Checking Sector Allocation and Diversification - Is it required?

Investing Strategies
1

Dear All,

Today I was having a discussion with few good investors (who are already on VP). The topic was:

)- When speaking about Capital Allocation, do we also need to check Sector Allocation ?

Here I am talking not about stock picking but talking about risk management

For simplicity I am assuming a 10 Stock Portfolio with 10% alocation to each stock and for

Say, I have 4 Pharma Stocks in my portfolio (i.e. 40% of my portfolio in Pharma Sector) and then I find a great company with excellent fundamentals (within Pharma again) and decide to allocate 10% money to it.

What is the Problem ?

1). Post this investment I will have 50% in Pharma Sector alone, so should I continue with this, irrespective of anything (because I focus on stocks and not on sectors)

2). Should I sell an existing **good **Pharma stock (which I feel has run its full course) to allocate money to the new stock.

3). In case of a sudden Government intervention (like it happened in Gold Industry), my portfolio might take a good beating, if it was heavy of one sector alone.

4). Though I have managed to diversify the companies in my portfolio, I have not diversified the Industry risk.

Question is, should I let go of a good stock, or re-allocate money within existing stocks.Obviously the risk always remain, but by diversifying industries/sectors, I am trying to manage my allocation to a particular sector and trying to save my self from a Black Swan event.

Why it is not a problem

1). My core competency is Technology/Pharma. I know in and out of the sector and I can manage a high sector allocation (Extremely Valid Point)

2). I focus on picking good stocks and it does not matter to me if they are all from same industry.(Valid Point)

3). I have made a lot of money on this sector, and currently the market is upbeat on IT and Pharma, and they are the market leaders, so I will continue with my existing strategy (Not a sensible****argument in my opinion)

May be seniors like Donald, Ayush and Hitesh Bhai can guide on this.

2

Hi Aswin

i,

I see many issues with your logic. I will list few of them.

1> Risk, as many people feel, does not come due to concentration. Risk comes because of not knowing the business fully, not knowing the correct entry/exit points, and many such unknowable. Diversification acts as a poor substitute for ignorance.

If you know a business inside out fully, and are sure about its future potential, make sense to invest in it disproportionately. Fat pitch balls are rare, have huge upside potential (for examples 20%+ roe/roce, zero debt, awesome management cos, available at ~10 pe, because of low market cap, and low float). Make sense to bet heavily when such opportunity knocks your door.

2> When in consumer sector, we tends to divide it to make sub-category like FMCG, Dairy, and than Cera/Astral/Asian Paint like cos. Make sense because of each sub-category has different business characteristics. So even if you have 5 stocks from consumer sector, they can have different underlying business fundamentals and hence get effected differently. May be there is a shortage of milk, increased focus towards sanitation, and wow, you have good gains in Cera/Heritage, and bad sales of cigarates and a down in ITC.

3> This is because, the original discussion is on is it fair to have 30-40% allocation in pharma. Pharma can have different segment, with different business characteristics. API/CRAMS/domestic/emerging market/chronics segment/generics/bio-similars/oncology/Formulation/Drug discovery are different aspects of pharma business.

For example USFDA should be hardly a concern for Ajanta as it is an awesome play on emerging market/targeted therapy/and its MR army. The same USFDA issue has been a positive for Shilpa, as it is seeing increased demand, as it has the only USFDA OK manufacturing plant wrt few of Oncology APIs, and pharma biggies are buying from it. But adverse USFDA can bite Aurobindo hard, and stagnate Alembic’s plan to enter US big time. So we cant just mix all of them in a single basket, and say one shouldn’t be having all of these beyond a limit of pf. Makes no sense to me.

As long as you can find non-correlated business (or better inversely correlated business) which are still awesome in their own way (some may be rapid grower, some stalwarts, some turnarounds, some margin expansion story) but are from same super-industry

segment, I see not much issue with having high stake in it.

3

Hi Subhash,

The good part from your argument

U mentioned a really good point about Non-correlated business. This is what we should see while striving for diversification and managing risk.

I also mentioned that sector knowledge plays a key part in deciding sector allocation. One should not strive for diversification just for the sake of it. Be on the pitch you know (core-competency).

Obviously I am not even going towards stock picking. There you are bang on, but that is not my target for this discussion.

The bad part

You are using the word ignorant for people who seek diversification. Its not a polite word to use.

This is a collaborative learning forum. Each one should be entitled to place his idea and discuss on it. We can question other people’s thoughts, but cant call them ignorant or use other impolite words.

4

I beg to differ with you sir.

In my comment, I have never said people who diversify are ignorant. Feel strange that you concluded the same from my statement. What I meant is complete knowledge will result in being invested 100% in single equity. And because we (where I include the ignorant myself) know way less than 100%, we need to diversify.

So my quote “diversification is a poor substitute of ignorance”, which I must confess is copied from some book/article I read, just forget which one. Be assured, that blessed enough to think-off/make such big statement.

So my idea is, risk can be reduced by knowing more, and diversifying. And any given day, I will prefer reducing risk by knowing more than diversifying. Plus, when odds are heavily in your favor, many books (like Dhando Investor), approaches like kelly criterion suggest that you bet disproportionately, disregarding one’s usual percentage target/industry percentage target.

Regards,
-Subash

The bad part