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Equitymaster Portfolio: Revisited

Aug 24, 2002

The Oxford Dictionary's definition of investment is - the act or process of investing. Now, what is investing? To understand what is 'Invest'ing - the definition states that - (a) apply or use of money, esp. for profit (b) provide, endue or attribute. There are two vital points to observe from the definitions. Firstly, investing is 'application' of money that is hard earned for a profit (not to lose principal) and it encompasses providing or attributing money (in this context it is time frame).

After having understood the meaning of Investing, one of the first questions that arise in the mind of retail investors' is "Where should I 'invest' my money?" In this context there are various avenues ranging from National Savings Certificates to bank deposits. But since returns from such investments do not earn much over a longer term, especially when interest rates are falling, the most-favored and 'misunderstood' investment avenue is equities.

After having identified equities as a better investment alternative, the next question in a person's mind is "Which stock should I invest in?" Unfortunately the answer to this question is not quite simple and depends on a number of factors that includes risk appetite of the investor (i.e. Am I willing to forego my principal for higher returns?). We at Equitymaster devised a portfolio in 2000 to show the power of prudent investing and a clear diversification strategy. Our portfolio has been divided into three categories.

CORE:
These have been defined as stocks that can be held by investors across most age brackets and status. These stocks represent companies with very good management and strong financial performance over the years. One criterion that we applied to these stocks was how they fared in the recent downturn in economic activity. Other issues considered included - position in sector, prospects for the sector itself.

STARS:
Companies that have good managements, sound financial track record and good prospects but not without risks. These companies, to put it in a way, are not in the core list because there are certain issues that have made them more 'risky' than the core stocks that have been identified.

FLYERS:
This group represents stocks that have high risks associated with them. Nevertheless, they are in a situation where they can leverage on their present position (Zee for instance) to generate returns much in excess of their peers.

PORTFOLIO:
The number of companies in our portfolio comprising core, star and flyers are 44. Of this, there are 9 companies in our Core list, 17 stocks in the Stars category and 18 in Flyers. We allocated Rs 1,000,000 to each stock for equal weightage. Our basic approach towards selecting companies for our portfolio was a bottom-up approach because there are sectors like housing that continue to grow at a brisk rate despite a slowdown in the economy.

We had deliberately entered the buy price of all stocks as of January 1, 2000, the peak times during the tech rally to prove investors that even if one invests at high prices, investing in good companies with a long-term perspective can be fruitful. To put things in perspective, the buy price of Infosys as on that date was Rs 7,839 (Core), Aventis Pharma Rs 1,119 (Stars) and Telco Rs 217 (Flyers).

The next crucial question is, How has the portfolio performed when stocks markets have exhibited extreme volatility in the last three years?

The performance chart…
(% gain/loss) 1-month 3-months 6-months 12-months Since Jan`00
CATEGORY
Core -2.6% -2.0% -6.6% 18.6% 3.8%
Stars -4.5% -3.2% -6.5% 10.9% -21.9%
Flyers -6.5% -2.9% -6.8% 1.2% -27.4%
Portfolio -4.7% -2.9% -6.6% 9.5% -19.8%
INDICES
BSE Sensex -4.6% -3.3% -13.7% -6.6% -41.6%
CNX Nifty -4.8% -6.0% -14.3% 15.5% -38.1%
Nasdaq 7.9% -14.5% -17.1% -24.4% -63.9%
Dow 12.9% -10.4% -7.9% -12.3% -17.2%

Consider the performance of all the major indices like BSE Sensex, NSE Nifty, NASDAQ and Dow Jones since January 2000. While NASDAQ has fallen by as much as 64%, Sensex and Nifty are lower by 42% and 38% respectively. Dow Jones, on the other hand, has declined by 17%. Given this backdrop, we analyse the performance of each category.

CORE:
This is obviously an elite category that has proven track record, a creditable management and generate wealth for the investors. Commodity and FMCG stocks account for 13% and 31% of market value of core portfolio respectively. The rest is spread between financial institutions, energy and software sectors. Infosys is the only software stock in the Core portfolio.

Coming to the performance, of the nine stocks in this list, there are only four gainers viz. Asian Paints, BPCL, HDFC and Nestle. Buoyancy in housing demand and favorable interest rates has benefited both Asian Paints and HDFC over the years. While HDFC is up 94% since January 2000, Asian Paints has added 49% wealth to the shareholders. BPCL has gained significantly over the last two years on the back of disinvestment expectation. Nestle, despite a slowdown in the economy, has managed to outperform its peers.

Since January 2000, the value of Core portfolio has appreciated by only 4%. While returns may not be encouraging, one has to apply relativity theory to stock markets and gauge a trend. Also one has to keep in mind the buy prices. On the other hand, if one were to consider the performance in the last 12 months, the Core portfolio has appreciated by 19%, which is commendable by any yardstick.

We have also compared our portfolio's performance with three top mutual funds in the country. Barring Zurich India's Growth Fund, the portfolio has outperformed all other funds. This goes to show that prudent and diversified investment strategy does create wealth in the long run.

Comparison with Mutual Funds...
(% gain/loss) 1-month 3-months 6-months 12-months
Core -2.6% -2.0% -6.6% 18.6%
Stars -4.5% -3.2% -6.5% 10.9%
Flyers -6.5% -2.9% -6.8% 1.2%
Portfolio -4.7% -2.9% -6.6% 9.5%
Pioneer ITI Bluechip (Growth) Fund -0.8% 3.5% -5.3% 16.3%
Templeton India Growth Fund -3.4% 1.5% -6.3% 12.2%
Zurich India Growth Fund -1.2% 2.2% 1.4% 33.5%

STARS
This is a highly diversified portfolio comprising 17 stocks across the board. Auto, energy and pharmaceutical sectors account for 20%, 24% and 12% of market value of this bunch. Stocks like ACC, Aventis, Cipla, Colgate and Hero Honda find place in the Star category because of some risk element. While Colgate is a single product company, Hero Honda's agreement with Honda is expiring in FY05. Reliance also falls into this category because of management issues.

Of the 17 stocks, there are only six gainers since Jan 2000 that includes ABB, BSES, GAIL, HDFC Bank, Hero Honda and HPCL. Hero Honda clearly is the top performer. The stock is up 135% since Jan 2000, which goes to show how a strong and visionary management can add value to the shareholders.

Overall, given the medium-risk-medium-return profile of the stocks, the portfolio has been volatile since Jan 2000. However, it has managed to outperform all indices. Looking at the past one-year performance, the portfolio has gained 11%.

FLYERS
This is a high-risk-high-return portfolio. But as we have specified above, they are in a situation where they can leverage on their present position to generate returns much in excess of their peers. Select Tata Group companies like Tata Power and Telco find place in this group. Ranbaxy, MTNL, Grasim, HCL Tech, L&T, Pfizer and SBI are the other prominent companies in this list.

Of the 18 stocks, there are only three gainers since January 2000 viz. EIH, ICICI Bank and Tata Power. While ICICI Bank is the star performer of the group (up 79%), Tata Power is higher by 36%. Overall, the portfolio has lived upto its name with extreme volatility. The portfolio is lower by 27%.

A re-look at our portfolio
Even though we believe in long-term investing, it is important to review one's portfolio once in a year to analyse whether they have performed to their mark. If not so, what is the reason for the same? Not because they are not the flavour of the season anymore, but because of the fact that the company's management has failed to deliver, when situation demanded their best.

Downgrades
HDFC was the only downgrade this time. The stock has been shifted from Core to Stars. The housing finance major, despite its expertise and leadership in the sector, faces severe pressure on spreads in the near future. With PSU majors like SBI going overboard on increasing contribution from the housing loan division, HDFC market leadership is being threatened. The company's diversifications like insurance are long gestation businesses and returns may not live up to expectations. Keeping this in mind, atleast for the next two years, HDFC's profitability could be affected.

Upgrades
Dr. Reddy's and SBI are the two upgrades. While Dr. Reddy's has been upgraded from Stars to Core, SBI is promoted from Flyers to Stars. Strong performance in the generics business and the agility displayed by Dr. Reddy's management to move up the value chain is quite impressive. The company is fast emerging as a speciality pharma company. The company's research pipeline holds potential and there is better visibility emerging in the ANDA (Abbreviated new drug application) pipeline.

Meanwhile, SBI is revamping its business strategies, which is reflected from its speedy efforts in implementing technology and retail focus. It has also restructured its business and as a result productivity ratios have improved. Exit from select non-core businesses like mutual funds is also on the anvil.

The new ones
Gujarat Gas and IDBI Bank are the new inclusions. Both stocks were added to the Flyers category as IDBI's stake in the bank is the big negative and Gujarat Gas has limited supply constraints.

Conclusion
While making an equity investment decision, keep in mind that one is buying the business of the company and not its EPS alone. Warren Buffet in his annual shareholders letter 1998 wrote and we quote: "Our policy is to concentrate holdings. We try to avoid buying a little of this or that when we are only lukewarm about the business or its price. When we are convinced as to the attractiveness, we believe in buying worthwhile amounts."

Bottomline, be convinced and don't lose focus amidst the noise around you.


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