Stock selection has been glorified over the years as a skill chased by all, but mastered by a select few. What to stocks to invest in is often also one of the first questions asked when discussing investments - the classic ‘koi tip hai?’ never dies.
But neither the tip-givers or takers fully understand why they are investing in a certain business, what the dynamics are and what the moving parts of that stock are. It does, at the end of the day, require in-depth research and a thorough understanding of the economy, industry, company and valuations.
The question non-existent amongst amateur investors is of sector allocation. And on the contrary, to any professional fund/portfolio manager, the first concern is always sector allocation. Why is this so important?
Sector allocation > Stock selection
Say you invest in Company A, which is fundamentally strong, is a blue-chip, has a sound track-record, dominates its space, has been exhibiting decent growth, doesn’t have debt, has strong cash flows, is run by a good leadership team, and is also priced reasonably. Seems like a no-brainer if you have read any material on stock selection.
And now let’s say the same Company A is in the IT Services industry. No matter how good the company is, how much better it is than competitors, and how liked it is by customers, it won’t make money if the sector isn’t doing well.
If the US falls into a recession, corporate earnings in the US get affected. Their ability to spend on IT reduces, and their IT budgets take a hit. Company A not only loses the amount of work, but also accepts lower billing since their top customers just can’t pay the same rate. But with staff in India, costs remain the same. Company A suffers from both revenue decline and margin contraction. It is not able to sustain the valuations it previously commanded. The stock falls, or at best doesn’t rise.
In this case, if the sector itself isn't doing well, no matter what, the company is not going make your portfolio outperform.
Using sector allocation to build a portfolio
A good approach to follow when building a portfolio is to follow a top-down approach. How do you go about this?
Look at what the Nifty 50 is made up of in terms of sectors. After all, you want to beat the Nifty 50 consistently in order to be doing justice to investing your money by building a portfolio.
Take a view / form an opinion on the sectors of the Nifty 50. Example: IT negative, Banks positive, Oil & Gas positive, Infrastructure positive, FMCG negative, and so on.
Decide on over / under weight on sectors depending on your view. Example: If the weight of FMCG in Nifty 50 is 10% and you are negative on FMCG, you will be under weight FMCG.
Essentially your exposure to FMCG from the above example should be <10%. It can be slightly under weight (8%), severely under weight (5%) or even so under weight that you hold 0% in FMCG. The percentage should depend on how negative you are on the sector.
Similarly, if you are super positive on Oil & Gas, you may want to allocate 25% of your money to the sector, against the 15% in Nifty 50.
You can then move to selecting the best stock(s) in the current scenario to allocate to your sector. If it’s Oil & Gas, you may have a view that you want to own Reliance because it’s the largest, and also has exposure to retail and telecom which you are also positive on.
If it’s Mota Bhai all the way, you could go 25% in Reliance. If you want to diversify, you could perhaps split the allocation between Reliance and ONGC (or some other PSU).
You can repeat the same process for other sectors and move towards building a portfolio.
Notice how we didn’t even talk about stocks till step 6, and you still got to building a portfolio rationally!
Why do this?
If you simply place your bets in the right sectors, and avoid the wrong ones, you will automatically beat the Nifty (of course, assuming a decent stock selection, even if it’s not the best).
To beat the Nifty, you needn’t be fully invested in the right ones, or completely avoid the wrong ones. You can just be heavily invested in the right ones and lightly placed on the wrong ones. The amount of excess returns will depend on how right you are, and how bold your bets were.
The process applies basic rationality and logic, and can make the otherwise seemingly daunting task of building a portfolio rather intuitive and successful. For example, you can just apply basic know-how to stay away from IT because of the US economy, or to invest in Infrastructure anticipating the government’s focus.
Why you may not want to do this
The approach requires you to be well-aware of what’s happening globally, at all times
Moreover, you also need to understand the basics of how each of these industries work to make good connections of developments with implications
Despite a simplified process, stock selection is still important! That again may be a tedious approach if you can’t invest time studying companies
With this approach, you would have to constantly move things around as developments take place
While there’s all the gyaan available on stock selection by finance gurus and noob influencers alike, a rather logical method to building a portfolio can work much better - at both generating returns, and having confidence in where you have invested.
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