Criteria for Portfolio Construction

I was seeing fundamental reports on Ranbaxy from two brokerage houses on the same day – one a buy report, and another a sell report.  It’s natural to ask who is right between the two? Well, it depends.

I get queries on portfolio advice from fellow investors – whether a particular stock is a buy or sell, how much weight it can be allocated in the portfolio, how many stocks to have and so on. I wonder how can you give any meaningful advice without knowing the investor’s profile, goals, time horizon and his/her risk taking ability.

The point is stocks are held by investors for different reasons. There cannot be any one-size-fits-all approach when it comes to portfolio construction. Come on.. you may buy a pair of shoes from the best brand and company, but of what use if that’s not your size. Equity portfolio is not the same but customization to your fit is definitely necessary.

Let’s look at the key criteria that I find useful to gather information on before giving any portfolio level advice to an investor.

1.       Time horizon – Number of years (or months) one would be comfortable holding a stock. Somebody said “forever”. Well there are very few stocks of the evergreen kind. Even if there are, that call has to be taken with successive reviews, not at one shot for rest of your life. Markets are too dynamic to make such a judgment.

2.       Individual profile – This covers investor’s age, background, number of dependents, lifecycle stage, nature of employment, whether pensionable job, current networth and asset allocation.

3.       Investment goals – Important questions to ask are – while investing in stocks are you primarily looking at capital appreciation alone or for steady dividend income? Is retirement planning one of the objectives when you buy equities as a long term strategy?

4.      Return expectation – G-sec or Bank FD rate + x% that you’d like to earn for the risk that you wish to take when investing in equities. How much is this x%? One can’t beat the market every single year. Realistic return expectation can hold an investor in good stead over a period of time.

5.       Risk appetite – To put it simply, can you take in your stride part or full loss of capital invested in a stock. I’m not saying that will happen to you, but as part of mental make-up, are you financially prepared if markets or stocks held don’t go the way you want them to be for sufficiently long time. It can happen for various reasons and seasons.

6.       Equity weightage – What percentage of your networth is already in equities and in financial assets? And what percentage of your networth would you like to be in equities?

7.       Concentrated vs Diversified – Hold a concentrated portfolio of 3-4 stocks or diversify to 15-20 stocks or build a MF type portfolio of 30-40 stocks. This debate is a bigger issue and may deserve a separate post. For the time being, suffice to say depends on the investor profile.

8.       Risk tolerance – Can you sleep well if one of your large positions is down by 20-25%?  In equities, volatility is a given, and if every fall worries you then the low beta portfolio needs to be crafted accordingly.

9.       Family needs - Number of years you won’t need to dip into equities without compromising your family goals and personal needs that are not deferrable (like planning for a house, kid’s higher education, marriage etc).

10.   Investing skills - One’s basic skills as an investor in terms of behavioural patterns and educational background in finance.

11.   DIY - Last but not the least, if you’re going to be DIY Type (Do-It-Yourself) investor, better to assess upfront how much time you can devote to researching companies & stocks. I mean can you give say 8-10 hours per week or more. If not, active portfolio management may be a difficult ask, and one may need help from an expert or some professional advice.

To elaborate, you may get a tip from a reliable source or service on buying a stock XYZ in February 2012. Now with fundamental changes in company’s fortune you don’t know whether it’s still a hold in 2014, or you should have dumped it in the first year itself when the initial investment thesis went wrong. Sound grounding in criteria for portfolio construction is helpful in understanding such situations.

Seas of concern and Mounts of hope

As we begin the new year, it may be useful to step back and take a look where we stand in terms of what was actually wrong with the year gone by. Most commentators seem rather relieved to have got rid of that 2011. When we say wrong, reference is not to the numerology of 2011, but the scars the year left on all stock indices – main index, sector indices, mid cap, small cap – whatever you pick is down by anything from 20% to 40%.

I came across a report recently that condensed the concerns as 11 “C"s, which pretty much sums up the challenges. In this post, we call it the seas (“C”s) of concern.  I discuss some of these and my current take on each one of the factors briefly, with the usual right to be wrong.

C1 - Central bank tightening:  RBI hiked policy rates taking the interest rate in the system to multi-year high, and in the process, successfully “killed” growth without tackling inflation. Monetary policy tools could not have filled up for government inaction in addressing fiscal ills. It is natural to expect that interest rate hike cycle will now reverse in 2012.

 C2 - Crisis in Europe: Euro problem is not resolved by any means. In context of India Inc, impact of Eurozone crisis manifests itself in 3 forms - companies having (a) direct customers or business in Europe (b) shareholding of promoters, or FIIs out of Eurozone, who may be affected by Euro situation (c) subsidiaries in Europe. For other companies, there may be no fundamental roots in the crisis so impact, if any, is largely sentimental. I hold the same view for 2012 if our company is linked through any of these.

 C3 - Corruption scandals occupy headlines: More than directly impacting the business, such issues have negative effect on investor sentiment. The way things are developing we will see more of this dampening 2012 as well.

 C4 - Costs rise faster than revenues:  Corporate earnings hurt as margins drop. Raw material prices continuing at the same elevated levels are not going to be reversed, though their increase in percentage terms compared to last year will flatten out in 2012. Added to this is the increase in fixed costs which take time to spread over volume growth. In this context, it is important to note that only those businesses with moderate to high pricing power might be in a position to pass on the cost increase, for the rest it will surely hurt the earnings trajectory.

C5 - Compression in multiples: This is interesting since I like to analyse the historical valuation multiples that markets accord to a stock. Cut in earnings and growth is like a double-edged sword since it impacts both earnings and PE multiples. At a fundamental level, we discussed before some of these aspects here. It is this double blow due to which we have seen prices becoming half for so many stocks in last 6 months.

C6 - Cold Storage for policy action: Enough has been said in the media on this aspect and I won’t be adding any value by elaborating on it. Post state level elections, may be, we will see some concrete action on economic reforms agenda in fiscal 2012-13 which can have mildly positive effect for markets.

C7- Cost of living rises: Inflation proves too stubborn and economic fall-out of this leads to lower discretionary spends, well relatively speaking. When we say inflation, I’m not referring to government figures, but the reality of price rise at the ground that hits actual surplus available to common junta. Consumer looking to prune his budget spending will first look to cut out on non-essentials luxury items, and somebody has to lose out in the process.

C8 - Consumer stocks outperform: You must be thinking why this is included in the sea of concerns. Issue is lot of smart money is hiding in the “safety” of consumer stocks in the recent fall, which has prevented correction in their valuation that was otherwise warranted given increase in material costs and slowdown in projected growth rates. It is anybody’s guess if some correction can happen in this theme during the current calendar year.

C9 - Currency slides to all time lows: This has effected more companies than market had thought initially in ways more than one – (a) Forex borrowings by way of FCCB, ECB, bilateral etc. (b) Imported raw materials (c) Hedges taken at higher rates of rupee (d) Selling products domestically which are denominated in USD, partly covered in (b). We have not discussed commodity prices here but interplay of cyclical variables is going to be important going forward. With weakness in rupee persisting, this would linger on in the new year.

C10 - Capex tumbles:  Investment climate has sort of collapsed in the wake of high borrowing costs, issues of coal supplies, iron ore mining, environmental clearances, slowdown in release of orders, telecom issues & legalities. Just recall the time it took for Vedanta – Cairns approval. On a sidenote, in the M&A space, some of the previous overseas acquisitions of India Inc have not done that well which does not help the story either. 2012 can see improvement from where we are and then it will be down to the company specifics.

 C11 - Corporate confidence shaken: To me, this is probably the most worrisome of the lot. It takes time for an entrepreneur to start making fresh commitments & investments in a grim scenario.

It looks to be another rough year ahead with all these contributory factors staring at us. I don’t understand how experts are reeling out their picks & targets for 2012 as if Mr Market works by calendar. This brings us to the mounts of hope. One hopes some of the feel-good factor comes back in corporate circles, at least by second half of next fiscal, if not earlier.

Macro-economic scene is not in our hand but what choices we make certainly are.

Best wishes for a great new year, have a peaceful & prosperous 2012!

Bottom fishing – Myth and Reality

In last couple of weeks, there has been too much talk from “experts” appearing on TV channels or print media or net about investing at bottom of the markets or whether bottom is formed or how far is that level and so on. In equity investing, Bottom fishing refers to buying the cheapest stocks in valuation terms at lowest levels. Let us look at some of the common myths in this regard followed by my views on each one of them. I am sure you are coming across lots of these advices and grand mythical statements now a days.

Myth # 1 – Investors can start buying at current levels and add on dips.

Views: This is such a cliché statement for whatever it means. We analyse it here in slightly more detail, as to what our beloved “expert” is saying.

-          If this is addressed to an investor who is new to equities, do you really think a novice will muster courage to step into such volatile equity markets. God forbid, if Johnie steps in and Sensex tanks 1000 points next day and there goes his stock, will Johnie be able to get sleep? Contrast it with bank FDs where Johnie is getting 10% assured return. So, this piece of advice makes no sense to our Johnie.

-          If this is addressed to an existing equity investor, Johnie is already invested and licking his wounds because his portfolio is in red by x%. In all probability, he might not be holding large cash balance to invest further. Even if Johnie is holding some cash, there is a second thought in his mind whether to put this as well in markets or deploy in safer options. This piece of advice makes no sense to this existing investor either.

-          If this is addressed to an experienced investor who can analyse stocks indepth, is this advice necessary? Either way, such an investor will assess the situation and decide the best course suiting the personal investment style.

Myth # 2 – We have strong support at 4,540.

Views: Again this and its like are some of the most rubbish statements one can come across in a bear market. When there is a concentrated bout of selling or basket selling by a large institution or FII there is no respite. Who cares for this mumbo jumbo levels of 4,540 or 4,440 or any other number given by some analyst. In some of the previous bear markets, I recall by the time analysts were giving a support level, it was getting broken such was the ferocity of the fall.

Myth # 3 – You cannot time the bottom.

Views: If our expert is referring to bottom level of Nifty or Sensex while making this statement, it should not unduly concern a discerning stock-picker investor. Please undertsand that different investors are interested in buying different stocks and all stocks do not bottom out at the same time in terms of price. To cite an example, if one is interested in a popular stock like HUL, it is making lifetime high when Nifty is at 2-year low.

Myth # 4 – Downside is limited to not more than 5%. There will be a V or U shaped recovery.

Views: Whether some astrologer or Santa Claus has given all these prophecies. And how can you decide the precise alphabet of recovery when range of growth in economy varies by the week, fiscal deficit is out of hand, more subsidy driven social programmes are on drafting table, currency fundamentals are out of place, Eurozone topshots themselves are not sure of resolution of debt crisis.

Myth # 5 – This time it’s different (This is not 2008).

Views: In markets, ticker is all. Buy-hold-sell decisions have to be made around that. So how can one market fall be more calibrated or more disciplined compared to another fall. But human being is such a rationalizing creature that any event or action can be justified with some reason when none is actually applicable in view of macro uncertainty factors I mentioned in Myth # 4.  

To conclude, don’t be misled by the noise around. Nobody knows how long this correction will continue price-wise or time-wise. Specific stock selection is what matters. As usual, keep grabbing the good opportunities provided you have the staying power and patience. It is times like these that separate the men from boys.

All the best!

Virtual Stock Portfolio – Investor Link

Over the last 6 months, we have discussed quite a few stock ideas. It would be an interesting idea to introduce a virtual portfolio of Rs 1 million consisting of say 10 stocks with equal weight. I might have vested interest in some of these stocks and with other stocks, it would serve as a tracking list. Besides the learning value, it will give a sense how Mr Market is viewing the stocks and their returns. This is not intended to be an investment advice for anyone and all the usual disclaimer clauses apply.

Another advantage of creating a virtual portfolio is that it can be done after market hours at the closing prices of today. We take closing prices of today, December 01, 2011. We have 10 picks each with an allocation of Rs 1 lakh to make up the Rs 1 million portfolio.

Each of the 10 stocks will have a starting weightage of 10% in the virtual portfolio.

Typical time horizon for this portfolio is 2 years, and risk profile is moderate.

Objective is to generate stable returns as an investor, and will not be chasing momentum by taking undue risks.  On return expectation, it’s fine so long as it can beat the bank FD return and/or outperform the main index (Nifty 50 at 4,937 and Sensex at 16,483 as at close on 01-12-2011).

Ok, so let’s get going…

Our opening list is this.

S.No	Scrip	CMP 01-12-11 (Rs)	Market Cap (Rs crore)	Quantity (No.)	Invest. Amt (Rs lakh)	EPS FY-11 Rs	P/E ttm
1	Bajaj Electricals	181.00	1,799.09	550	1.00	14.66	13.42
2	Balmer Lawrie Co	537.65	872.45	185	0.99	74.35	6.52
3	Corporation Bank	352.00	5,223.15	287	1.01	81.44	3.53
4	Hawkins Cooker	1,500.15	793.25	67	1.00	60.07	17.21
5	Hinduja Globa Sol	321.10	668.94	310	1.00	52.09	6.25
6	IL&FS Inv Mngrs	26.75	547.49	3,740	1.00	3.32	7.96
7	JB Chem Pharma	71.95	608.18	1,390	1.00	13.98	0.88
8	South Indian Bank	21.95	2,486.25	4,560	1.00	2.59	7.43
9	Tata Global Bev	88.25	5,454.28	1,130	1.00	2.92	16.58
10	VST Industries	1,115.20	1,714.21	90	1.00	61.53	14.19
	Total				10.00

All prices are closing prices on NSE as at 01-12-2011 (except Hawkins which is only on BSE). We will not be bothering ourselves with brokerage costs & STT for this hypothetical exercise. While churns are not expected to be very frequent, if there is any incidence of capital gains incurred, we will provide for that in return computation. Dividends will be accounted unless they are small to be rounded off.

Shall we do a small intro of each of the stocks, hmm.. it will become a very long post. Anyway, most of the stocks in this Virtual Portfolio have been discussed on this blog. Few others like Balmer Lawrie, Hawkins, JB Chemicals, Tata Global Beverages and VST Industries are fairly well known & established names in their respective areas. We have covered market cap varying from Rs 500 crore to Rs 5,000 crore in this portfolio. We have diverse sectors in this virtual portfolio covering the following :

(1)  Electrical appliances & projects

(2)  Packaging & Logistics

(3)  PSU Banks

(4)  Private Banks

(5)  Domestic appliances

(6)  IT (BPO space)

(7)  Financial Services (PE space)

(8)  Pharmaceuticals

(9)  Beverages (Tea)

(10)FMCG (Cigarettes)

We’ll be re-visiting how this set of stocks is performing, can’t assure any frequency though, and will shuffle the stocks as and when required. After all, you can take all such liberty with a hypothetical portfolio.

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