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Monday, July 14, 2014

The idea of Diversification

Note: This paper is originally published in the Journal of Commerce and Management Thought (http://goo.gl/7htI1W) in July 2014 edition.

“Wide diversification is only required when investors do not understand what they are doing.” – Warren Buffett

Investopedia defines diversification as a technique that reduces risk by allocating investments among various financial instruments, industries and other categories. It aims to maximize return by investing in different areas that would each react differently to the same event.

So can we diversify all the risk that is there in the investments? If not then what we can diversify and what we cannot?

There are mainly two types of risk: Systematic Risk and Unsystematic Risk.

Systematic risk is also called non-diversifiable or un-diversifiable or market risk. This risk is beyond the control of individual investments, companies or industry. This risk comes with factors like interest rate, inflation rates, exchange rates, and political instability. The concept of systematic risk applies to individual securities as well as to portfolios. The market or systematic risk cannot be diversified and hence it is non-diversifiable risk which investors have to accept.

Unsystematic risk is also called diversifiable risk. It is a risk associated with specific company, industry, market, economy or country. This risk can be reduced through diversification and hence it is diversifiable risk. The most common sources of unsystematic risk are business risk and financial risk. If we invest in various assets then they will not all be affected the same way by market events.

The below example will help us clarifying the impact of Systematic and Unsystematic risk.

There are two software companies. One deals primarily in software services and another with niche product space. Both these companies export their products or services to overseas market and earn revenue in American Dollars (USD). Later they get this revenue converted in Indian Rupees (INR). If exchange rates of USD to INR changes with INR getting depreciated then both the companies get more INR revenue without making any business changes while opposite is also true. Here if an investor selects either of this company then the exposure to exchange rate fluctuations, and accordingly an impact on the earning on these companies, will remain the same. This is a systematic or un-diversifiable risk. The risk will not be diversified even if we select either of these companies.

Now in another scenario, the product company is developing a software product in the space of Analytics and has made significant investments towards that. This is a business specific risk. If the product is successful then it is huge gains otherwise huge losses. This risk associated only with the product company and not with the market. Hence this risk can be diversified by selecting another company which may not have a similar kind of exposure in the product category.

We are clear that company specific or diversifiable or unsystematic risk can be diversified by allocating investments among various financial instruments, industries and other categories. Now if we have to diversify the risk associated within a portfolio of multiple stocks then how many stocks can help us diversify this unsystematic risk?

There are several academic studies available to support the idea of number of stocks to diversify the unsystematic risk; however, there is no consensus. One such study is conducted by Frank Reilly and Keith Brown. In their book Investment Analysis and Portfolio Management, they reported that for randomly selected stocks about 90% of the maximum benefit of diversification was derived from portfolios of 12 to 18 stocks. In other words, if you own about 12 to 18 stocks, you have obtained more than 90% of the benefits of diversification, assuming you own an equally weighted portfolio. There is another study which indicated 30 stocks. Whatever the number, it is significantly less than all the stocks in the market.

This set of 12 to 30 stocks will help you removing more than 90% of the unsystematic risk. But you will still have systematic risk remaining in the portfolio of stocks. This systematic risk will give you the same return in the market as if you had bought a passive market index. If you want to obtain a higher return than the markets, you increase your chances by being less diversified or have a more concentrated portfolio. At the same time, you also increase your unsystematic risk and thereby total risk. Remember, diversification may help us in protecting the wealth, but concentration will help in building the wealth.

Warren Buffett rightly said that “Diversification is a protection against ignorance. It makes very little sense for those who know what they’re doing.”

About author: Niteen S Dharmawat is an MBA and cleared CFA Level 2, CFA Institute USA. A firm believer in long-term financial planning, and a 20 years veteran of the stock market, he likes to analyse the economy, and individual stocks. He also conducts investor education sessions.

He likes reading books/magazines/news papers on the topics as diverse as general management, technology, investment, fiction, marketing and the Gita.

He is a person who believes that "Everything else can stop but learning".

Source: http://www.investopedia.com

IDFC = Discipline + Fortitude


In my view it is value for money and has ingredients to be a multi-bagger. FIIs can't buy IDFC post IDFC's getting the banking license. So there were virtually no reports and keen interest post April 2014. The stock got stuck as the rally is driven by FIIs. Infra companies where IDFC does funding has seen good rally. Most of the people were negative about the counter due to several such reasons.

IDFC has seen its ever high in Jan 2008 at 235 levels. Since then the balance sheet has quadrupled. IDFC did a QIP sometime in 2010 at around 168 levels and since then the balance sheet has doubled. The stock is still languishing below 150. The company has a revenue of close to Rs9000crores v/s MCap of Rs22,000Crores. It's book value is Rs 100 and trading at a multiple of less than 1.5 to its BV. The NPLs and GPLs of IDFC are 0.37% and 0.56% respectively. IDFC has an extremely well capitalized balance sheet. The bank will start with around Rs.11,000 crore, Rs.12,000 crore of net worth on day one.

The company has an advantage to start the banking business now. In the last 10 years, there have been important developments in banking regulation and in technology, both of which, for somebody like IDFC, i.e., with deep pockets and no legacy creates an important opportunity. They may use the best of the technology available and thereby reducing the cost of operations. It is expected that their cost of operations will be lower by 10-15% of a typical private sector bank as there is no legacy technology involved. This will help them in getting better ROEs in times to come.

IDFC, if you notice, has started the recruitment for its banking business. They are at another advantage since not too many banking licenses are distributed. Had it been 3-5 more licenses given then it would have put pressure to pick the right employees at a higher cost. Between Bandhan and IDFC, IDFC is better placed to attract talent. Some of the recent recruitment announced by IDFC includes: (1) Pavan Pal Kaushal as chief risk officer. Kaushal, with over 30 years of experience in the financial services sector, is expected to bring in the expertise to start a bank. Prior to joining IDFC, Kaushal led the financial services risk practice at EY India covering credit risk, operational risk, market risk, corporate and treasury risk management. He has also served as chief risk officer for ANZ Banking Group Ltd in India. (2) Avtar Monga, formerly with Bank of America-Merill Lynch, has been brought in to head operations and technology. Avtar Monga, formerly with Bank of America-Merill Lynch, has been brought in to head operations and technology.  (3) Ajay Mahajan, formerly with Yes Bank Ltd, will be leading the markets and institutional banking team.

The stock has not moved since FIIs can't put money and in fact their holding has to come down to below 49%. The decision about FII holding will happen in the upcoming AGM in the last week of July. There are two ways to do it. Go for QIP route and give the additional shares to DIIs or go for FPO and give it to DIIs and Retail. In my view the company should prefer the first one.

After their holding comes down below 49%, they may divide the business in three companies and all three may get listed, subject to approvals from regulators. If that happens then it will lead to value unlocking. Also FIIs will be allowed to increase stakes beyond 49% in businesses other than banking.

Recently MS upgraded IDFC from UW to OW with revised price target from 115 to 175. It was done before the budget. But more importantly, MS report gave a reference of Raghuram Rajan's statements, the governor of RBI. It was about relaxation of CRR and PSL norms. The report gave a target of Rs 300 in best case scenario.

At present, for every Rs 100 crore raised through deposits, banks have to keep Rs 4 crore with Reserve Bank India as CRR (which earns zero interest income) and invest Rs 22.5 crore in government bonds to meet SLR norms. Beside, Rs 40 crore has to be lent to priority sectors.  The budget accepted this relaxation for infra funding by banks. It has to be seen whether these norms are prospective or retrospective. If retrospective, no doubt it will benefit IDFC more. But in either case it will benefit IDFC as they understand infra funding more than anyone else. The relaxation in norms would mean IDFC will have better profitability and thereby ROE.

The stock may or may not come down due to variety of reasons including more provisioning in upcoming quarterly results to lower ROE due to investments in banking business. In my view IDFC has to be in core portfolio for next couple of years, at least without too much worrying about the short term hiccups. It has good management, and they did well with the infra sector funding business. If we are confident of Indian story then it will benefit the banking sector the most.

Disc.: I am holding and my views can be completely biased. So please do your research before you take any decision. I wish to increase on every fall.

Happy investing.

Niteen S Dharmawat
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IMPORTANT DISCLAIMER: Investment in equity shares has its own risks. Sincere efforts have been made to present the right investment perspective. The information contained herein is based on analysis and up on sources that I consider reliable. I, however, do not vouch for the accuracy or the completeness thereof. This material is for personal information and I am not responsible for any loss incurred based upon it & take no responsibility whatsoever for any financial profits or loss which may arise from the discussion above. I sincerely request you to do your homework before you take any position whatsoever. I, my relatives or friends may have/have positions in the stocks discussed here.