How to construct a Dream Stock Portfolio ?

How to construct a Dream Stock Portfolio ?

All Investors want to have a dream portfolio and want to invest in Multi Baggers. They feel equity investments will give them multiple returns in the shortest possible time.

As a normal policy, We don’t recommend individual stocks, but asset classes.

However, it is the beginning of a New Year, so lets play a Game. 

Let’s assume that all the companies are available at Par, at their issue price. The Indian economy is at the current level of approx. $2.5 Trillion and expected to double in the next 7-8 years. So how do you go about constructing a Model portfolio? 

In traditional investment theories, Growthand valueare two fundamental approaches, or styles, in stock and stock mutual fund investingGrowth investors seek companies that offer strong earnings growth while value investors seek stocks that appear to be undervalued by the marketplace.

Growth investing

Growth investors are attracted to companies that are expected to grow faster (either by revenues or cash flows, and definitely by profits) than the rest. As growth is the priority, companies reinvest earnings in order to expand.

Don’t expect dividends from growth companies. Growth companies offer higher upside potential and therefore are inherently riskier. There’s no guarantee a company’s investments in growth will successfully lead to profit. Growth stocks experience stock price swings in greater magnitude, so they may be best suited for risk-tolerant investors with a longer time horizon.

Value investing

Value investing is about finding diamonds in the rough—companies whose stock prices don’t necessarily reflect their fundamental worth. Value investors seek businesses trading at a share price that’s considered a bargain. As time goes on, the market will properly recognize the company’s value and the price will rise.

In this game that we are playing, because the price of each stock is at par, so all the stocks are hypothetically available at equal value. So value investing approach loses its relevance in this game.

Stock prices rise due to a number of factors: earnings growth; acquisition by a larger company at an above-market price; stock repurchases by the company; an increase in the price the market is willing to pay, for one rupee of earnings, due to increased growth prospects and institutional interest etc. Typically, large-company stock prices rise only for the first reason, while smaller companies will see prices rise for all reasons.

Now, how do we go about constructing our model portfolio. Generally while taking investment decisions, people tend to follow the herd, but before deciding on your investment, one must consider one’s own need, risk appetite, goals, liquidity etc. Please don’t follow the herd as also outlined by this couplet by Saint Kabir.

Let’s list out some basic things which need to be kept in mind while constructing a model portfolio.

Invest in businesses you understand : 

Both warren Buffet and Peter Lynch are big proponents of this approach. Buffet doesn’t prefer investing in Tech stocks because he feels he doesn’t fully understand the business model and challenges in the industry.

Peter Lynch’s philosophy was that the best tools to identify great stock ideas are your personal experiences, and that of your friends and family as consumers of products or services. 

If you rate the products or service of a company highly, you should also explore it as a potential stock investment. After all, a happy and loyal customer base should translate into good business performance and in turn, good stock performance. 

This approach may seem too simplistic but remember, your first hand experiences as a customer may reveal much more about a company than any sophisticated analysis done by a financial expert. 

Just think about it – which is your favorite car,( Maruti), which motorcycle will you buy your son ( Hero) which cookies do you like to eat with your morning Tea or coffee(Britannia, Hindustan Lever, Nestle), what are your favorite brands of clothing (Arvind Mills)and footwear (Bata), Which bank do you use (HDFC Bank) Which company products do you use in constructing a house, (Asian Paints, Pidilite, Ultra Tech, Havells, Kajaria)- and there you go! 

You are already thinking stocks. These companieshave been outperforming the benchmarks by a mile and have created umpteen millions in the last 10-15 years.

Focus on buying an existing and well-understood business with an ultra-slow rate of change.

Buy an existing business with a well-defined business model and a long history of operations that can be analyzed. This is less risky compared to going for a start-up.

Invest in simple, well-understood businesses.

As Buffet said; look for mundane products that everyone needs. Following this requirement alone eliminates 99% of possible investment alternatives.

Some investors bet on change but Warren Buffett bets on things that won’t change.

Where Will that company be in the next 10/15 years 

As a rule, avoid Cyclical industry and highly capital intensive businesses which generally result in a lot of debt on the books and overleveraging.

Does the company have an Economic moat, a competitive advantage, an entry barrier? What possible disruptions can the company face in the coming years? Just visualize, will the company be there when your goal is to be achieved in 10/15/20 years.

Dow Jones of the US, which is 100 years older than the Nifty, has witnessed a 400 per cent churn in the past 118 years. While the Nifty has replaced 34 cos in 18 years, Dow has swapped nearly 120 companies since it was established in 1896. On an average, both indices have seen a 3.8 per cent churn every year. 

For those who believe that giant market-leading firms are highly unlikely to be kicked out of the Sensex, please note that all of the following firms were in the Sensex in 1992 – Century Textiles, GSFC, Bombay Dyeing, GE Shipping and Ballarpur Industries. The disruption created by the end of the ‘License Raj’ was such that all of these firms were out of the Sensex by 2002. 
Similarly, in 2005, Ranbaxy Labs, HPCL, Satyam Computers, Grasim Industries and Reliance Infra were an integral part of Sensex and no prizes for guessing what happened to these companies by 2015. 

Write down your investing rationale.

An articulated investment philosophy will keep you on the right track. Write down your buy decision clearly, not ambiguously, whenever you buy a stock. Keep it short – no more than a paragraph or two. When the reason you bought the stock is no longer true, sell. In this way, your sell strategy is built into your buy decision.

Let’s say you buy shares of XYZ Co. because you believe its profit margins will rise from 12% to 18% over the next 3 years.

Scenario #1

After several years, the profit margins haven’t budged.

Your thesis – company’s profit margins would rise – is false.

Action: Dump the stock

Scenario #2:

After 2 years, XYZ Co.’s profit margins are at 15%. Margins are rising.

Your initial investment equation is still true.

Action: Hold

Scenario #3

Profit margins are at 19%.

The company’s margins rose above 18%. The company has exceeded your expectations. Check out the reasons for the change and sustainability and decide.

Action: If sustainable, Hold otherwise, Book profits

Have a reason for buying every stock. As soon as the reason comes into doubt, ask yourself if it is time for a change.

Apple Inc. is the world’s largest company. Its founders Steve Jobs and Steve Wozniak are hailed as heroes of our age. Its iPhone and iPad have conquered the globe. However few people know that it also had a third founder – Ron Wayne who sold his stake in Apple for just $800 in 1976. Had he kept his stake, it would have now been worth $35 billion. 

Ron Wayne is counted as one of the unluckiest men in the world. 

However can any one of us confidently say that we would not have done the same thing with a virtually unknown company in a pre-computer age? 

Hence, a written Investing rationale is important.

Invest in Companies with honest and competent management;

Avoid sexy, go for boring.

Passion and integrity are some of the most important things that Buffett looks out for when prospecting a company to buy. Why? The passion for the business will ensure that managers will breathe, sleep and live for the company.

The primary responsibility of every management is to allocate capital effectively. How the manager uses the company’s retained earnings or new funds will determine how far the company can go. Yet, as Buffett points out, very few managers are trained in capital allocation. Many Indian promoters got swept up in the boom years of between 2003-2007. They decided they needed to go global and chased large acquisitions world-wide – actions they would pay dearly for a long time to come. Suzlon, Bharti Airtel, Vishal retail, are some examples of overly ambitious managements and strategy gone sour.

A dull business run by good businessmen with high integrity is far better than a glamorous business with mediocre management and a business run by unethical management.

There is the analogy of drunk men setting their sights on the hottest woman in a bar, hoping to “get lucky”. She eventually rejects all of them.  “Wouldn’t it be a lot better to look in the local library to find a woman? Most men don’t look there. It’s out of the way and not thought of as a sexy hangout. But a guy probably has a better shot of finding someone at the library than at a crowded bar with tons of competition.”

Avoid businesses that a smartphone can destroy
Technology is a disruptive force. It has destroyed the fortunes of many varied industries. Buffett talks of the effect of technology and the damage it can do to some industries.

‘If something comes in where there’s a technological component that’s of significance, or where we think the future technology could hurt the business as it presently exists, we look at that as something to worry about.’
There are many businesses destroyed by smartphones. Most are struggling to remain alive. Digital cameras, video games, alarm clocks, travel agencies, book stores, calculators, Music CD and DVD players are just some examples. 

Avoid companies selling products that can one day become an app.

The more certain something is, the less likely it is to be profitable.

There is basic rule in life as well as in Stock Investing – Nothing in this world is absolutely certain. When many people are absolutely sure of something, you should be suspicious.

Do not think in terms of what you wish. Never act without checking the facts. Whenever you see people acting in the same way, it is time to investigate supply and demand objectively. 

In 1980, everybody wanted to own gold pushing the price to $850 per troy ounce. But gold began to get overproduced as the suppliers were bound to increase production to match the price rise. A lot of individuals bought gold at inflated rates assuming it is not just “any commodity”.

As more gold began to get mined, demand scaled back. Many who owned gold jewellery sold it to the refineries for melting, which further increased the supply. By 2000, the price had dipped to $250 per ounce. The exact same change in supply and demand happened with silver, which tumbled from $50 in 1980 to under $4 a couple of decades later.

When you see the mob mentality and see them being unrealistic, stop and make an objective assessment of the supply-and-demand equation.

Anything that is a “must see,” “must try,” “must read,” should almost certainly be avoided, especially if it is popular. As the old maxim goes, 

“Be fearful when others are greedy, and be greedy when others are scared”

Markets essentially follow earnings. Which companies or sectors are going to do well in the journey from $2.5 Trillion to $ 5 Trillion are the sectors to look out for. Companies with good financials, passionate management and long lasting Economic Moats should be shortlisted to invest in.

In the end, remember that Equity investment is for growth, if youwant regular income, invest in Debt. In the short run, equity is volatile but in the long run, it beats other asset classes hollow in terms of return and growth

Your model portfolio will vary according to your age, time left for your goals, risk taking ability, understanding of the market and the dynamics involved.

If you want to invest in stocks, you will need detailed research, patience, and ability to withstand shocks and take risks.

Ralph Wagner in his book, Zebra in Lion Country, employed the zebra metaphor to argue his case for investing in Equities. Zebras typically move in herds. Those at the edge get to graze on fresh grass, those at the center have to make do with trampled grass. But those chomping on the fresh grass are taking a higher risk, since they are prone to becoming lion lunch. While the skinny zebras have a higher chance of survival, they have to settle for the sub-standard grass.

Hence to get greener grass, be ready to take higher risk.

A safer way to invest in Equity is to go the mutual fund route. Check out our blog on the subject, “Whether you should invest in Direct Equity or Mutual Funds ?” https://sahayakgurukul.blogspot.com/2018/11/investment-in-stocks-or-mutual-funds.html

Contact your financial advisor, Construct your Model portfolio and evaluate it against your financial goals for testing its efficacy.

Happy Investing!

Stay Blessed Forever!

Sandeep Sahni

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sandeepsahni@sahayakassociates.com,info@sahayakassociates.com

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