Free Press Journal

The basics of building a defensive stock portfolio


As black swan events become too commonplace in the equity market, here’s the lowdown by Aditya Parikh on how to build blocks of a defensive stock portfolio

As the age of volatility dawns, our financial times seem to be punctuated by words such as Trump policies, demonetisation and Brexit. Hapless equity seems to be ensnared by the newest pied piper in town- disruption. And the phrase brace for impact has leapt into the financial lexicon. In such times, maintaining a strong defence is as important as an aggressive stance.

Change is the only constant in a volatile world. So it’s important to know when to morph an aggressive portfolio into a defensive one, till the tides change again. A defensive portfolio in many ways is the simplest and hardest to build. It’s simple because, one really needs to just stick to the basics. It’s hard because, most never do.

Strong foundation
When making a concrete building, the foundation is the most important. Get that wrong and the fanciest of buildings might bite the dust. For the lay investor, it’s about getting the basic structure right, it’s about laying the foundation well. Once the basics of a defensive portfolio are in place, the rest becomes easier to achieve. Knowing a few basics can help place that first concrete slab well.  First of all, diversification- it’s loud, clear and non-negotiable. The basic risk needs to be spread over at least two components- number of stocks and number of industries/sectors.

There are various financial theories around how many stocks are adequate to reduce risk. Though the consensus over a magic number still eludes, the number 30 seems to have gained some traction. In popular financial theories by Benjamin Graham and Fisher and Lorie, the number 30 found mention. Also, the well known BSE Sensex is made of 30 stocks, while the NSE Nifty is 50. So a number around 30 could be a start point.

Diverse options
The second component of diversification is equally essential- diversify across industries/sectors. If one picks 30 stocks at random, it’s like throwing darts at a board, hoping something sticks. So there needs to be some method to the madness. Instead, if one picks, after researching about 10-15 industries/sectors, this spreads the risk further. This would give one about two or three stocks per industry in a 30 stock portfolio, adding a little more depth to that diversification.

Don’t forget to research
Thirdly, researching what you buy. Since you don’t buy goods without inspecting them, don’t buy a stock without researching it. Understanding the company financials and the business plan is a must. Since it’s a defensive portfolio, the financials need to be seen from a prism of conservatism. The financials need to be studied for stability of cash flows and the stability of the company’s earnings.

Also, companies with low debt and high cash reserves are usually better equipped to handle volatile times. Further, businesses that are pure-play or specialists are sometimes better than over-diversified companies, as the business plan and cash flows are easier to understand. Management is that qualitative aspect that can make or break a company; it’s the ‘x’ factor. If the management has carried the company through a few economic cycles smoothly, extra points for that.

After deciding the number of stocks, the number of industries and then finally zeroing in on the companies, comes valuation. Pricing and valuation can be one of the most confusing areas of finance. There are reams of data and theory on this and one can get completely lost. Valuation is the alchemy of art and science. Brokerage research reports and the stock exchange websites are good ways to start understanding the valuation aspect better. An alphabet soup of  words like PE, Market Cap, interest coverage ratio etc. will be thrown at you and it’s confounds most.

First, ask your investment advisor or stock broker to explain it to you in plain English. Though these words sound like esoteric jargon, they can easily be broken down and simplified. Two, mainly stick to fundamental analysis i.e. understand the Balance, Profit & Loss statement and other company financials and ratios, before jumping into any other valuation metric. You are making a defensive portfolio, which normally means it’s not short term speculative investing. It’s not a very high churn. The idea is to study, buy and hold for the mid-to-long term. So, fundamental analysis usually trumps technical in this form of investing.

Amount matters
Fourthly, diversification and spreading risk doesn’t just stop here. When to invest and how much to invest are questions that too need to be answered. Investing the entire money at one go, puts one at the risk of trying to time the market. The best fund managers, many a time, have not been able to time the market. So, trying to time the market is sometimes a fool’s errand.

Rupee cost averaging or Systematic Investment Plan (SIP) reduces the risk of timing the market. So, starting a simple SIP and spreading the money over a long duration, negates the need to time a market. Discipline here is a must, several times during the course of investing it will be tempting to make a big audacious bets. But a high risk- high return strategy can be counterproductive when building a solid defensive portfolio. Stick to an SIP and marry discipline. The bulls and bears both waltz with the stock market. And, greed and fear both whisper sweet nothings into the ear of the market. Sometimes we need to listen to greed, and sometimes heed fear. In these unchartered times, fear is a not a voice to be ignored.