5 observations on the stocks portfolio you shouldn’t have

Investing in stocks is simple but building a stocks portfolio is hard. 

I found no better example of this than a portfolio of a friend of mine. 

When I saw the portfolio, I had mixed feelings.

Here is a portfolio which has some of the best names that one can invest in, yet, on the other hand, it will mostly likely, and ultimately, disappoint the investor. 

The issues go beyond the obvious ones such as having 39 different stocks in the portfolio. (My friend is also investing in some of the recent IPOs taking the tally higher) 

Let me tell you why.

First, have a look at the portfolio yourself. 

Prima facie, I found very little wrong with the portfolio. There is Infosys, Reliance, L&T, ITC, Vinati Organics, CERA SanitaryWare, L&T Infotech, Castrol. These are some of the best and most profitable businesses of India and at least some of them should definitely find place in any investor’s portfolio. In fact, I myself own some of these companies in my personal portfolio as well.

Then I had a closer look.

Observation #1

Out of the 39 names that the portfolio consists of 3 names which have given more than 100% absolute returns (I am not aware of the purchase date or the holding period).

And there are 6 names where the investor has lost more than 50% of the initial investment

Let me assure, even my strike rate as an investor is not very different.

Out of 10 stock I invest in, I will lose money in 3 stocks. 4-5 stocks will go nowhere and I will make serious money in 2-3 stocks.

We cannot tell beforehand which of our portfolio stocks/companies will do well and give us good returns. However, as they say for gardening – “water your flowers and remove the weeds”, it is very important to get out of bad stocks and let your winning stocks run.

There is the problem. Only 3.4% of the invested (initial) amount was invested in the winning stocks.

And a whopping 23% of the invested (initial) amount was invested in the mega losers 

Just imagine where this portfolio would have been had the case been opposite.

We as investors tend to give a lot of importance to “stock picking”. We always ask “kaunsa naya stock khareeda?”, when it is equally important to 

• Allocate enough money to our winning stock / companies
• Recognize the bad stocks and get out of them as early as we can

Observation #2

Investing in stock markets is the most democratic and transparent way of creating wealth. 

You and I may not have the skills / capital / drive to start and grow a business. 

But as an investor you can become a part owner of the best companies run by the best entrepreneurs / businessmen and make money with them.

Now, in the above portfolio, there are 9 lending businesses (banks/NBFCs).

Lending businesses are inherently risky.

It is very easy to give out the loan, what is most difficult is to recover it in time.

A massive 35% of the initial capital has been invested in lending businesses and in aggregate there is a loss of 30% of the invested capital

Leverage works both ways – it helps one make a lot of money quickly and also aids in the rapid loss of capital when the tide turns.

There are two ways to invest in lending businesses

• Just stick to the best, e.g., Bajaj Finance, HDFC Bank, Kotak bank, Gruh Finance, etc. 
• Invest in moderately good survivors after a massive financial /credit crisis – 
  E.g., Canfin Homes, LIC Housing Finance, REPCO Home Finance (check out the last cycle from 2010/2012)

As an illustration, the stock price of Can Fin Homes went up 35 times from Rs 20 to about Rs 680 sometime in late 2017 at the peak of the last economic cycle. For the last 3 years, the stock price has, in fact, given negative returns.

Observation #3

Doubling down on your mistake

The investor seems to have bought Yes Bank first around Rs 255 almost 40% below its ATH (all-time high) of Rs 400. 

Then after losing more than 90% of this capital, the investor put in 20 times more money at Rs 43. Today the stock price is Rs 17 and the investor has lost 55% of this capital as well (as of now).

My take

• You are likely to lose money in some of the stocks, however, don’t compound your mistake by buying a bad stock.
• If a stock / company is being discussed on TV/newspapers everyday, it is probably best to stay away from such a stock.

E.g., there were 16+ lac retail shareholders of Yes Bank in Dec-19 Vs just 3+ lac retail shareholders in Kotak Bank which is a far better managed bank with far better chances of the stock price going up than Yes Bank.

Observation #4

Portfolio Diversification

It is obvious that all your eggs should not be in one basket. One MUST invest in multiple stocks. However, when one invests in 39 different names, how is it possible for the normal investor to keep track of what is happening with each of the portfolio companies?

One has to keep track of quarterly results, analyse competitors, keep abreast of expansion plans of each of the portfolio companies, read about Indian and global business news.

Neither is portfolio risk going to go down just because I selected 40 stocks to invest in nor is one going to make very good returns because at least by luck some of the stocks will go up 2/3/4 times. This is amply illustrated by the portfolio.

The stocks which have given very good returns did not have enough capital allocation and the 9 lending businesses have in aggregate given sub-par returns.

Also, I am definitely not going to make most money in my 27^th best idea.

In my opinion and experience, it is better and cheaper to invest in a low-cost Index Fund than try to dabble with little conviction in dozens of stocks.

I want to concentrate my research effort and then put in big money in the select number of businesses /stocks that have the highest potential.

The answer to the question of how many stocks should be there in one’s portfolio has to evolve organically based on the depth and breadth of the research that has gone into selecting them and also the level of conviction in each of those stock ideas.

This number is different for different people. 

For me, this number is around 8-12 stocks.

I know many people who have a single stock portfolio and have made big money multiple times over. And on the other hand, there are also successful investors who invest in even 100+ stocks.

Observation #5

Investment Philosophy and Process

Though I do not know what thought process has gone into buying each of the stocks, but let me tell what it looks like.

• The stocks seem to have been bought based on the “hot stock” of the month. E.g. Yes Bank has a 14% allocation (at cost) in the portfolio.

• There is a significant allocation to financial stocks (banks & NBFCs) which I speculate were bought before 2018 when all these businesses were doing very well and their historical returns were excellent. Basically, the investor seems to be buying the flavour of the season

• Names like Pondy Oxides, Archidply Industries, Chalet Hotels, Hemispehre Properties, HFCL find a place in the portfolio. I do not expect the average investor to have some special insight / deep research done into all these companies. I suspect they are not bought with enough depth of research or conviction.

I am not saying these are bad stocks to own and the investor also seems to have made money in these stocks, but the nature of the overall portfolio suggests to me that the investor has bought new stocks without correcting old mistakes.

No single investment philosophy makes money all the time. 

Sometimes value investing will work, other times day trading will work and at other times shorting the market will work.

As a corollary, no philosophy of investing will keep failing all the time.

However, as an investor, we have to stick to a philosophy which helps us make repeatable and sustainable returns over several years. (Our earning life spans 35 years between age of 25 yrs and 60 yrs)

To summarize, we need an investment system (philosophy) that we will be able to stick to and implement through good times and bad times.

The more likely way to build significant wealth is by executing a sound investment philosophy over multiple market cycles (booms and busts).

Final Comments

Equity investing follows some very simple principles. The key is in the implementation. 

For the average investor, picking stocks is not very difficult. 

The difficulty is in allocating the correct amount of capital to the correct idea, having a process to course correct and keeping emotions out of the investing process.

The past one year has been one of the best teachers. Many people were right and sold early before the massive 40% crash in Sensex in Mar-20. However most of them failed to recognize / acknowledge the turn of the market and have majorly remained in cash even to this day.

Many others initially did not sell, but then kept on holding to those stocks far too long which they should have sold and bought something else.

Others were able to correctly spot the market bottom in Mar-20 and invested heavily. However, they got scared and cashed out either in Aug-20 or Nov-20 and missed the huge market rally after that.

Sometimes it pays invest in a mutual fund or hire an investment advisor for your stocks portfolio instead of trying to do everything yourself.

This analysis was generously shared by Amey Kulkarni of Candor Investing.

And now, you can have Amey’s expertise working for you through the Wealth Compounder Direct Stocks Portfolio on the smallcase platform. Read more about it here.