Portfolio Management Optimization

Portfolio Management
Portfolio Management 1
Monthly Income Required by Middle Class
Family
Year
Year 2020:
2000: ???
Year 1980: Rs.10,742
Rs.1,017
Year
1960:
Rs.104
Data Source: Central Statistical Organisation (CSO)
Sensex Chart – From Jan 1980
What is the Probability of Losing Money?
Sentiments Affecting Markets
Core & Satellite Portfolios
Satellite
Satellite Core Satellite
Satellite
Portfolio Analysis & Construction
Life Events & Financial Objectives
• Premature Death
• Retirement
• Serious Illness
• Death of Spouse
• Aged Parents
• Children Getting Married
• Second Home
Wealth
• Remarriage
• Starting a Business
• Divorce
• Paying for College
• Job Loss
• Relocation
• Home Purchase
• Birth of Children
• Marriage
• Temporary Disability
Age
The Risk-Return Tradeoff
Risk Profiling
• Return
• Risk
• Time Horizon
• Tax Implications
• Liquidity Needs
• Legal Implications
• Unique Circumstances
Asset Allocation & Portfolio Construction should be
commensurate to the risk profile & financial
objectives
Risk Appetite and Profiling
Low Risk High Risk

Tolerance Tolerance
Moderately Moderately
Conservative Aggressive
Conservative Aggressive
Asset Allocation
Moderately Conservative
Conservative
25%
40% Equity
75% Debt
60%
Equity
Debt
Moderately Aggressive
Aggressive 25%
40%
75%
60%
Equity
Equity
Debt
Portfolio Management Debt
12
Portfolio Allocation
Small-cap Equities
Mid-cap Equities
Large-cap Equities
Return
Investment Grade
Corporate Bonds & Debentures
Money Market Instruments
Portfolio Management Risk13

Direct Equity or Mutual Funds
Direct Equity Mutual Funds

• Need expertise to manage • Managed by a professional
• Need to track investments • Fund manager tracks
by yourself investments
• Lack of resources for • Backed by strong research
team
research
• Greater importance given to
• Might get carried away by fundamentals
sentiments • Can get exposure to higher
• Lesser Diversification number of stocks for the
same amount invested
Direct Equity or Mutual Funds
Direct Equity Mutual Funds

• Fees can be high • Management fees are
capped
• Short-term Capital Gains Tax • Does not incur tax if fund
manager sells securities
• Systematic Investment has • Ease of staggered
operational difficulties investments – SIPs & STPs
Discretionary vs Non-Discretionary
Discretionary Portfolio Non-Discretionary Portfolio
Management Management
• Buy and Sell decisions taken • Buy and Sell decisions taken
by the portfolio manager by the client
• Clients have no/less control • Clients have more control
• Portfolio Manager needs • Clients need the expertise
the expertise to manage to manage
• Typically offered by • Typically offered by stock
professionals broking companies
• Less customization • More customization
Discretionary vs Non-Discretionary
Discretionary Portfolio Non-Discretionary Portfolio
Management Management
• Ideally suited for clients • Ideally suited for clients
who do not have time / who have time / expertise
expertise • Usually has a fixed fee
• Usually has a fixed or structure
variable fee structure
Modern Portfolio Theory
• Attempts to maximize portfolio return for a
given amount of portfolio risk
(Or)
• Attempts to minimize portfolio risk for a given

amount of portfolio return
Portfolio Return
Security Expected Expected Std. Investment Weight
Return Deviation Amount (Rs.)
(Risk)
Security A 10% 10% 1,00,000 25%
Security B 12% 20% 1,00,000 25%
Security C 20% 12% 1,00,000 25%
Security D 8% 4% 1,00,000 25%
Total ??? ??? 4,00,000 100%
Portfolio Return
(Risk)
Security A 10% 10% 1,00,000 25%
Security B 12% 20% 1,00,000 25%
Security C 20% 12% 1,00,000 25%
Security D 8% 4% 1,00,000 25%
Total 12.50% 11.50% 4,00,000 100%
Portfolio Return
(Risk)
Security A 10% 10% 1,00,000 25%
Security B 12% 20% 20,000 5%
Security C 20% 12% 1,80,000 45%
Security D 8% 4% 1,00,000 25%
Total 14.10% 9.90% 4,00,000 100%
Portfolio Return
(Risk)
Security A 10% 10% 1,00,000 25%
Security B 12% 20% 1,80,000 45%
Security C 20% 12% 20,000 5%
Security D 8% 4% 1,00,000 25%
Total 10.90% 13.10% 4,00,000 100%
Passive vs Active Portfolio Management
Passive Portfolio Management Active Portfolio Management

• Based on the belief that • Based on the belief that
markets are efficient and markets are inefficient and
market returns cannot be a specific style can beat the
surpassed regularly over markets
time
• Timing does not matter • Timing is the key
• Low cost • High cost
• Usually, holding tenure is • Usually, holding tenure is
long-term short-term
Capital Asset Pricing Model
• Cost of Equity = Rf + β(Rm – Rf)
Where, Rf = Risk-free Rate
β = Equity Beta
Rm = Required Return on Market
• Cost of Capital = (Equity % x Cost of Equity) +

(Debt % x Cost of Debt)(1-Tax Rate)
Risk-free Rate
• As on 18th December 2015, the Indian 10-year G-
Sec yield closed at 7.728%. What is the risk-free
rate for a company listed in the Indian stock
exchange?
– 10-year GSec yield of 7.728%
– 10-year GSec yield of 7.728% + Default Spread of
2.64% = 10.268%
– 10-year GSec yield of 7.728% – Default Spread of
2.64% = 5.088%
– None of the above
Risk-free Rate
• Should be based on a risk-free asset whose
actual return is the same as expected return
– No default risk
– No reinvestment risk
• Time horizon matters
– Thus, the risk free rate will depend on when the cash
flows will occur
• Not all government securities are risk-free in
nature
Portfolio Evaluation
Need for Portfolio Evaluation
• Is the portfolio commensurate with the
individual’s risk-return profile?
• Is the portfolio commensurate with the macro-
economic scenario?
• Is the portfolio poised towards helping the
individual achieving his financial goal?
• Have the portfolio dynamics changed over time?
• Standard Deviation: A measure of the dispersion of
a set of data from its mean. The more spread apart
the data, the higher the deviation
• Jensen’s Alpha: Portfolio Return – Expected Return

(or) Portfolio Return – Benchmark Return
• Beta: A measure of the volatility, or systematic risk,

of a security or a portfolio in comparison to the
market as a whole
• Sharpe Ratio:
(Portfolio Return – Risk Free Rate)
Std. Deviation
• Treynor Ratio:
(Portfolio Return – Risk Free Rate)
Beta
Basic Stock Picking Techniques
Fundamental Analysis
Equity
Research
Fundamental Technical
Research Research
Fundamental & Technical - Comparison
Technical Analysis Fundamental Analysis

• Analyses past price • Analyses finances of the
movements company
• Looks for patterns in price • Looks for ratios, industry
charts analysis and forecasting
cash flows
• Looks for trends that • Looks for factors affecting
emerge due to sentiment the long term profitability
changes (Short Term) and growth of a company
• Views it as a Stock • Views it as a Business
The Two Types
Top Down Analysis
Economic
Analysis
Industry
Analysis
Company
Analysis
Bottom Up Analysis
Valuation Ratios
• Price to Earnings (P/E)
• Price to Book Ratio
• Price to Sales Ratio
• Enterprise Value (EV) to EBITDA
Earnings per Share (EPS)
• EPS = Net Profit / No. of Shares Outstanding
• Two companies with same Net Income can have

different EPS, due to no. of shares
• Diluted EPS
– When ESOPs, Warrants & Convertibles are
considered in the EPS calculation
Price to Earnings Ratio (P/E)
• P/E = Price / EPS
• Trailing P/E
– Last year’s earnings are used
– Preferred when forecasted earnings are unavailable
• Forward P/E
– Forecasted earnings are used
– Preferred when historical earnings are negative /
irrelevant / unavailable
Rationale & Drawbacks
Rationale Drawbacks
• EPS is the driver of • Earnings can be
value negative
• Widely used in the • Management’s
industry discretion over
• Related to stock reported earnings
returns • One-time earnings
Price to Book Ratio (P/B)
• P/B = Price / Book Value
• Book Value = Total Assets – Intangible Assets –

Liabilities
Rationale & Drawbacks
Rationale Drawbacks
• Book Value is usually • Non-physical assets
positive are excluded
• More stable than • Misleading when
EPS asset levels vary
• Appropriate for • Accounting practices
Financial services can vary
firms
Price to Sales Ratio (P/S)
• P/S = Price / Sales per Share
Rationale Drawbacks
• Sales are usually • Can misrepresent if
positive bulk of the sales are
• Revenues are done on credit
difficult to • Revenue recognition
manipulate
practices vary
• Useful when
earnings are
negative
Enterprise Value (EV) to EBITDA
• Enterprise Value = Market Value of Stock + Market Value
of Debt – Cash – Investments
• Useful when valuing companies with high debt levels (like
commodity, construction companies, etc.)
• Capital structure neutral
– Compare companies with different levels of debt
• Useful in the case of mergers & acquisitions
• Other EV Ratios
– EV to Sales
– EV to EBIT
– EV to FCFF
Few Sectoral Guidelines
• FMCG: High EBITDA Margins (>20%), full tax
payment, very high dividend payout ratio (>50%),
positive CFs from operations, nil or negligible debt,
high ROE (>30%), very light balance sheet, high
trading multiples
• Utilities: High debt, stable ROE (15-16%), normally
negative CFO, full tax payment, heavy balance
sheet, trading at multiples equivalent to market
average
• Infrastructure: High debt, ROE more than average
(18-20%), mostly negative CFO, very heavy balance
sheet, trading multiples higher than market average
• Automobiles: High operating & financial leverage, tax
benefits, not very heavy balance sheet, high ROEs (20-
25%), positive CFO, normal dividend payout ratio (20-
30%), trading multiples higher than average
• Information Technology: High EBITDA margins (>20%),
very high export earnings, positive CFO, high dividend
payout ratio (30%), high cash on books, high ROEs (>20-
25%), trading multiples higher than average
• Commodities: Very high debt (D/E>3x), highly cyclical
earnings, very high operating & financial leverage,
EV/EBITDA used, lower multiples
• Financials: High ROEs, debt is raw material, P/B
is used
• Capital Goods: Order book > 2-3x of sales, high
operating leverage, ROEs higher than market
average, trading multiples higher than market
average
Biases in Investing
What is Not Fundamental Analysis?
• My friend said that XYZ stock will double in one year.
– Someone recommended it to him.
• This stock has been going up continuously for the past

one week
• I have a gut feeling this stock will go up
• I have known this company from my childhood. Hence

it is a great stock – A probable bias
Biases in Investing
Anchoring Bias
• When estimating an unknown, an arbitrary
initial value is selected and then try to adjust it
up or down as new information is processed
• New data is not viewed with objectivity
• Anchored to initial estimate
Mental Accounting Bias
Wealth is Fungible
Overconfidence Bias
Overconfidence Bias
• I have all the information about the company
• I have worked in the company for 30 years. So, I
know the company very well
• Illusion of knowledge
• Self – Attribution Bias
• Self – Protection Bias
• Prediction Overconfidence
Loss Aversion Bias
Herding Bias
Herding Bias
This zebra hasn’t even seen the predator. It is

just following the herd
Framing Bias
Both are just the SAME…!!

How to Evaluate An Advisor?
• Understand how your advisor is paid
• Understand any conflicts of interest
• Does this advisor work with other clients?
• What services does the advisor offer?
• How & how often does the advisor communicate
with clients?
• Is the advisor a fiduciary?
• Check on professional certifications and training
Traits of a Good Financial Advisor
• Keeps his clients’ interests always above his
interests
• Understands his clients and educates them
properly
• Disclose all the necessary information and follow
a transparent process
• Maintains a balance between both his clients
and his employer
Power of Compounding – The 8th Wonder
Compounding interest is the EIGHTH WONDER of
the world. One who understands it, Earns it… One
who doesn’t, Pays it…!!
Power of Compounding – The 8th Wonder
Compounding interest is the EIGHTH WONDER of
the world. One who understands it, Earns it… One
who doesn’t, Pays it…!!
Albert Einsten
Lessons from Warren Buffet
Rule No.1:
Never Lose Money
Rule No.2:
Never forget Rule No.1
• Someone is sitting in the shade today because
someone planted a tree a long time ago
• Risk comes from not knowing what you're doing
• It's far better to buy a wonderful company at a fair
price than a fair company at a wonderful price
• When a management with a reputation for
brilliance tackles a business with a reputation for
bad economics, it is the reputation of the business
that remains intact
• In the business world, the rearview mirror is
always clearer than the windshield
• I never attempt to make money on the stock
market. I buy on the assumption that they could
close the market the next day and not reopen it
for five years.
• We simply attempt to be fearful when others are
greedy and to be greedy only when others are
fearful
Closing Thoughts
• Do not put all eggs in one basket
• Your portfolio should be commensurate with
your financial objectives
• Take informed investment decisions
• Always stick to your lane
• Understand biases and try to mitigate them
Thank You

Portfolio Management Optimization

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Portfolio Management

Satellite Core Satellite

Low Risk High Risk

Money Market Instruments

Portfolio Management Risk13

Direct Equity Mutual Funds

Direct Equity Mutual Funds

• Attempts to minimize portfolio risk for a given

Passive Portfolio Management Active Portfolio Management

• Cost of Capital = (Equity % x Cost of Equity) +

• Jensen’s Alpha: Portfolio Return – Expected Return

• Beta: A measure of the volatility, or systematic risk,

Technical Analysis Fundamental Analysis

• Price to Book Ratio

• Price to Sales Ratio

• Enterprise Value (EV) to EBITDA

• Two companies with same Net Income can have

• P/B = Price / Book Value

• Book Value = Total Assets – Intangible Assets –

• This stock has been going up continuously for the past

• I have a gut feeling this stock will go up

• I have known this company from my childhood. Hence

• New data is not viewed with objectivity

• Anchored to initial estimate

This zebra hasn’t even seen the predator. It is

Both are just the SAME…!!

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