The number of stocks traded on the Indian stock exchange is over 8000. How do you construct a portfolio of stocks from such a wide universe? The task of studying each and every stock of the 8000 stock universe for shortlisting for a portfolio is extremely time consuming and is also highly impractical. You will have to identify your own universe for selecting stocks for your portfolio in order to construct the right portfolio.
The stock universe for portfolio construction can be identified by many factors. Market capitalization is one factor that you can use for your stock universe. The stock indices are largely driven by market capitalization. The BSE Sensex, BSE 100 and BSE 500 are constituted with stocks based on free float market capitalization. Free float market capitalization is the full market capitalization of a stock adjusted for promoter/management holding.
Stocks are differentiated by market capitalization into large cap, mid cap and small cap. Large cap stocks are seen as the most liquid and well analysed while mid and small cap stocks come down the pecking order of capitalization and information availability.
A large cap universe will restrict the number of stocks within which you can select stocks for your portfolio while a mid to small cap universe will broaden the number of stocks. It is recommended to look at a broader index such as the BSE 500 for your stock universe.
Sectors are a narrow way of identifying a stock universe. You can shortlist a few sectors such as banking and finance, IT, FMCG, Capital Goods and Auto for your universe. If you are using sectors for a stock universe you will have to have a clear reason why you are choosing a particular sector for stock selection.
Dividends, profitability and earnings are other parameters for identifying a stock universe. Debt levels and cash flow generation are other such quantative parameters for identifying a stock universe.
Themes such as consumption, investments and even religious beliefs are used as a universe for portfolio construction. You would have to believe in a theme if you do want to use it as your universe.
The best approach for you would be to use a broad index such as the BSE 500 for your stock universe. A top down approach will help you shortlist the sectors from which you can shortlist stocks for your portfolio. Once you have shortlisted the stocks, you can use various parameters such as growth in market share, earnings expansion and rising profitability to select the stocks for your portfolio.
In the next issue of “Learn to be you own fund manager series” we will look at the optimum number of stocks for your portfolio and how to assign weights to the stocks in your portfolio.