A prudent portfolio

[Many people told me that they are "kind of getting the hang of things" that matter in investing but they don't know where to start and how to start. They are afraid of losing their capital in their maiden attempt. While sharing the knowledge, data and analysis helps people, sharing real life examples is a real morale booster. That's why I'm sharing with you a story of a small portfolio]

Four months ago, I created a portfolio for Seema partly as a token gift to her for her excellent work as editor of Unfair Value and partly to prove to her that value investing works, even during slowdown. Women are a difficult lot. They need proof. They need constant reinforcement even for the things they keep in a jar labeled "Truth". So you can guess that the odds were stacked against me.

As I have said in the past, the investor is a key variable in the equation of investing. It is impossible to give a specific advice without knowing whom you are advising. After discussion with her, I listed down the things that were important to her. (1) Capital Protection (2) Regular Income (3) Investments in domains within her circle of competence (4) Scope of long term appreciation (5) Low volatility

The investment characteristics you would look for in candidate companies for such a portfolio will include companies which are financially strong and entrenched in their respective industry segments. They have a healthy cash flow and low capital requirement enabling them to pay liberal dividends. For capital protection, they should be quoting at discount to their real support levels like book value and discounted cash flow value. Volatility is something that is beyond an investor's control and the only thing you can do is to diversify. At the same time, I wanted to keep the portfolio limited to things she knew about, i.e., regular day to day use products and services.

The interesting aspect was that the list of her objectives was different from mine. Low volatility and regular income don't rank high in my personal list. Also, I can choose from a much broader field due to my understanding of various industries based on the knowledge accumulated over many years. Then the size of the portfolio was small which meant that I could invest in much smaller companies than I usually do. (I limit myself to only large companies, typically top 200, because I don't feel comfortable putting large sums into small companies and I want to limit the number of companies in my portfolio to less than 20).

During the editing of previous issues, we have had discussions about Castrol and Gujarat Gas, which made her comfortable with the sectors these companies operated in. I chose Indraprastha Gas for her due to her familiarity with the company and the dividend payout being higher. At that time, banks were selling at really dismal valuations with doubts about solvency of some large private banks. So I chose a PSU bank, Oriental Bank of Commerce, with high dividend yield, low NPAs and low price to book value. Then I added 3 small companies, Mahindra Finance, Venky's and Hawkins. These 3 companies were interesting in their own ways and met the criteria I had set forth.

Hawkins is a 50-year-old brand of pressure cookers which has sold 3.59 crore pressure cookers since its inception. It is very well entrenched in the market. They sold 20.6 lakh pressure cookers last year. The company earned a return on networth of a whopping 56.33% in 2008 (which rose to 81.8% in 2009). Its dividend payout ratio (dividend/EPS) had been in the range of 47% to 66% which showed that the company needed very little additional cash for growth. It was easy to analyze the company. If you have ever bought a Hawkins pressure cooker, you know the company. Interestingly, a pressure cooker as a product is immense value for money. It can pay for its cost within months by saving fuel. Not surprisingly, it is usually the first big ticket purchase for a very poor family when their lot improves (a cycle comes next).

Venky's is a company I got interested in during the times of the bird flu. Contrarian that I am, I was happily relishing roasted chicken when flu fear stricken denizens of the mortal world chickened out. I wanted to buy Venky's below cash but I failed. In the process I read about hatcheries, broilers, production of eggs and emerging trends in packaged meat. Their pathetic looking website (worse than Berkshire Hathaway's) had loads of interesting facts if you can find tem (like nine of every ten eggs consumed in India are laid by BV 300, a layer developed by Venky's. A layer is a hen, bred specially for laying eggs). The company pays good dividends and it was selling at a discount to book value.

Mahindra Finance is an NBFC which is quite strong in rural finance. The workings of rural finance are very different and banks lack the infrastructure and will to tap the opportunities. A Mahindra Finance employee has to ride his bicycle for miles before he reaches a village to collect EMI. At times the EMI is paid in one rupee coins. Defaulting on the loans is a matter of losing pride in the village and that keeps the NPAs low. The company also piggybacks on the growth in vehicle sales of its parent, providing financing of tractors, jeeps, autos and yes, Scorpios and Xylos.

Now the results of the portfolio. The outcome is quite satisfactory so far. The portfolio gave her a dividend yield of 6.06% which is the same as the after tax yield available on fixed deposits. The only source of volatility for the portfolio has been its rapid advance. It never went below the invested capital.

Company	Price Paid	Dividend (Rs)	Div. Yield	Current Price	Gain
Hawkins	163	20.0	12.3%	345	111.6%
Oriental Bank of Commerce	99	7.3	7.4%	167	69.4%
Castrol Ltd	295	15.0	5.1%	385	30.4%
Indraprastha Gas Ltd	96	4.0	4.2%	138	43.8%
Venkey’s Ltd	88	3.5	4.0%	117	32.6%
Mahindra Finance	205	5.5	2.7%	262	27.5%
Aggregate			6.06%		53.86%

For the long term analysis, the short term capital gain can be safely ignored. The 53.86% gain in four months was a result of excessively depressed prices and is unlikely to be repeated. What is certain is that her portfolio will give a yield better that 6% in the coming years. As the years pass the prices of these companies will keep pace with growth in business and that in the long run will yield a return in excess of 15%.

I have strong reasons to believe that investors can get good results by sticking to conservative investing principles and by focusing on things which are real like dividends, networth, strength of brand, familiarity with the company's products and services. You don't need to be able to predict the future. If you can trace the history of a company on how it reached to its present strength, you are better off than those using fancy algorithmic models

P.S.: If the approach seems too simplistic to your intelligent brain, there are enough ways in the world to get lousy returns using sophisticated methods. For one such example, you can read about Religare's Agile fund. Agile stands for Alpha Generated from Industry Leaders.