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It’s December. It is time for the smart investor to review her investment goals, evaluate stock portfolios and reposition them for achieving those goals. The smart investor focuses on listing out the goals for which she is investing. For each of the major and minor goals, the investor, possibly with the help of a financial planner, should put an estimate of the time frame and amount.

How does one know what something will cost in the future? One can use the current costs as a starting point and then the future estimate can be based on escalating the costs in line with inflation rates. Very crudely, one could use the interest rates on bank fixed deposits as a benchmark estimate of inflation. Or, one could assume 40% higher 5 years from now and double the current costs for 10 years from now.

Classify the goals into near-term, mid-term and long-term. Whatever is required within 3 years is near-term, 3-10 years is mid-term and 10 years or more is long-term.

For the near-term portion, invest in options that are capital protected. One probably has to have nearly 80% or more of the amount required already in hand. If there is a shortfall, one has to add more every month or at every opportunity. The focus is to preserve the capital in the near term and add whatever extra can be earned. Growing that capital aggressively is not the objective.

For the mid-term portion, the focus is on growth assets. Typically, this should be in listed equities. For each goal, one will have to estimate the amount that has to be invested now. For this, one will have to use long-term returns of the major equity indices. While elaborate present value calculations can be made, a rough thumb rule can be about 50% of the amount required in future. If it is within 5 years take it up to 60-65%, and if it is more than 7 years it can be reduced to 35-40%. This amount should be invested in a well-diversified portfolio.

For the long-term portion, this should mostly be in listed equities, but some (not more than 20%) can also be in alternative investments, such as real estate, private equity funds, and infrastructure funds, among others. This is possible since one can invest in less liquid assets given the long horizon. However, majority allocation should be in listed equities since the risk-return-liquidity value proposition of listed equities remains superior to most alternatives. The most important alternative—which most investors miss out—is global listed equities.

Now for the selection process for listed equities.

For mid-term equities portfolio, the focus should be relatively larger stocks, i.e., mid- to large-cap stocks. These are large, stable companies with strong fundamentals. The revenues should be big—Rs5,000 crore or more for Indian equities and $1 billion-plus for global equities. At this size, the companies are major contributors to the gross domestic product (GDP) and tend to be well-entrenched in the ecosystem. Focus on companies with higher profit margins, which gives them a cushion against problems such as external shocks or loss of revenues.

Next, the focus should be on companies with low debt. These companies are safer and not subject to pressure from lenders and are more immune to external shocks.

The companies should have relatively high return on equity, at least higher than the borrowing costs. This means that they have the ability to pay interest on their debts and also create more value than their cost of capital. High return-on-equity businesses are well-entrenched and are what Warren Buffett calls “moat companies".

The next important criteria for the mid-term portfolio is companies that pay dividends. This indicates that the company is probably generating enough free cash flows and the management is willing to share some of it with minority shareholders. It is an indicator of better operating performance and good corporate governance as well.

How much to pay for all this? In general, do not pay more than 20 price-to-earnings (P-E) ratio and have companies with a dividend yield of at least 1%. Build a diversified portfolio of such companies for the near term. Hold at least 10 stocks, ideally 25.

For the long-term portfolio, some of the companies can be small caps as well, possibly with revenues of Rs1,000 crore for Indian companies and $250 million for global listed equities in other developed markets.

The other criteria listed above stand for this portfolio also, except one can choose companies with low or no dividends as well. While majority of the allocation should be to the most undervalued companies in the market, say, 15-25 companies, a small allocation can be made to what are called global thematics. These are thematic portfolios based on social, technological, economic or political trends, which are likely to significantly impact certain emergent sectors that could explode in economic importance over next 5-10 years or more.

Review your goals, and take the advice of a trusted adviser on liabilities, the planned portfolio, insurance and taxes. Once it is vetted by the adviser and you are comfortable with it, start implementing.

May the Value be with you!

Vikas Gupta is the chief investment officer of a global investment research firm

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