Why do we add a new security to our portfolio ?
To reduce risk and ensure not all our eggs are in same basket, the underlying thought process is if stock A doesn’t do well at least stock B will provide some returns and compensate for loss if any in stock A
This makes perfect sense if you go by what Harry M. Morkowitz said in 1950’s [emphasis mine]

The investments have different types of risk characteristics, some caused systematic and market related risks and the other called unsystematic or company related risks. Markowitz diversification involves a proper number of securities, not too few or not too many which have no correlation or negative correlation. The proper choice of companies, securities, or assets whose return are not correlated and whose risks are mutually offsetting to reduce the overall risk

It explains why investors invest in diverse spectrum of industries whose fortunes are not tied to each other
However many investors feel discomfort in adding a new company from a similar industry, At least I do. My thinking process is I already own TCS what the use of adding another IT company in the portfolio ? After all the company related risks faced by TCS and any other large IT company would be same
Over years I have found this is a flawed way to think about diversification, what we need to focus is to select companies whose return are not correlated and in many cases they could very well be in same industry. Let’s take example of the following companies in pharmaceutical industry
1. Ajanta Pharma
2. Suven Life Sciences
3. Granules India
All three of them have varied business model which is in turn is their source of uncorrelated returns, see the chart below which is a very simplified model of Indian pharmaceutical business adapted from this article

Diversification-1

Now also look at the simplified version of focus area of above three companies

Diversification-2

Even though all three of them are in same industry (and hence would be affected by few common input variables) still large part of their success would come from their continued success in their chosen areas of focus

So if you have Suven Life Sciences in your portfolio which is in contract research and manufacturing company serving regulated markets then by adding Ajanta pharma which is a speciality pharmaceutical company engaged in development, manufacture and marketing of finished dosages in unregulated markets you are diversifying your portfolio

What is risk of adding too many companies of same industry ?

The focus area snapshot is a point in time, as companies operate in same industry they would want to make inroads in others focus areas especially if the area is lucrative

e.g.

Ajanta pharma is entering regulated markets while on other hand Granules wants to get a larger pie of revenue from its CRAMS joint venture and formulations segment, risk is as these companies become large the boundaries of their focus areas would expand and not remain mutually exclusive thereby their returns would start becoming correlated

How do you think before adding another company from same industry ? Share in comments

 

Disclosure – I own all three companies in my personal portfolio and above post is not a recommendation to buy