From 2011 till about 2018, I was almost exclusively a small and micro cap investor.
To such an extent that the odd 12,000 Cr market company looked like a large cap compared to the rest of my portfolio.
This preference of mine was due to the market conditions of the 2011-14 period and the continuation of the small cap run through the 2015-18 period. This culminated in the 2018 small cap sell off where the average stock in that segment not only fell 30-35% but also stayed there until September 2019. That period wasn’t easy to deal with, which led to me moving to a multi cap approach for external capital to contain drawdown risk better in bad cycles.
2018-2021 was a different type of a mini cycle. It was period where the market cared more about quality and consistency of minimum assured growth rather than cheap valuation. Cheap stayed cheap in spite of delivering good earnings while expensive stocks became more expensive. This continued through the 2020 dislocation as the market started focusing on a “chosen few” stocks for whom no price would be high enough ever – be it the near term, medium term or the long term.
Through the 2018-2021 period, my stock picking style remained the same at its very core – growth at a reasonable price, willing to pay up but not willing to pay a hefty premium for stocks. Just that I was applying this across the range of market capitalization and not just to small and micro caps. This played out brilliantly till mid 2021 with this approach beating the benchmark by more than 10% p.a. All this while, my legacy small and micro-cap portfolio stayed as is without new additions or changes. Ever since I started managing external capital in 2019, all of my incremental money has gone into the same set of stocks that I’ve been buying/suggesting for clients.
Over the past few days, I’ve been going through the performance of many portfolios to get a sense of how the market texture has changed and to get a better sense of where the puck might be in a few months from now. A logical extension of this was to see how the legacy small & micro-cap portfolio has performed with respect to the benchmark and the multi cap portfolio.
Here’s what it looks like
1 Year return of the legacy small cap portfolio is 25%+ while the NIFTY 50 and other benchmarks are on the verge of going into negative territory soon.
Some of the stocks in that portfolio (not recommendations)
- Mirza International
- TCPL Packaging
- L G Balakrishnan
- Sanghvi Movers
- Shalimar Paints
- Greenpanel Industries
- Greenply Industries
- Amara Raja Batteries
See a trend here?
Each one of these stocks had some or the major concern that they had to deal with since 2016. For Mirza International it was corporate governance, balance sheet strength; for TCPL it was bad unit economics following their foray into flexible packaging; for L G Balakrishnan it was sector related pessimism; Shalimar Paints had pretty much every single possible problem to deal with; for Greenpanel it was industry overcapacity resulting in pricing challenges & debt heavy balance sheet.
One might ask why I continue to hold onto my tail position in Amara Raja Batteries, this can be the subject of a detailed post in itself. We’ll leave it for another day.
Each one of these stories was trading at a dirt-cheap valuation in an absolute sense after the small cap debacle of 2018. Investors just weren’t interested even when the numbers were steadily getting better. Today the market is just a bit more sanguine on the prospects of these businesses, in a few cases there has been no rerating yet, just the price moving in line with earnings delivered.
For the record, the multi cap approach has underperformed the benchmark by a good 5-6% over the past 1 year, on a 3-year and 2-year basis the absolute alpha is still more than 10% p.a. but the past 12 months have been a leveler; to some extent on expected lines. If anything, I was guilty of turning a bit conservative too soon towards the mid of 2021 as you can read from the monthly newsletters.
The legacy small cap portfolio has just been playing out a counter trend.
Has the market lost its mind in the past 12 months to such an extent that Asian Paints and Dr Lal Path Labs have become whipping boys while Mirza International and TCPL Packaging look like champions?
In spite of the obvious differences in BQ and MQ?
What are the takeaways here?
One of the very few things that can reliably make money across cycles is an obsessive focus on getting variant perception right.
If you look at the long-term return from the large cap, mid cap and small cap indices in India, their returns aren’t as different as you would expect them to be.
While tracking businesses across market caps is beneficial, the decision to include a business in the portfolio should be driven more by possibilities of positive variant perception than by the market cap of the business.
It comes down to
- Having a view that is different from the consensus market view
- Your view turning out to be the right one over a period of time
- The market eventually coming around to your view
- Doing this at a strike rate of > 60%
The most reliable way of expressing variant perception is through valuation, it indeed is “bhav bhagwan che”. Stories don’t make money for investors; it is price action that does. Hence, entry valuation doesn’t just matter but also covers a whole lot of risks and contingencies for investors. Sometimes the market presents opportunities in large caps, sometimes in small caps and sometimes in specific sectors.
A stock that is priced for most of the positives of the underlying business has a slim chance of beating the market return over the medium term. Momentum might take prices higher in the short term but that usually does not last.
Fish where the valuation is reasonable, you can’t go too wrong with this if you do the basics of business analysis and corporate governance checks right.
While there is a lot of gyan peddled on being obsessively focused on a few businesses and knowing them really well, this doesn’t necessarily protect portfolios from drawdowns. The only thing it can do is help you hold through periods of underperformance, and hopefully this will impact your investing outcomes over the long run. The linkage is indirect and never direct, though it is sold as a direct and simple linkage often.
So how does one go about this?
For a start, one needs to have a wide enough coverage of businesses to be able to sense where the puck is going to be. There simply is no way around this if you want healthy outperformance over all time frames and not just the long term.
Variant perception calls for a lot of ground work. It calls for an investor to track valuation across market cap and sectors, have a good sense of the base rate of growth across these segments, think in terms of range of outcomes and say “My money is better off there rather than here”. This after considering the changes that are likely to happen in each sector over the medium term, doing a corporate governance check on the coverage universe and having a relative ranking mechanism handy within each segment. Once we figure out which are the waters that we need to fish in, the work becomes very business specific to see if there is something good enough (but not very conspicuous) happening that can change the numbers and narratives for the better over the next 2-3 years. The market is usually efficient enough to not throw full tosses at you regularly.
Doing this on a quarterly basis for a coverage universe of 100-125 businesses is a lot of work.
Beyond the tangible analysis part, it becomes very individual driven and is tough to automate. Try as much as you can, writing a model to mimic exactly how an individual goes about stock picking is next to impossible.
Depth of analysis can be done only for a limited set of businesses by any analyst. It is just not possible for the same individual to have differentiated insights and views across all sectors. Every great fund manager always has the odd sector or two he doesn’t have much of a clue about.
Whereas, breadth of analysis can be done by anyone who is willing to invest into building a process for the same and doing the grunt work.
Kind of sums up why I’ve decided to increase the team size recently.
