Why do we add a new security to our portfolio ?
To reduce risk and ensure not all our eggs are in same basket, the underlying thought process is if stock A doesn’t do well at least stock B will provide some returns and compensate for loss if any in stock A
This makes perfect sense if you go by what Harry M. Morkowitz said in 1950’s [emphasis mine]
The investments have different types of risk characteristics, some caused systematic and market related risks and the other called unsystematic or company related risks. Markowitz diversification involves a proper number of securities, not too few or not too many which have no correlation or negative correlation. The proper choice of companies, securities, or assets whose return are not correlated and whose risks are mutually offsetting to reduce the overall risk
It explains why investors invest in diverse spectrum of industries whose fortunes are not tied to each other
However many investors feel discomfort in adding a new company from a similar industry, At least I do. My thinking process is I already own TCS what the use of adding another IT company in the portfolio ? After all the company related risks faced by TCS and any other large IT company would be same
Over years I have found this is a flawed way to think about diversification, what we need to focus is to select companies whose return are not correlated and in many cases they could very well be in same industry. Let’s take example of the following companies in pharmaceutical industry
1. Ajanta Pharma
2. Suven Life Sciences
3. Granules India
All three of them have varied business model which is in turn is their source of uncorrelated returns, see the chart below which is a very simplified model of Indian pharmaceutical business adapted from this article
Now also look at the simplified version of focus area of above three companies
But, unfortunately, only few are effective cheapest viagra djpaulkom.tv with no side effect. Some ingredients in these capsules have mind-alerting ingredients, resulting in low stress levels and cialis canadian pharmacy http://djpaulkom.tv/master-of-evil-coming-soon/ enhancing mental endurance. Don t crush or break the medicine. viagra levitra Herniated disc is levitra cheap online a condition mostly related to the loads. Even though all three of them are in same industry (and hence would be affected by few common input variables) still large part of their success would come from their continued success in their chosen areas of focus
So if you have Suven Life Sciences in your portfolio which is in contract research and manufacturing company serving regulated markets then by adding Ajanta pharma which is a speciality pharmaceutical company engaged in development, manufacture and marketing of finished dosages in unregulated markets you are diversifying your portfolio
What is risk of adding too many companies of same industry ?
The focus area snapshot is a point in time, as companies operate in same industry they would want to make inroads in others focus areas especially if the area is lucrative
e.g.
Ajanta pharma is entering regulated markets while on other hand Granules wants to get a larger pie of revenue from its CRAMS joint venture and formulations segment, risk is as these companies become large the boundaries of their focus areas would expand and not remain mutually exclusive thereby their returns would start becoming correlated
How do you think before adding another company from same industry ? Share in comments
Disclosure – I own all three companies in my personal portfolio and above post is not a recommendation to buy
Does it mean that Suven which is into CRAMS and ‘Innovators’ field (which should be the most profitable segment – other than of course, unregulated market), would eventually give a better profits than Granules and Ajanta or at least better than Granules ?
No doesnt mean this each of them have chosen a different path to progress
I understand that they all have chosen different path to progress. But which ‘path to progress’ (I call it ‘strategy’ or ‘strategic direction’) would yield better profitability given that they will be efficiently able to execute the strategy (which is basic assumption for all the players).
So in nutshell, assuming that all the players will be efficiently able to execute the strategy, which strategy will give better profitability ?
In my case, I have massive exposure to the Indian cigarette industry – ITC and VST Industries. I own VST Industries for the generous dividends which I deploy to other equities/funds and ITC for the fact that it is transforming itself into a FMCG Major (excruciatingly slow that approach may be).
Risks of this approach ? Plenty – The war the Central and State governments wage on legal tobacco products while not taxing bidis and turning a blind eye to smuggled cigarettes, the declining rate of smoking , lawsuits ,the pricing power not adequately compensating for the decline in volumes etc.
Why do I still hold these stocks then ? Primarily , this is nothing new from what we observe for other tobacco manufacturers across the world. Cigarette stocks have been some of the best performers since the 1960s ( whne the risks of smoking were first brought public) primarily due to perpetual undervaluation , hefty dividends and reinvesting of those dividends bringing forth even more dividends.
Will history repeat in India? Maybe not , but it certainly has a good chance to rhyme :). And what is equity investing if not investing in probabilities?
Interesting take!