How to build a direct equity portfolio – Part 2

Published: February 23, 2023 at 6:00 am

In this article, Vijay discusses guidelines on how to build a direct equity portfolio. This is the second part of the series. The first part is here: How to build a direct equity portfolio – Part 1.

About the author: Vijay is an electronics engineer and management graduate (IIM Bangalore). He has worked as a technical expert in the automotive industry for the last 25 years. He has an active interest in subjects related to macro Economics, wealth building and technology matters.  He has an investing experience of close to 15 years in equity and mutual funds.

Note: Opinions published by guest authors do not represent the views of freefincal or its editors.

About the article: This is an attempt to assimilate the learnings related to portfolio building from different practitioners, including my personal experiences with direct equity investing.

Let us start by defining the broader goals of Equity portfolio building.

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  • To consistently and comfortably beat inflation (by a delta of 2-3%)
  • To satisfy personal goals. Goals can be different for different people depending on the risk appetite. Example of goals could be building a pension corpus for retirement investing, to generate income through profits to buy real estate in some years etc. Hence, a broad spectrum exists with trading on one side and investing on other side. Even inside investing, there can be several strategies based on risk tolerance level of individual investor.
  • If the Simple Goal of investing in Stock market is to just beat inflation while the investor does not have time or want to spend time analyzing several stocks, then the simplest way would be to invest in Index Funds that have a low Expense ratio. As we have seen above, the Nifty and Sensex would grow over a period of time enabling one to comfortably beat the inflation rates.

Note: If you follow this strategy, the assumption is that you are not investing your entire means of savings into the Index. If you follow the stock market, there can be 3 different types (see graphic below):

  • Bull market: Indices keep going up (~20% of overall time horizon)
  • Bear market: Indices keep going down (~10 – 15 % of overall time horizon)
  • Bunny market: Side wards movement of indices (~70% of the time)
Types of stock market movements
Types of stock market movements

As there can be periods where Index can move sidewards for months as you can see above, no real growth of wealth is possible in a shorter time frame. Rather if you have invested in Index during Bunny market phase and then a Bear market starts, you can end up losing money in case you want to withdraw the money. Hence, having an overall cash flow management strategy has to be evolved after consulting your Financial advisor (i.e. Don’t put all eggs in one basket).

  • During side ways movement phase, it is advisable to invest via SIP’s that allows you to do averaging.
  • Don’t panic during Bunny market or Bear market phases as the Index will go up over the long term. Hence, it is important to keep your SIP’s going. To borrow the famous quote from Buffet “Be greedy when others are fearful”, do one-time investments in addition to your usual SIP’s in Bear market phases. This will allow you to make better returns when the market comes up.
  • For investors who really look to build a Porfolio beyond Index funds, you should divide the Portfolio into 2 parts – Core ad Non Core.
    • Core : This is the basket of stocks that you are going to identify and accumulate over the long term in order to reach your investment goals {i.e BUY and FORGET}.
    • Non Core: This is an opportunistic basket where you make some actions to take advantage of short term market movements.If you also do Trading, then Swing Trading, Intra day, Future & Options come in this basket.
    • If you plan to be only an investor, then you can only invest in Index funds and keep this in Non core basket.

Caution: It is important to understand that it is not necessary to take higher risk like F&O to fill your Non core portfolio. The point here is that the profit that are gained from this short term activities have to be moved from Non Core to Core Portfolio. If you are having only Index funds in Non core, then the strategy should be to rotate cash by selling Index funds after a breakout is finished and buy core stocks or deploy in Liquid funds (waiting for reinvestment).

Cash Rotation: As an investor, you also need to have a strategy of cash rotation from Non core to Core. Remember the way you grow your wealth is when you reinvest your profits which again grows. When you see markets giving clear breakout, you should wait till that bull run is finished and market finds a new consolidation zone. Profit booking shall be done at this point and rotate the capital to core portfolio.

Avoid High Debt companies: As part of your core portfolio, do not pick companies or industry that have high debt. Companies can make organic expansion by ploughing back their operational profits. Another way of expansion is to take debt from Public sector banks, Private banks or from Bond market. When interest rates are increased by RBI, this would severely increase the interest payments for the companies who are highly leveraged. We have seen the case of famous industrialists who filed for bankruptcy when they are unable to pay the high debts. Hence, as a guideline do not buy companies where debt is equity ratio is more than 0.2 – 0.3

Striking a Balance: Do not invest only in stocks in an industry yet to mature. At a broad level, you can classify industries into Over matured, Mature and Under matured. An example of Over matured industry could be Oil or Sugar where there is no new innovation that is happening. On the other hand, Electric vehicles industry in India right now cannot be called as Mature. Though you can have an EV stock as part of your core portfolio, the advice here is not to have only stocks picked from Under matured industries.

Portfolio diversification: When building a core portfolio, identify 4 – 5 sectors and pick good quality stocks in these sectors. When doing this, have a guideline not to invest more than 5% – 10% in any single stock in your core portfolio.

When picking stocks for core portfolio, choose companies that are higher in value chain than the lower ones. For example, a Tyre company or a company that makes wiring harness for vehicles are lower down in the value chain (B2B) than Maruti who sell to customers (B2C). B2B companies have less bargaining power than those who buy from them when there is perfect competition. Reference: Read Porter’s 5 forces model to understand this better.

Patience: Once you have done research and picked a stock for your Core portfolio, stick with it. At some point in time, some stocks in your Portfolio can be red. We will deal later with how to pick a stock and the basic research you should do. Unless there are clear fundamental shifts in the reasons for which you chose the stock, don’t get disappointed or indulge in panic selling. Remember, we are speaking about long-term investing here.

Schematic risk vs reward curve
Schematic risk vs reward curve

Understanding the Risk Reward curve: As you can see in the risk-reward curve, direct equity investment if done right carry a higher reward and hence higher risk as well compared to other investments like FD’s or Mutual Funds. As an investor ages, you should come towards the left side of risk curve. For example, you can invest more in Mutual funds and Direct equity when you are in your 30’s while the focus should shift towards safe instruments like FD’s and debt funds in your 60’s.

Conclusion: Building a Portfolio is a long-distance journey. The above guidelines on Portfolio building should hold you in good stead. Good and consistent research on identifying stocks that will form your core portfolio is of paramount importance {80% of job done}. We will deal with the subject on how to identify good stocks in the subsequent articles.

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