Friday, May 6, 2011

Portfolio Construction

It has been more than a month since I posted my last article and so much has happened in the market since then. I listed several stocks that were beaten down at that time in the last article and most of them went up by 15% – 25% within a month only to come down again. Short term investors who buy in every dip and sell in a pullback tend to make money when the market is moving sideways like this and over the long term, long term investors should match them in terms of returns if not beat them. But to remain invested for a long time, it is important to build a portfolio of stocks that will catapult your returns (20% CAGR) while protecting your capital. Though it looks simple, it is easier said than done. Constructing a good portfolio takes lot out of you in terms of time and money while precise understanding of market dynamics, changing environments and guts to make tough decisions are prerequisites. I have tried to construct a good portfolio and have done reasonably well although I made lot of mistakes along the way and I thought of sharing some of the finer points that I learnt in the process.
Long Term Portfolio
The reason that many leading investors recommend to keep stocks for a longer term is to allow the stocks enough time to create the kind of earnings that support your cost price plus expected returns. For example, if you have bought Axis Bank in the month of November 2010, you would have certainly paid Rs.1500 – 1600 a stock. Market has been declining since then and Axis Bank is down by 20-25% from that level. In order to recover your capital and make at least 25% of returns out of it, you need to allow enough time, may be a year or two, so that the earnings catch up the valuation at which you bought the stock plus the 25% of return you expected. Looks simple, isn’t it? Not so simple though. Not all the stocks recover in the expected lines let alone making returns. That’s where your skill in constructing a portfolio comes into play. It is not without a reason that fund managers are getting paid well.
There is a myth that you have to buy only midcap and small cap stocks to beat the index returns but it is far from the truth. You can in fact build a portfolio from SENSEX or NIFTY stocks and still beat the index returns hands down by a big margin. How? The most important thing in building a portfolio is not only the selection of stocks but also the proportion of money that you allocate to each and every stock in your portfolio. Let’s see how this works with some practical examples.
Assume you had 15 Lakhs to invest during the month of June 2010 and you constructed a portfolio selecting 15 stocks from the SENSEX scrip’s. Assume that you selected the following 15 stocks to form an Index and named the index as STAR15.
HDFC Bank, ICICI Bank, Mahindra and Mahindra, Tata Motors, Bajaj Auto, Hindalco, Bharti Airtel, Cipla, Hindustan Unilever, Tata Consultancy services, Reliance Industries, BHEL, NTPC, L&T, DLF
Even for the illustration purpose I have opted for the most diversified list of stocks to avoid any bias to a particular sector.
Let’s see three scenarios and how it would have made a difference in returns.
Scenario 1: You had 15 Lakhs and you allocated 1 Lakh each on the 15 stocks. From June 2010 to May 2011, the return would have just mimicked the returns of the Index STAR15 that you assumed.
Scenario 2: You had 15 Lakhs and you decided to allocate 10 lakhs for the following 8 stocks since you thought they would perform well.
Reliance Industries, L&T, BHEL, Cipla, ICICI Bank, Bajaj Auto, NTPC and DLF.
You have invested the rest 5 Lakhs in HDFC Bank, Tata Motors, Hindalco, Hindustan Unilever, Tata Consultancy services, Mahindra & Mahindra and Bharti Airtel.
What do you think your returns would be? The returns would be sub optimal and in fact lagged the Index (STAR15) by a considerable margin.
Scenario 3: You invested 10 Lakhs in HDFC Bank, Tata Motors, Hindalco, Tata Consultancy services, Mahindra & Mahindra, Bharti Airtel and Hindustan Unilever and another 5 Lakhs in Reliance Industries, L&T, BHEL, Cipla, ICICI Bank, Bajaj Auto, NTPC and DLF.
Result: Your returns would have beaten the Index (STAR15) by a big margin and in fact you could have got more than 50% returns if you have allocated more money to Hindalco, HDFC Bank, Mahindra & Mahindra and Tata Consultancy Services.
So the point I am making here is, proportion of money that we allocate to a particular stock is as important as the stock selection and in fact more important than the stock selection sometimes. I don’t think you could have gained 50% return either from the portfolio of midcap stocks or the complete list of Index stocks from the assumed period. The notion that only midcap and small cap stocks can give Index beating returns is far from the truth though there is an element of truth in it. For example if you have invested all 15 Lakhs in TTK Prestige, you would have gained 300% returns by now. But it is very difficult to take that kind of a risk in a single stock. We can only make educated guesses and rational decisions. May be we can take those decisions if we sit in the board like some other big investors.
Stocks for the Next Decade
I am tracking a list of stocks which is enough to create a good portfolio. I went with the safety first approach where I gave more importance to the fundamentals and future direction they might take. May be if interested, you can pick few from the list as well. The list contains good mix of established and emerging companies.
Banks
Axis Bank (Fast Growing and entered into investment banking through ENAM Deal Recently)
ICICI Bank (Has Fast Growing Subsidiaries and global presence)
State Bank of India (Largest Bank in India with unmistakable track record)
Canara Bank (One of the largest PSU banks available at good valuation)
Andhra bank (Very good midcap PSU with attractive dividends)
Indusind Bank (Fast Growing Bank with retail client focus)
Yes Bank (Fast Growing Bank with Corporate Client focus)
Non Banking Finance Companies
Rural Electrification Corporation (Focus on Power Infrastructure Financing)
LIC Housing Finance (Growth area of housing finance with a backing from LIC)
Indiabulls Financial Service (Housing Finance company with good dividend History)
Dewan Housing Finance (Growing Housing Finance company focusing middle and lower income)
Magma Fincorp (Growing NBFC Focusing vehicle loans)
Shriram Transport Finance (Established NBFC in Used Commercial Vehicle space)
Bajaj Finance (Turnaround NBFC in Consumer Loans)
Mahindra Finance (Strong Parent and Presence in all kind of loan segment)
Infrastructure
Adani Enterprises (Next SENSEX Company)
L&T (Best Infrastructure Company)
BGR Energy (Growing EPC & BOP Service Provider in the power space)
IL&FS Transportation Networks (Very good road portfolio with good mix of annuity and toll projects)
IRB Infrastructure (Good road portfolio with huge order book)
Power / Energy
Coal India (Near Monopoly in Coal assets)
Adani Power (Growing Power Major with strong fuel security)
Torrent Power (Very good company present in the entire value chain of production & distribution)
Crompton Greaves (Excellent company in power systems space+consumer durables)
Diamond Power & Infrastructure (Growing small cap company in the power cable business)
Left out JSW Energy due to the fact that they have failed to get adequate fuel security amid falling merchant rates. If you are invested for 10 years in this stock, then it can give serious returns.
Left out Reliance Infrastructure due to the fact it is headed by Ambani scion and they get involved everything except business these days.
I have invested in both of these stocks, but will not make additional investment. Lesson learned. But both can give good returns over long term. It is just they don’t deserve to be in the core portfolio.
FMCG / Consumer Goods
ITC (Best in the FMCG Business if bought at the right price)
Godrej Consumer Products (Very good management & inorganic growth)
Titan Industries (Excellent performance in the past, Valuation is the concern)
Asian Paints (Leader in Paint Business)
Amar Remedies (Growing Small Cap FMCG Company)
Bajaj Corp (Very good fundamentals)
IFB Industries (Can tap the growing demand for consumer electronics)
McLeod Russel (Best Company in Tea Business)
Gitanjali Gems (Fast growing Jewelry Company)
Shree Ganesh Jewelry House (Undervalued)
Auto
Bajaj Auto (In best position to tap the two wheeler market)
Mahindra & Mahindra (Tractor & SUV Specialists and good management)
Tata Motors (Strong Performance off late)
Ahmednagar Forgings (Growing Small cap auto parts company)
Realty
Godrej Properties (Strong Management and good land bank)
Oberoi Realty (Zero Debt company with premium product)
Anantraj Industries (Low debt and Presence in National Capital Region)
Steel
JSW Steel
Sesa Goa
Pharma / Healthcare
Aurobindo Pharma (Good Pharma company available at reasonable valuations)
IPCA Labs (Evergreen Pharmaceutical Company)
Lupin (Strong performance in the past)
Apollo Hospitals (Largest Hospital chain and excellent brand value)
Jubilant Life Sciences (Reasonable Valuation)
Opto Circuits (Unique in its space)
Only problem in the Pharmaceutical space is the high valuation and it can go up from here or people might book profit sending the stock prices crashing.
Packaging
Bilcare (Major Player in pharmaceutical packaging)
Ess Dee Aluminum (Growing Pharmaceutical and FMCG Packaging Company)
Parekh Aluminex (Good Business & Stable Customers)
SRF Limited
Agriculture
Rallis India (Strong Parent and best performance)
United Phosphorus (Very good fundamentals)
Jain Irrigation (Major Player in Micro Irrigation)
Gujarat State Fertilizer Corporation (Undervalued)
Coromandel International (Strong Presence in South India and good Capex Plans)
Left out Lakshmi Energy & Food because I don't really know why it is under performing in spite of good fundamentals. I have made investments but will not make additional investments.
Leather Products
Bata India (Strong Brand Image)
Mirza International (Very Good Small cap company with good brands)
Superhouse Limited (Good Fundamentals)
Relaxo (Good Product line)
We can definitely create a decent portfolio from the above list but it is not the rule either. If we spot a very good opportunity in other stocks, we should be ready to grab it as well. For example, if Muthoot Finance goes down to Rs.125 in a correction. There is no point wasting time. They are in very good business of gold loan and their future looks promising. So it makes sense to invest in that. Likewise there could be many other opportunities and we just need to have open mind.
Angel Broking is projecting FY13 EPS of Rs.1488 for SENSEX and the consensus SENSEX EPS for FY13 is Rs.1400. If that turns out true, the SENSEX can reach 25000 levels within next 2 years and investors who build a good portfolio this year will stand to benefit a lot.
Kumaran Seenivasan

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This is a blog about stock market investments, investment strategies, and related topics. Any statement made in this blog is merely an expression of concerned authors opinion, and in no case should it be interpreted as an investment advice to buy stocks, sell stocks, or for that matter advice for any other issues be it money related or not. By using this blog you agree to (i) not take any investment decision, or any other important decisions based on any information, opinion, suggestion or experience mentioned or presented in this blog (ii) verify any information mentioned here, independently from your own reliable sources (for e.g. a registered investment advisor) and thereby check for possible inaccuracies. This blog is to create investment wisdom among general population and the authors are not responsible for
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