Investment strategy: Accumulating large-caps, timing momentums

The sharp decline in stock prices since January 2008 has left many wondering as to whether the market will ever climb up. Such gloom and doom is part of human nature. We always swing from bouts of optimism to spells of extreme pessimism. As the saying goes, greed and fear drive asset prices. And it is fear that is currently gripping the market. Several investors asked us the optimal strategy that they should adopt in current market conditions.

This article attempts to answer this question. It acknowledges the fact that not all investors and analysts are competent to find the market bottom. Small investors should, hence, consider accumulating large-cap stocks in their core portfolio. The satellite portfolio could primarily carry cash and some momentum stocks to moderate and adapt to investors’ emotional biases.
Accumulating inside core

The core portfolio contains large-caps and represents the long-term component of the total portfolio. Investors could now consider buying large-caps for their core portfolio. It is important to remember that the core portfolio is about value-investing, not market timing.

Suppose an investor with Rs 20 lakh wants to construct a portfolio that has two constraints. One, the portfolio cannot have more than 2 per cent risk exposure to a single stock. And two, the portfolio will have a sector cap of 20 per cent.

Now, suppose the investor decides to buy Tata Motors at Rs 400 but does not want to hold the stock if it closes below Rs 300. The capital-at-risk is Rs 100 per share and Rs 40,000 for the stock (2 per cent of Rs 20 lakh). This means that the investor can only buy 400 shares (Rs 40,000/Rs 100). The investor may, of course, overweight or underweight a stock in the portfolio.

The optimal strategy is to accumulate stocks (buy in tranches) at the current level. This strategy acknowledges the fact that the objective is not to engage in tactical asset allocation (or market timing). Rather, it is to simply buy value stocks at various price points.

This strategy allows generously for downside risk — the risk that any stock could decline after it has been included in the portfolio!

It is important to understand the difference between accumulation and downside averaging. Accumulation is buying the budgeted 400 shares of Tata Motors at prices ranging from, say, Rs 425 to Rs 350. The investor will not buy Tata Motors thereafter, even if the stock were to decline further. Downside averaging is about sinking more money into the stock even after buying the budgeted 400 shares. Such a strategy is harmful for the portfolio.
Cash is king?

The satellite portfolio carries short-term exposure to momentum stocks. Such stocks are easy to pick in a trending market. The current market is hardly one. So, generating higher returns from this portfolio may not be possible for now.

Investors should, therefore, consider holding cash equivalents in this portfolio till there is a confirmation of an uptrend in individual stocks. But all of investors suffer from emotional biases. One such bias is the need to trade regularly in the market and to expect cash-flows into the trading account.

To moderate and adapt to this bias, investor may allocate not more than 25 per cent of their satellite portfolio to take active bets in the current market. It is best to take such bets with strict risk management rules.

Sophisticated investors can also trade on shares “borrowed” from their core portfolio. Suppose an investor has a view that Tata Motors will find near-term resistance at Rs 500 and near-term support at Rs 370. She can let her satellite portfolio “borrow” half the number of shares of the stock held in her core portfolio and trade on them. The profit/loss on the trade will go to the satellite portfolio and the stock, back to the core portfolio.

Care should be taken not to indulge in this strategy. The reason is that portfolio will be exposed to risk if the stock does not decline and instead moves up.

Often, investors will be reluctant to buy back the shares at a higher level. This will lead to sub-optimal allocation of the core portfolio.
Conclusion

The core-portfolio should not hold more than 10-12 stocks. It is preferable to hold not more than five stocks in the satellite portfolio at any point in time. It is important to buy sector leaders in the core portfolio as such stocks provide good upside potential when the market turns after a corrective phase.

Finally, investors should remember this if nothing else. It is sometimes optimal not to trade at all in the satellite portfolio. And most of the times, it is better to ride the trend than move against it. Taoists call it Wu Wei.
Source : The Businessline dt. 20 7 2008