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When the entire market is on a high, here’s how to pick stocks

Betting on a particular theme in the stock market can be a high risk-high return strategy in portfolio planning. The cyclical and seasonal nature of certain sectors often throws up opportunities (for a limited period) to make high return bets on specific sectors.

For example, after two consecutive droughts in 2014 and 2015, everyone was almost certain that calendar 2016 would be a year of good monsoon in India and, therefore, rural consumption was expected to see a revival in 2016 after languishing in the two previous years.

Though the rural consumption ‘theme’ was playing out almost as per everyone’s expectation, the government’s decision to demonetise high-value currency notes dealt a body blow to the rural economy and the consumption theme thus got derailed at least in the short run.

But theme-based investing can have serious ‘time constraints’ and an investor must clearly spell out time horizon for such strategies.

So what should be the stock-picking strategies for theme-based investing?

Diversification: A theme-based portfolio should be built in such a way that it is well-diversified (sectorally, geographically) even if there is limited scope for such diversification within a theme.

For example in a portfolio based on the infrastructure theme, one can invest across sectors such as capital goods, construction, real estate and even infrastructure financing companies. The infrastructure theme does not necessarily mean the stocks have to be linked to construction activities alone, infrastructure financing companies, for instance, too can see better realisations from higher infrastructure activities in the economy.

Valuation: Stock picking with correct valuation is very important for theme-based portfolios. However, it is easier than done. Stock valuation should be compared with peers as a single figure cannot explain things in isolation. It should be relative and not absolute. Besides all stocks available at cheaper valuations do not guarantee better future returns. Typically, if the market thinks that a particular stock has better prospects of prospering in certain conditions, most of them would chase that stock increasing its valuation, which sometimes may exceed its real potential. Avoid such stocks.

In other words, if the price-to-earnings ratio (as one of the parameter) of a stock in a specific case trades above industry average, it can be called overvalued and avoided.

There could be stocks that may not have run their course, but are available at relatively cheaper valuation. One may like to hold such stocks in a portfolio.

Finding a stock at ‘cheaper’ valuation with immense future potential is like finding the Holy Grail nowadays. If you are lucky, you should be able to find a couple of such stocks.

Timing: In an economy and a specific stock market, a particular theme remains in vogue only for a certain duration. Therefore, unlike long-term investments, timing can be important in making money through theme-based investments. Within that theme, sectors and stocks from a particular sector may trough and peak at different times.

For example within the rural consumption theme, sectors such as consumer non-discretionary (FMCG, pharma) would peak and trough much faster than the consumer discretionary sectors such as consumer durables and auto, because of the ‘essential’ nature of the former.

This makes the job of building a theme-based portfolio very difficult and may require timely chopping and changing as well.

Investment themes are cyclical in nature and, therefore, they have to be timed in such a way that you enter fairly at the beginning of a cycle and exit around the peak. It is better to have a return target, which once achieved (even if before the peak), one can exit that investment.

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