Given current level of pessimism in the market, I thought it was imminent to write this blog for all participants in the market. For some, this could be basic knowledge, for some this could help breathe and relieve stress, and for most this could be learning. Let us first look at the reasons why our market corrected so drastically?

In this write up, I will support my view while covering topics such as asset allocation, portfolio volatility and psychology. We must agree that our indices were overvalued with them trading at above 25 Price-to-Earnings, a danger zone given corporate earnings in 5 years have grown by single digit number. All it needed was a small prick from a needle to cause this downfall. Price-to-Earnings that high wasn’t sustainable and correction was expected. Some of the reasons for downfall include, the current government budget, NBFC liquidity crisis and cyclical slowdown in sectors.  The whole market has been bleeding since the budget. Foreign portfolio investors have run away from India and domestic investors are selling due to fear and panic. This has led to blood bath in stock market.

What surprised me was the depth of correction that was not foreseen. Apart from major blue-chip stocks such as HDFC, Infosys, TCS, Asian paints etc., most midcap and small cap stocks have corrected big time. Here are few questions I will address. Does this steep correction offer value? How can investors use the current market to develop portfolio?  How can investors grab the opportunity in the right way? We shall see all of it later in this article

Never chase individual stocks:

Can I get names of stocks that would go up 5x in next 2 years? These are some very wrong questions to ask. I agree, given current valuations, there are stocks that are available at bargain prices and will offers handsome returns as the market recovers. However, investors must focus on strategic asset allocation (rather than taking excessive risk in individual stocks) and build a portfolio for next 5 years or even longer time horizon. Putting all your eggs in one basket is silly and risky. I reckon investing in a diversified portfolio of 25 good businesses. I say this because even after careful analysis few of them may not perform as expected, and on an average you can expect more than market rate of return with reasonable faith in businesses bought.

Current psychology:

“Stock market is terrible, stocks market is gambling, stock market is bad for health.” I hear this often and it is not surprising that it comes from those that love being entertained by the news media. I repeatedly say stocks are businesses that sell in the market for a quoted price. It is our duty to identify good companies, buy them at fair valuation and stick with them for a long time. You can read my investment guide for more on this at http://mjkfinvestment.com/Research.

A month back I received a post on Whatsapp with the list of 70-80 publicly traded companies that went bust. Now all the perfectionist come out and talk about defaulting companies as if they run a business so perfect that they achieve 100% accuracy in what they do. Given the vast number of companies, some of them were bound to go bust due to competition, inefficiency and several other reasons. 

Is 70-80 companies going bust a lot? 

We have more than 5000 companies listed, that is less than 1% companies defaulting. It is our psychology to focus more on the bad than good. You will still hear stock XYZ lost 50% of its market value, but rarely hear that the underlying business of a stock ABC is doing extremely well or hear about stocks that gave 20% CAGR in last 10 years. Media loves spreading negative news and thus in turn pull down prices to a level an intelligent investor would like to grab the opportunity. Extreme pessimism can be spotted by how media portrays current stock market scenario. As Howard Marks says, 'Stock market swings from extreme pessimism to optimism and hardly spend time in between’. It is easy to identify times when markets are in Euphoria and investors must be careful in adding stocks in big amounts. Similar is explained by Warren Buffet, ‘It is better to buy when others are fearful and sell when others are greedy’. People behave the opposite and fail to buy during pessimism when stocks are cheap.

 Our market Nifty 50 (a portfolio of 50 stocks) has returned CAGR 15% with not all the stocks in Nifty performing well. Let me further explain this why a portfolio approach is desirable. My father bought shares into index fund in the year 2002 when it was at 1000 and today index is at 10,800. This is 15-16% CAGR. At this  rate your money doubles every 5 years. He did witness of 2000 tech boom, 2008 housing crisis and 2015 major correction. Despite all this he stayed invested. Congratulations to him, he did not get swayed by daily market gyrations which is the most difficult aspect of stock market investing. To see index fall from 12,000 to 10,000 should be no big deal for investors with a very long view.

Let me show you the drawdowns weathered by a very famous Indian investor. Most would guess him. 

His journey from 0 to 100 crores came with 50-70% drawdowns. Despite this he stayed invested in his portfolio of good businesses and compounded handsomely. Even the best investors like Warren Buffet has seen 50-80% correction in their companies. Despite this, how did they make money? Right Asset allocation and Portfolio approach! In fact, Warren Buffet and other prudent investors were busy deploying cash during the downturn.

How to create a portfolio?

Begin by not putting all your eggs in one basket, but also do not make a mistake of not putting major weight on your top ideas. Companies that you have high conviction deserve greater weight and those that you have less conviction can have lesser weight. Focus on having top 10 ideas weight 50-60% of portfolio. It is much easier to find great companies than to juggle with risky companies. The allocation to such companies will have lesser weight and therefore lesser impact of heavy drawdowns. However, these are equally important in portfolio as they can improve and become large companies going ahead. Turnaround stories are a must. I will soon have a summary of the book, ‘One up on Wall Street’ and Peter Lynch’s strategic allocation where he talks more about portfolio construction. 

If you are a passive investor who cannot research full time, you must approach an investment advisor to create a portfolio with right allocation as per your risk willingness and ability. I believe in active investing due to inefficiency in our markets and there are many small cap companies still uncovered and big opportunity lies there.

To conclude,

Don’t be disturbed by market gyrations. Focus on building a portfolio or buy the ones that already exists in the market. Use your own risk and return objectives to form asset allocation. Include bonds if you desire less volatility. For families that are gold lovers can have some asset allocated to gold. I am not a big fan of gold investing, but I do have an opinion to not exceed 5% of your networth. Add to small caps and riskier stocks only when you have a very strong base of assets or a huge corpus. Keep in mind, when a small cap or mid cap become a large cap, a lot of wealth can be created. Believe that is where the real juice is to chase abnormal profits. For any further questions.

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