One of the readers (Dilip) asked me on how do I select the stocks, how to average out and how to go about building a portfolio. I am trying to capture my experience which though needn’t be exhaustive, should provide a good starting point to select the stocks.
Advice: Please do your own research and take your own calls. As a disclaimer, I am sharing my experience for illustrative purposes only. PLEASE TAKE YOUR OWN DECISIONS..
Now, first of all, one should understand the importance of equity and how a well constructed equity portfolio would work in the long run. I would definitely recommend the study of related blogs, articles in www. However, one article by Monika Halan in Mint is an eye opener. Please do read this article: “The slow cook of equity“.
Now, my portfolio construction has followed a few basic principles.
First, I am not attaching a stock / sector to a specific goal. My goals are being serviced through a combination of Mutual Funds and Debt Funds/Investments. I am investing in stocks to create an alternate income via Dividends while providing the necessary growth/impetus to my overall portfolio.
Next, the construction of the portfolio follows a categorization of stocks:
1. Large Moat companies (LM in further discussion):
– Good Business which can be easily identifiable
– Good Management with a proven track record (atleast > 10 Years)
– Fair confidence that these companies would exist after 10 years
– Good Dividend Payouts
– No Debt
2. Niche Business (NB):
– Good Large/Mid-cap companies with proven record
– Not too may players in this area
– Decent Profitability, Growth ratios
– Preferably no debt
– Dividend Payouts would be preferable
3. Risky Impetus companies (RI):
– Typically Mid/Small cap companies
– Available at attractive valuations
– Debt should be under control
– Good record for atleast 5 years, potential to grow
Now that we have established the groups, the next step is to identify the stocks that fall into these buckets. The basic ground rules for selection of stocks remain identical with some deviations for different groups.
I mainly use Moneycontrol to analyze a stock/company. The basic ground rules of selection are:
1. Zero Debt
2. P/E should ideally be below 16. At max, I would extend this rule to 24
3. P/BV is an indicator, but not a critical factor
4. Dividend Yield (especially for LM and NB) should be > 2%
5. Operating Profit Margin (OPM) should be > 20-25%
6. ROCE/RONW > 20 – 25
7. In the cash flow, company is using cash to invest in future and Cash Balances shouldn’t be decreasing
8. In the cash flow, company should NOT be taking/borrowing money to pay interest
9. Tax payouts (Screener site is better for this factor) should be according to the norms for the company/industry/sector
10. No Corporate Governance issues
These form the most important factors in stock selection. This is not an exhaustive list, but is definitely essential for shortlisting a stock. Given these conditions, if you refer to my portfolio, you can identify the different stocks falling into different buckets.
LM: Infosys, TCS, ONGC, NMDC, Larsen, HDFC Bank, Sun Pharma, Coal India
NB: Castrol, REC, Hexaware Technologies
RI: Vinati Organics, Ambika Cotton, Kaveri Seeds
I have left out IL&FS Investment managers as I am planning to consolidate my portfolio and rejig a little. Kaveri Seeds has a good record and there could be some surprises that I have put it in Risky category. The rationalte for the same is that there are some clarifications required in terms of royalty payment and Govt.’s move to regulate seed prices.
Beyond all these, I typically add a couple of stocks from Tata group as I love their philosophy and am a big fan. I already have TCS, but stocks of my current interest are Titan and Tata Motors.
In a bear market like the one on going currently, I definitely would love to average out the price of some of my stocks, especially in the LM bucket. Why? Well, these are companies which are part of indices and would be beaten down due to stock market downturn. This makes them attractive and definitely a potential buy. Please note potential buy.
If a particular stock’s is down between 5 – 10% in my portfolio i.e. current prices is 5-10% lower than my purchase price, I add a few more stocks (multiples of 5 / 10) based on my available budget.
For ex: In the recent bull market, I am averaging out TCS as my initial purchase price was much higher. Similarly, my INFY price is much lower, so I am waiting for the same to come below 950 levels to add more. However, if P/E is around 16, then I will definitely consider to add some positions, which needn’t be a particular percentage.
If a particular stock is down by around 20%, then I would definitely look at the reasons for the same and start building positions by adding atleast 5% of my existing portfolio more i.e. if I own a stock (Existing Qty: 500) whose value has gone down by 20%, I would add anywhere between 25 – 100 stocks (5 – 20%) based on the price. Please note that these deep corrections mean there are multiple factors. The rationale for adding is mainly based on the confidence in the company and the business and potential to turn around in 10 years time frame.
For ex: NMDC in my portfolio is down by 20%. I am planning to add atleast another 10-30% of my existing portfolio to average out the price.
I usually review my portfolio every 6 months and check if I need to remove any stock from the same based on conditions.
Additions, well… If any new stock comes on the scene that meets my criteria, is not part of my portfolio, then I definitely take some positions in the same. I don’t buy a stock for the sake of it, but only if I believe in it.
My expectation is that over a period of time, my LM should be able to give atleast 8% returns on my initial investment via Dividends. Why Dividends? Because, Dividends are TAX FREE.
Please note that the expectation is on MY INVESTMENT i.e. if I invested 1 Lakh in the LM bucket, I should get Rs. 8000 as dividends. The dividend yield of companies are in the range of 2-3%. The dividend yield is relative to CMP (Current Market Price).
Example: INFY is trading at Rs. 1130 with a dividend yield of 5%. It means that I will get Rs. 56.50 per share/year. As an example, if I invested Rs. 45000 to buy 50 stocks @ Rs. 900, I would be getting Rs. 2825 as dividend income. This turns out to be 6.3% return which is going towards my target of atleast 8%.
Please note that not only I am getting 6.3% tax free dividend, my investment has grown by 25% which is the main crux of the overall strategy.
Extending the illustration, let’s say I have 1 Lakh. I bought 75 shares of INFY @ 900 and 300 shares of NMDC @ 110, say an year ago. Today, I would have got a total of Rs. 6802 as dividend (6.8% returns) and my overall portfolio would be worth Rs. 1.1 Lakh (NMDC has gone down from 110 to 86 levels). With good diversification, one achieve a good dividend payout while cushioning the overall portfolio.
Note:It may be tempting to think, why not put everything in INFY. Just think if it was NMDC and what you may feel now especially after the deep cut. No one has a crystal ball and it requires a strong heart and patience to invest in stocks.
Thoughts/Feedback/Suggestions are welcome….