi-cap oriented as any company irrespective of its size can be a part of this smallcase. The selection criteria of the smallcase are to scout for companies that have a dividend streak of 5 years – companies that have not decreased their dividend payouts over the course of the last 5 years. On top of that, we also take into account the average dividend yield. What is dividend yield, you ask? It is a financial ratio (%) that tells you the amount of dividends a company is paying out relative to its share price. For instance, if a company has paid a total dividend of ₹2 in the entire year and the share price is ₹30, the dividend yield comes to 6.67%. Therefore, we look to include companies whose average dividend yield is at least 2% over the past 5 years.

Sorting criteria: They are just a derivative of the filtering criteria, in the sense, we sort the results based on the primary criteria of dividend yield. With all the companies, out of 700, that pass our factors, we sort them with the highest to lowest dividend yield and pick the top stocks. The number of stocks selected based on this step generally focuses on two important factors – the portfolio should be sufficiently diversified and the minimum investment amount should also be in a reasonable range.

Buffer rules: Basically, we check to see if any of the existing companies in the portfolio is failing the selection criteria. For instance, if the average dividend yield for a particular portfolio company comes to be 1.9% (the rule is 2%), then, we apply buffer rules. Meaning, we continue with that stock, in order to reduce churn in the portfolio. The buffer ranges for every selection criteria are decided by the team keeping in mind the fact that the ranges should be practical in nature and not too relaxed to avoid churn.

Red flags: These are our proprietary red flags which we maintain for all stocks in our universe. They help us in weeding off companies which are either witnessing stock manipulation, corporate governance related or any other issues which we think carry along an unnecessary risk to the overall portfolio (like a stock in the news due to IT raids or Adani group stocks after the Hindenburg report).

Commonly asked questions from our investors

The smallcase examples taken here are just for reference. They are interchangeable.

Q1. Why was a particular stock dropped from Value & Momentum, but added in Dividend Stars or vice versa?

As mentioned earlier, these model smallcases strictly follow the model criteria. If a particular stock is getting dropped from Value & Momentum and at the same time getting added to Dividend Stars, it is because that stock is failing the former’s criteria and passing the latter. There is no analyst discretion involved.

Q2. When you drop or add a stock, is it a recommendation in general?

Any stock addition and deletion are purely model-based, Therefore, if a stock is dropped from a smallcase, neither does it mean that the stock is poorly poised nor is it a sell recommendation. For instance, Uno Minda was dropped from the CANSLIM-esque smallcase during the March ‘23 rebalance because it failed the momentum criteria. This is not a judgment on its past performance or expected future growth potential.

Q3. Why do you sell stocks that are at a loss?

In the previous edition of Musings with Analyst, we spoke to you about the exact same problem that a lot of our investors face, i.e. Disposition Effect. Holding on to your losers and cutting your winners is a recipe for disaster. Selling loss-making stocks is much better than holding them.

We hope you got a clear understanding of the way we build and rebalance our model smallcases. In a similar way, a few newsletter editions ago, we had written about the way Windmill Capital builds thematic smallcases. You can read it here, in case you missed it.

Disclaimer: Investment in securities market are subject to market risks. Read all the related documents carefully before investing. The content in these posts/articles is for informational and educational purposes only and should not be construed as professional financial advice and nor to be construed as an offer to buy /sell or the solicitation of an offer to buy / sell any security or financial products.
Users must make their own investment decisions based on their specific investment objective and financial position and using such independent advisors as they believe necessary.

Windmill Capital Team

Windmill Capital Private Limited is a SEBI registered research analyst (Regn. No. INH200007645) based in Bengaluru at No 51 Le Parc Richmonde, Richmond Road, Shanthala Nagar, Bangalore, Karnataka – 560025 creating Thematic & Quantamental curated stock/ETF portfolios. Data analysis is the heart and soul behind our portfolio construction & with 50+ offerings, we have something for everyone. For more information and disclosures, visit our disclosures page here –https://windmillcapital.smallcase.com/#disclosures