How to construct your portfolio is revealed by Aziz!

I get plenty of emails for portfolio reviews. I am amazed to see the list of stocks people hold in their portfolios. Last week I got an email of almost 35 different companies portfolio and he wants to add another 20 in them! I can tell something is not right over here. Why you need so many companies in your portfolio?

After having a word with few of my clients and asking their views in regards to this I found that it is fair to blame ‘Diversification’ for such behaviour. Even fund managers who manage millions of rupees stick to 30 – 40 companies! Even with that behaviour I am not convinced. It is time to re write the rules and understand how to construct your portfolio.

Let me assume that you have one lac rupees to invest in stock market. Betting on one hot tip can change your one lac into fifty lac or can wipe out whole of your capital. The option over here is to build a portfolio slowly and cautiously so that it beat the market return in long run. First it is important to recognise best businesses. We at Valueoperations call them as A1 Businesses. If you invest within those businesses when they are trading at discount to its intrinsic value that we do for our private fund operations, you will find yourself way up.

With one click of mouse, my team and myself can filter all A1 businesses from around 1400 listed on National Stock Exchange (NSE). If you narrow down your search then there are around 40 – 70 businesses that qualify for our A1 quality. If you filter further to find how many trade below its intrinsic value then the number comes around 20.

The simplest way to construct the portfolio will be to invest 5000 rupees in each stock that is giving margin of safety. But that is not the way we work in our office.

Traditional portfolio theory suggests it is advisable that investment should spread between the uncorrelated and an unrelated industry, then the chances of any single investment causing permanent and unrecoverable capital loss is reduced. Diversification therefore reduces risk. But same time spreading your investment you know nothing about also increases your risk. If you diversify your money in 10 bad stocks then still the goal of your diversification is not achieved. The risk is not omitted from your portfolio.

I don’t remember where I have read but there is a saying that, ‘ you can’t have a baby in one month by getting nine people pregnant!’ this is true for traditional blue chip portfolio. Portfolios of ‘C’ or ‘B2’ quality companies from list will not produce amazing result over the long run, so diversification won’t offer any benefit. Charlie Munger (Warren Buffet’s partner) once said that, “ if you mix raisins with turds, they are still turds.”

Assuming you buy extraordinary businesses, the greatest benefit of diversification occurs when you increase your holding from one extraordinary business to two – not two banks or IT stocks. The less correlation within the stocks the less volatile your portfolio will be and as a result the risk lowers down by adding stocks. The constraint we face over here is that this benefit starts fading around 10 –12 stocks.

For example, we think Infosys and TCS are A1 quality business. Both are trading at discount to its intrinsic value. We think intrinsic value of Infosys will rise by 16% next year and TCS intrinsic value will rise 19% for next year. Which one would you prefer? Will you buy both? I would prefer TCS to Infosys if TCS were trading at steep discount then Infosys.

So do we invest ten thousand rupees in ten different stocks? There is a simple formula while investing: the higher the price you pay the lower your return. The lower the price you pay for extraordinary business the higher the return.

Lets get back to the 20 extraordinary businesses. If you know that company is trading at great discount to its intrinsic value then others it is better to invest more in that to generate super profits for your portfolio. It makes sense to weigh your portfolio according to how far each stock is trading from your estimates of intrinsic value.

It is perfectly acceptable to invest your one lac in 10 different extraordinary business or 12, as there is plenty of diversification you would have achieved. And if you find any extraordinary business that is generating return on equity of 80% and it’s trading at discount to its intrinsic value and is expected to double its intrinsic value next year then it is worth to invest 10% of your total portfolio in that business.

If you know what you are doing and can identify A1 businesses trading at steep discounts to its intrinsic value then broad diversification of 30 –40 stocks in your portfolio makes no sense. It does not make sense to me too!

My team and myself have received many emails regarding this A1 service that we are going to launch very soon. Many questions like, is it a paid service? What is the cost of service? Will that service be helpful to me? And many more such questions.

Let me tell you first about service. We are working hard to filter those A1 stocks from the pile of 1400 available to invest and will be sharing intrinsic value of them as per our model. You will have the opportunity to access all that information by click of mouse as I have right now. Also you will have access to explore more about the business and understand them. All the information will be updated in timely manner and will be discussed within the group in detail by my team and myself. We promise we will be there with you whenever you need our expertise.

This will be a paid service. It will affordable even for a person managing 25 thousand rupees portfolio! People who have seen it are saying, “ Quality information at affordable price” and “ any serious investor in equities can’t take risk of ignoring it”.

This service will be never given for free trials or any discounts in future. The only way to get discount for this service is to subscribe our blogs and become founder member now and when it is released for general public you will be treated as founder members and will receive the benefits. So keep checking your email everyday, as very soon you will find pre registration email from my team for you!