Why building a stock portfolio is like buying a car

One of the requests I receive most often from blog readers and newsletter subscribers is to help them in building a ‘good’ stock portfolio. Many think that this is a trivial task. All they need is a list of ‘good’ stocks to buy. It is not that simple. A portfolio is not a ‘T’ shirt with a ‘L’ written on its label that will fit 90% of investors. It needs to be custom-tailored for a near perfect fit, to suit each individual investor’s background, experience, financial commitments, risk tolerance, and future plans.

But the real problem lies elsewhere. Most young investors can spare Rs 1 - 2 lakhs. Some have recently started earning and can only spare Rs 3000 – 5000 per month. These are insufficient amounts for building a ‘good’ stock portfolio. So, I use the analogy of buying a car.

One doesn’t go out and buy a car – specially if they have just started earning. Some prior planning is required. (Car loans are readily available nowadays, but the EMIs can burn a big hole in your pocket.) A better option may be to buy a scooter or motor cycle for immediate transportation needs. Even then, you need to learn the rules of the road, and get a driver’s licence before you buy anything.

Unfortunately, there is no licence required to invest in the stock market. Most small investors jump into the market without any knowledge of the basic rules of investing. No wonder their stocks crash and they suffer heavy injuries (to their savings). Grow your capital by regularly investing in fixed deposits, recurring deposits, PO MIS, ETFs, mutual fund units till you have sufficient capital to buy a ‘good’ car.

Can’t you buy Rs 3000 – 5000 worth of stocks every month? Yes, but which stocks? You can’t even buy 10 shares of Tata Steel. So you’ll probably buy 100 shares of Suzlon instead, or worse still, 800 shares of Cranes Software! Your risk of loss will increase proportionately. You are far better off investing that amount of money every month in a ‘good’ fund like DSPBR Top 100 or HDFC Prudence. After 5 or 6 years of regular savings, you may have sufficient capital for a ‘good’ portfolio.

How much is sufficient capital? I suggest Rs 5 lakhs as a bare minimum. Rs 10 lakhs is a more reasonable figure. Can’t cars be bought for Rs 1 - 2 lakhs? Yes, they can. But they won’t be ‘good’ cars. How about a used car? That may work, but is likely to require regular trips to the service centre for repairs. And you really can’t be sure if a used car is really a ‘good’ car. The previous owner may not have driven or maintained it properly.

Even with Rs 5 lakhs, you will only be able to buy a decent entry-level car. But if you are ready to spend Rs 10 lakhs, then your choice of ‘good’ cars increases significantly. And if you own a Rs 10 lakh car, chances are that you will take good care of it by following scheduled maintenance procedures, getting repairs done promptly, adding accessories that will enhance your driving comfort and experience.

A ‘good’ stock portfolio needs sufficient capital, and has to be nurtured and maintained as well – by keeping track of market happenings, individual stock results, using opportunities to book part profits or add more on dips. The emphasis should be on safety, and not about driving/investing recklessly.

Why Indian investors should look at Emerging Market ETF charts

Indian investors have been worried about why the FIIs are pulling out of emerging markets and redeploying in developed markets. Some say that the relative valuation difference between emerging markets and developed markets is the real cause. Others are of the opinion that this is not a flight of capital but routine profit booking. There is another school of thought: the turmoil in North Africa and the Middle East has pushed up oil prices and made emerging markets riskier.

There is no doubt that FII selling in emerging markets has affected the Indian stock market indices. The series of scams – be it the inflated costs for the Commonwealth Games, or the telecom 2G spectrum allocation, or the various scams involving real estate development – seems to have shaken the confidence of the FIIs. The rising inflation rate, leading to a steady rise in interest rates, has increased the cost of doing business.

When and how will this situation get turned around? Politicians, government officials and the real estate mafia are not going to turn into honest and law abiding citizens overnight. Nor can inflation be curtailed by pressing a button. Who knows where the Middle East turmoil will be heading? In other words, the uncertainty overhang can not be wished away. And stock markets hate uncertainty.

Is the current fall in the Sensex and Nifty 50 a good buying opportunity? Will prices become even more attractive if one waits? How can an ordinary small investor decide what to do in uncertain circumstances? When fundamental analysis can’t provide clear answers, one has to look elsewhere.

Given below are the one year closing charts (in blue) of two Emerging Market ETFs traded in the US market – the iShares MSCI Emerging Index ETF (EEM) and the Vanguard MSCI Emerging Markets ETF (VWO). Superimposed on the two charts are the BSE Sensex chart (in green) and the S&P 500 chart (in red):

Since both the EEM and VWO ETFs track the MSCI index, their chart patterns are similar. The BSE Sensex was the clear outperformer during the period Jun – Nov ‘10. EEM and VWO ETFs caught up and outperformed the Sensex during Jan – Feb ‘11, even as they corrected down. Percentage profit booking in the Indian indices exceeded the selling in the MSCI emerging markets index.

During Feb ‘11, the S&P 500 has been the outperformer, but the gaps between the S&P 500 and the two emerging market ETFs are reducing. It is interesting to observe that the recent rallies in EEM, VWO and the Sensex have coincided with profit booking in the S&P 500.

Indian investors would do well to track the EEM and VWO ETFs for signs of FII investments returning back to emerging markets. Without FII buying support, the Indian markets are not going to move up any time soon.

Notes from the USA (Feb 2011) – a guest post

Sitting in India, we tend to become obsessed with what is happening to the Sensex and Nifty. Specially when both indices start heading south. Part of the reason for the recent corrections in emerging markets, including India, is the flight of FII money.

Far away in the USA, KKP can be more objective about investing in global markets. In this month’s guest post, he looks beyond the BRIC (Brazil, Russia, India, China) nations to other markets on the growth path. May be it is time for Indian investors to start developing a global outlook as well, to improve the total returns on their portfolios.

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What Next After BRIC? 

So, we all feel that the organic and FDI (investments) in India and China is the end game, right? Wrong. We know that there are frontiers beyond that, and even though India and/or China will be the next super-power of the world, there will be growth in other regions of the world that we need to focus on to keep our investments earning higher returns. We have to, therefore, teach our children to be open minded not just to the ‘change’, but more importantly to the ‘rate of change’ going on in this world. This will move ‘preferred’ investments from one country to another, or one region to another, or as this article points out, from the favourite BRIC’s to the Frontiers! What does that mean? Lets look into it…

We all know the BRIC (Brazil, Russia, India and China) countries, and the tear that they have been in the last 10 years. Lets talk in CAGR terms (Compounded Annual Growth Rates), i.e. total return per year, compounded on an annual cycle.

BRIC in general have done 14.75% CAGR as of Dec 31, 2010. India has done 17.19% CAGR if you were wondering, but you know what – Indonesia did 26.74% CAGR in that timeframe. This is staggering. Being in the US, we have a choice to invest just about in any country through vehicles called ETFs/ETNs. These are a collection of stocks put together by one of the large brokerage houses or fund managers that invest in a basket of stocks following a particular index. So, now, consider Frontier Country ETFs to capture explosive growth in what I calling ‘new markets’. By the way, there are a slew of countries that we (as investors) have ignored for a long time…..although, the countries are not new at all. But the time has come, and that time is now. Here are the current list of countries that belong to this ‘general’ Frontier Country list with the ETF symbols (valid for US investors and informational for Indian Investors):

1. THD - Thailand
2. ECH - Chile
3. TUR - Turkey
4. VNM - Vietnam
5. IDX - Indonesia
6. EPU - Peru
7. ESR - Eastern Europe
8. GXG - Colombia
9. FRN - Diversified across frontier markets (one of my customers)
10. FFD - MS Frontier Emerging Markets Fund

These ETFs have been performing really well since Mar 2009, and it’s all been one way and hence it has been hard to find the best entry point. On any pullbacks, I personally will be interpreting it as a buying opportunity and starting to put some money (in SIP mode in USD) for long term investments. Keeping in mind that India used to belong to this group once upon a time, there are risks associated with each of them. They possess risks such as illiquidity, non-transparency, inadequate regulation, substandard financial reporting, and similar hazards. They are at the very edge of the investable public securities universe and along with high potential rewards, come high risk.

MSCI, which is a prominent builder of indices, recently announced their list of the frontier universe which includes the countries listed below. FTSE classified their list of countries slightly differently, but both lists overlap quite a bit.

FTSE classification, frontier markets list as of September 2010:

Argentina; Bahrain; Bangladesh; Botswana; Bulgaria; Côte d'Ivoire; Croatia; Cyprus; Estonia; Jordan; Kenya; Lithuania; Macedonia; Malta; Mauritius; Nigeria; Oman; Qatar; Romania; Serbia; Slovakia; Slovenia; Sri Lanka; Tunisia; Vietnam.

As of May 2010, MSCI Barra classified the following countries as frontier markets:

Argentina; Bahrain; Bangladesh; Bulgaria; Croatia; Estonia; Jordan; Kazakhstan; Kenya; Kuwait; Lebanon; Lithuania; Mauritius; Nigeria; Oman; Pakistan; Qatar; Romania; Trinidad and Tobago; Serbia; Slovenia; Sri Lanka; Tunisia; Ukraine; United Arab Emirates; Vietnam; Bosnia and Herzegovina; Botswana; Ghana; Jamaica; Saudi Arabia.

Here is the performance of the Guggenheim Frontier Equity ETF, which is one of the few choices available today. Since this concept of Frontier countries is new, there are not too many funds out there that do this investment, although many ETFs include them in their Asia funds or Latin America fund or even Eastern European funds/ETFs. I happen to like Guggenheim investments since they have been a good customer of mine in the technology world, and have done a lot of technology upgrades within their infrastructure to enable the fund managers to do their job well. Now, that does not necessarily mean good investment results, but they also happen to have great investment results relative to their peers. Guggenheim services a set of private clients who we would call the filthy rich families, i.e. ones with more than $10M in Net Worth!

As you can see from the performance, I rest my case, and even though I have woken up a bit late to these investment type, I think these are young, dynamic, and real-growth-engines that will see their middle income earners grow within their own countries, and provide some real contributions to their own GDPs. Where there is return, there is risk, so while bearing that in mind, one has to invest only a portion of the portfolio and manage the overall risk. When the overall geography turns sour in a bearish environment, I am sure these markets will go down faster, bearing a higher volatility factor than the average. Just another chink in the armour that I am now providing to you to include and manage as you think about future-proofing your portfolio with an ultra positive return kicker!

What do you think?

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KKP (Kiran Patel) is a long time investor in the US, investing in US, Indian and Chinese markets for the last 25 years. Investing is a passion, and most recently he has ventured into real estate in the US and also a bit in India. Running user groups, teaching kids at local high school, moderating a group in the US and running Investment Clubs are his current hobbies. He also works full time for a Fortune 100 corporation.