Why is there a need to analyze a portfolio?
- A Portfolio Manager wants to know whether his portfolio is under or overvalued and the chances of it appreciating in value.
- A Wealth Manager wants to know the profile of a mutual fund before recommending it to his client.
- A Wealth Manager wants to show his client a profile of his current portfolio or how it would look like if the recommended rebalancing is carried out.
- A Fund-of-Fund Manager would like to analyze an external Manager’s stock picks to determine whether his investment style is suitable.
How do we analyze a portfolio?
We analyze portfolios using the same core technology that we use to analyze stocks. The unique point of this technology is our use of combination rather than stand-alone indicators to value stocks.
Valuing a stock based on stand-alone indicators is not very helpful. Take for example Apple Inc. These are the different values of the stock based on different methods.
Source: www.gurufocus.com
Depending on which method you choose, Apple’s stock could be grossly undervalued or overvalued. The range of values is too wide to be useful for investors.
ProThinker also uses multiple methods to value a stock. However, instead of giving you many values, we test all the different combination of indicators and give you the one combination that best explains the stock price. Usually, no single indicator can explain a stock price sufficiently. For example, some investors may look at a particular stock’s Price to Earnings while some may look at Dividend Yield. Therefore, a stock’s price is often affected by different indicators at the same time. Rather than guessing which indicators explain the stock price, we let the data find the combination of indicators that mathematically explains the stock price best. This combination approach almost always explains the stock price better than any single indicator.
Our stock valuation methodology can be extended to analyse portfolios. Below is an example of analysis done on the top 10 holdings of the Tata Equity PE Fund. While the portfolio consists of more than these 10 stocks, the combined holdings of the 10 stocks exceed 50% of the portfolio and the highest-conviction bets of the Manager will reveal his investment style for the whole fund.
Let’s do this analysis on the Tata Equity PE Fund, which has the following stocks as its top holdings. The weighting of these stocks have also been disclosed by the Fund.
| HDFC |
| Reliance Industries |
| Yes Bank |
| Tech Mahindra |
| Larsen & Toubro |
| Mahindra & Mahindra |
| ITC |
| Bajaj Auto |
| Power Grid Corp |
| HDFC Bank |
The following chart shows how the current holdings of the fund looks like in terms of its PE valuation. The blue line, which represents the value of the fund, is slightly below the red line, which represents the value of the portfolio if the stocks is trading at its average PE of 17.3x. Therefore, the fund is not expensive on PE terms and the upward sloping red line shows that the EPS of these companies are trending upwards based on consensus analysts estimates.
We then analyze the fund using the other valuation indicators.
Different valuation indicators will give you slightly differently conclusions from fairly valued to significantly undervalued. Therefore, our proprietary Composite Valuation Indicator is used to find the best combination of indicators that explains the stock price.
The Composite method of analyzing a portfolio is objective; we don’t rely on commission-driven brokers to tell us whether they think the fund is going to appreciate in value. It is accurate because we have one conclusion and not different conclusions depending on which indicator you use. Finally, it is verifiable because we show you the chosen combination’s predicted price in the past vs. the actual prices. By seeing how well the combination explains past data, you can have confidence that it will also do a good job in forecasting future prices.
Analyzing the risks of a portfolio
The conventional way of determining the risk of a portfolio is its historical volatility. We don’t think this is a good idea. Take for example a stock that has steadily gone up in price to the point where it is now significantly overvalued. The historical volatility would be low because of the steady increase in price. Yet the risk would be high and the stock has the potential to drop quickly if there is any bad news. Therefore, a better way to determine the risk of a portfolio is to determine whether:
– Valuation is too high
– Fundamentals are deteriorating (e.g. earnings, sales, dividends, cash flows, dividends)
– Financial condition is weak
– Quality of earnings is low
The first two can be determined from the Composite Valuation chart. We see that the Tata Equity PE fund is slightly undervalued (blue line below the red line) and the fundamentals (e.g. earnings, sales, cash flow, dividends, etc.) are improving (as seen from the rising red line).
In order to determine the financial condition of the stocks in the portfolio, the Altman Z Score is used. This is a well-known composite measure of a stock’s financial risk and the probability of bankruptcy in the near future. Altman Z Scores are calculated for all the stocks in the portfolio that are not in the financial services industry (Altman Z Score is not relevant for financial stocks) and the weighted score is plotted below.
Earnings quality is measured by another composite score known as the Beneish M Score. This Score measures the likelihood of companies manipulating their earnings through creative accounting methods. Again, the weighted Beneish Score is calculated based on the stocks in the portfolio.
If you like me to send you a sample analysis on a 10-stock portfolio, please contact me with the names and holdings of those stocks.