Now that you have identified the universe of neglected stocks and are ready to screen the stocks for fundamental strength, the only question that remains is how many stocks to own. While no perfect answer exists in specifying the ideal level of diversification, it is worth remembering that the universe of “neglected stocks” is not representative of the broader market since it is a very unique subset of companies. Consequently, it is only fair to expect that diversification is likely to be less effective in these circumstances. Much will depend on the magnitude of the offsetting effect (or what Harry Markowitz refers to as the co-variance matrix) given the mix represented in the aggregate portfolio. The efficacy and robustness of the filtering procedure should also have a significant impact in reducing risk. Given the methods recommended earlier, a portfolio of 15 carefully chosen stocks should prove adequate in trimming market risk without diluting the essence of the approach. Without further ado, let me share the results of my most recent efforts at putting together a bunch of high-performance generic stocks that allow me to sleep well at night!
Having passed the moment of truth by committing your money to these stocks, you now need to grapple with the issue of when to sell, evaluate the opportunity cost of switching and avoiding the rank duds! The crux of the generic investment strategy is to diagnose each stock’s position relative to the popularity flow. One obvious method is to monitor changes in the primary measures of neglect—analyst attention and institutional ownership. The other alternative is to track changes in price. While these two sets of signals tend to move in lock-step, quite often the response time differs. The price indicator has the advantage of being timely as well as more sensitive in its feedback. Changes in the primary measures of neglect serve as reliable leading indicators but are difficult to track on a regular basis given the absence of weekly/monthly data.
Calculating a measure of price momentum such as relative strength (vis-à-vis your chosen benchmark index) is probably the most dependable measure of “popularity flow”. The time period chosen to determine price momentum can vary from a month to the last six months. As long as the relative strength persists, you enjoy the ride. The critical question is knowing when to sell. When Baron Rothschild was asked about the essence of his investment success, he summed it up by saying, “I always sell too soon.” The best time to sell, as a practitioner of generic stock investing, is when both of the following conditions are satisfied:
- The price momentum is clearly exhausted and begins to reverse.
- Analyst coverage and institutional ownership begin to trend upwards.
In case the popularity flow fails to materialise, sell when either the fundamentals begin to decline or the price momentum is worse than the index for three consecutive months. The truly successful investor is dispassionate in implementing a clearly defined exit strategy without allowing either emotion or ego to get in the way of disciplined selling.
The suggestions on the screening process, extent of diversification and exit strategy are clearly idiosyncratic. While they have a veneer of formulaic precision and are supported by empirical research, these methods are nothing more than techniques to support better decision making. There is absolutely no doubt that the generic investing strategy is a DIY approach that depends considerably on personal judgment and preferences. The better your judgment and the more creative your decision making, the greater the rewards.
Remember to stay flexible and open-minded. The method is bound to improve over time like good wine as you continually incorporate the feedback from your own learning process. Embrace risk in a positive manner, have realistic objectives and remain patient.
As the Reverend Samuel Johnson put it: It is by studying little things that we attain the great art of having as little misery and as much happiness as possible.
Good luck and Godspeed! Sanjoy Bhattacharyya is a partner at Fortuna Capital Disclosure: This column is neither an offer to sell nor solicitation to buy any of the securities mentioned herein. The author frequently invests in the shares discussed by him.
(This article is excerpted from the latest Forbes India 01 November, 2013 issue which is now available at news stands and book stores. You can buy our tablet version from Magzter.com)