My portfolio is now a certified zoo. Although the bulk of my portfolio is in the top 10 holdings, I still hold several stocks which are not as attractive. I initiated a clean up few months back, but it is not as easy as i thought it would be.

How did I get here?
I have always had this problem to a certain extent – call it the teenager syndrome 🙂 – I fall in love with a different girl every month. The problem is that although I fall in love with new girls, sorry stocks, I have refused to let go of the old flames.

Some old flames are worth holding. Companies like asian paints, crisil and Gujarat gas are part of my core portfolio now. They may become overvalued from time to time, but they have phenomenal business models and great competitive advantages. These companies, if bought at the right price, are likely to give great returns over a period of 10 yrs.

The same is not true of several other stocks in my portfolio such as bharat electronics, Honda siel power products or novartis. These are companies with decent economics and fair management. It is just that they are not as attractive, both from a valuation and future performance perspective – call them mediocre stocks (though decent businesses).

I have been too slow in realizing that these stocks, at current prices, will not give great returns going forward.

So what should one do?
The most rational approach would be to sell the stock when it is selling at fair value or when a stock with superior risk reward characteristics is available.

I have usually been able to do that fairly well when the stock is very close to fair value or if I think the economics of the business are no longer attractive (or I have simply made a mistake in understanding it). I have been slow in making a decision on stocks which land in a grey zone. These are stocks selling at a moderate discount to fair value and have average prospects.

An example
Let me illustrate with an example – Bharat electronics. I purchased BEL in 2008-2009 time frame at an average cost of around 850 and have been able to get 100%+ returns in 3 years including dividends.

These returns though decent, are not earth shattering. They are in line with the returns I expected from the company when I invested in it. This company has a near monopoly in the Indian defence market and should keep doing reasonably well in the future.

I personally think that the stock is around 15-20% undervalued and is unlikely to give not more than 12-15% returns per annum over the next few years. These are decent returns, but unlikely to get your heart racing.

The key to such stocks is hold them till the undervaluation corrects itself and then be able to dispassionately analyze the stock and exit , if there are better opportunities available

If you know, why not sell it?
Good question – call it the endowment bias or inertia, but I have been slow to react. It has also been partly due to the issue of opportunity cost.

For most part of 2010 and 2011, I have not invested more than 50% of my net assets with the rest being in cash as I have not found attractive enough opportunities. In such a scenario, a moderately underpriced BEL seems to be a better choice than holding cash. The downside of such a thought process is that soon the portfolio becomes a zoo and one’s mental space (list of stocks being tracked) becomes too crowded.

So whats the plan?
Sell – though it’s not easy to sell and hold cash. In addition, one also faces the risk of regret if the stock which was sold recently, has a run-up after that. Who said investing was easy?

In the end, however to keep my sanity intact and manage a reasonable list of stocks, I plan to bite the bullet and sell these kind of stocks.

I was having such a happy time!. The economy was growing at 8%, midcaps and small cap companies were showing great increases in profits and the stock prices were following suit. The India growth story was coming true and due to my brilliance in recognizing it, my portfolio was up a billion percent from the 2009 lows. At the current rate, I could have retired soon. Damn this inflation !!

I am joking and being sarcastic.

Investing in inflationary times
If you follow the talking heads on TV and the self appointed gurus, then according to them you need an investing strategy for inflationary times, one for recessionary times, one for summer and may be one when it is cloudy in Timbuktu. I am in a real sarcastic mood 🙂

We have people recommending gold, silver, oil and all kinds of commodities. The time to buy commodities was 2009 when the world economy was in a ditch and not when everyone and his dog knows that commodities have gone up by 50% of more and are approaching peak levels

So what should one do? I cant speak for others, but I am not doing anything different from what I have always done – indentify good companies and buy them at a margin of safety – with emphasis on ‘margin of safety’

I often get asked – Company XYZ is a good company and growing rapidly. It sells at a high valuaton, but then the future is bright, so why not buy the stock?

Do you notice the assumption here?

‘The future is bright’
No one knows about the future. That is as close to a certainty one can have (not withstanding the claims by the gurus on TV). Did the market know that the world economy would fall off the cliff in 2008 or that inflation would spike in late 2010?

So how does one guard against the future – by insisting on a margin of safety when purchasing a stock. I will not buy a stock unless it is undervalued by a decent margin.

But, I did buy at a discount !
You may have valid point, that when you looked at a company, it appeared cheap based on the last few years of data. I have seen most of the people analyze the last five years of data and make a decision. Even I did that a few years ago.

The problem with looking at a short history is that one can miss some part of a business cycle completely and not realize how the company will do in that period.

An example
Lets look at an example to illustrate the point. I recently analysed construction material companies – visaka and Hyderabad industries.

Following are the net profit margins for visaka for the last few years
2005 – 6.9%
2006 – 6.5%
2007 – 5.5%
2008 – 1.8%
2009 – 6.3%
2010 – 9.5%
2011 H1 – 8.5%

There are a few things which stand out. The company’s margins have fluctuated a lot of in the last few years between a low of 1.8% to a high of 9.5%. The first point of analysis is to dig further and understand what was driving these margins.

If one analyses deeper, one can see that 2008 margins dropped due to a spike in raw material prices in 2008. So that gives a strong hint on how the company will perform in an inflationary environment.

2010 was a high in terms of margin and growth for the company. It is quite possible to assume that the company has reached a higher level of profitability. However if you dig deeper, you will find that there is no a particular reason in this industry for any particular company to have a much higher margin than others.

In addition, the other major companies like Hyderabad industries also had a cyclical high in profit margin in 2010. So the demand supply situation was favorable for the industry as a whole and the company was enjoying a nice tailwind

The 20/20 hindsight
It is easy to be brilliant in hindsight. You may be thinking – now this guy is telling us that he knew what was coming.

On the contrary, I had no clue whether the inflation would go up or not. My approach is to look at the last 10 years of performance and arrive at the margin range. In case of visaka, I assumed 5-7% for the company. At a normalized 7% margin, the company did not look very cheap.

So now what?
Things are never as good or as bad as they seem. The market may be over reacting to this whole inflation thing and this in reality is a good thing as several good companies may soon start approaching attractive valuations.

The key is to indentify such companies beforehand and then wait patiently for the market to offer an attractive price. It may soon be time to open up the wallet