From Universe to Portfolio: The Art of Stock Selection

When you work in capital markets, one of the most frequently asked questions is, “What is portfolio construction?” Don’t get me wrong, the most common question is still, “Which stock should I buy?”

But on a serious note, what exactly is portfolio construction? It might sound intellectual and even a bit overwhelming, but at its core, it’s one of the most intuitive concepts. Think of it as constructing a building. Before anything else, the builder must gather all the relevant factors that will contribute to the construction. The first step is to lay a solid foundation, followed by constructing the subsequent stories. Portfolio construction works in a similar way.

In essence, portfolio construction involves gathering a variety of factors and amalgamating them according to the investment strategy to arrive at a final set of stocks. Now, let’s break down that statement and understand the process.

To build a portfolio, the foundation is the underlying strategy or theme. For example, if I want to create a portfolio based on smart beta or asset allocation, the universe of stocks between these two will be quite different. The same applies to thematic portfolios. A portfolio focused on a rural-based theme will have a different stock universe than one focused on specialty chemicals. Even within the same theme, strategies can differ based on various factors, such as the market cap of companies. For instance, a momentum portfolio can be built exclusively on large-cap stocks or entirely on small-cap ones.

The point here is that a well-defined strategy or theme is the cornerstone of portfolio construction. This leads us to the next crucial aspect: stock universe selection. This process involves selecting the final set of stocks from a larger universe based on a combination of factors or criteria. Various permutations and combinations are considered to distil down to the final set.

For example, let’s say I’m designing a strategy that considers the top 500 companies by market cap. According to SEBI classification, the top 100 companies are large-cap stocks, 101-250 are mid-cap stocks, and the last 250 are small-cap stocks. If my strategy is to select only large-cap stocks, my universe shrinks from 500 to 100. Essentially, each strategy criterion narrows down the stock universe further and further to arrive at the final list.

To illustrate further, renowned index providers also have well-defined universes underlying their respective indices. For instance, the Russell 1000 index consists of the largest 1000 US companies, and MSCI factor indices are based on factors like volatility, momentum, and others.

A global portfolio manager has to navigate even more complexity, dealing with stock universes from multiple countries. For example, a manager might create a portfolio of stocks with the lowest monthly volatility from a universe that includes stocks from both India and China. The manager might then combine these countries’ universes, focusing on the large-cap segment, and finally filter out the low-volatility stocks.

At Windmill Capital, we manage over 50 smallcases, each based on a distinct investment strategy. Below are some of the categories of smallcases and corresponding examples:

• Asset Allocation: All Weather Investing, Horizon smallcases
• Thematics: Brand Value, Specialty Chemicals
• Models: CANSLIM-esque, Dividend Aristocrats
• Trackers: IT, Pharma Tracker
• Smart Beta: Low Risk, Quality Smallcap

Each of these smallcases has a predefined stock universe, from which the final portfolio is screened and built. To give you some perspective, the Quality Smallcap Smart Beta smallcase only considers small-cap companies, while the Dividend Smart Beta smallcase focuses on large-cap ones. Similarly, tracker smallcases draw their universe from relevant sectors within the top 700 stocks in India.

The idea behind explaining the intricacies of the stock universe is to highlight its importance as the foundation of portfolio construction. All professional investment managers first align their stock universes with their theme or strategy and then drill down to the final set of stocks based on specific rules. At Windmill Capital, since we work with a variety of smallcase themes and strategies, establishing a stock universe is a crucial part of our workflow.

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_{The content in these posts/articles is for informational and educational purposes only and should not be construed as professional financial advice and nor to be construed as an offer to buy /sell or the solicitation of an offer to buy/sell any security or financial products.Users must make their own investment decisions based on their specific investment objective and financial position and using such independent advisors as they believe necessary.}

_{Windmill Capital TeamWindmill Capital Private Limited is a SEBI registered research analyst (Regn. No. INH200007645) based in Bengaluru at No 51 Le Parc Richmonde, Richmond Road, Shanthala Nagar, Bangalore, Karnataka – 560025 creating Thematic & Quantamental curated stock/ETF portfolios. Data analysis is the heart and soul behind our portfolio construction & with 50+ offerings, we have something for everyone. CIN of the company is U74999KA2020PTC132398. For more information and disclosures, visit our disclosures page here.}