To Win in the Stock Market, You Must Win Big. Here's How... - The 5 Minute WrapUp by Equitymaster
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To Win in the Stock Market, You Must Win Big. Here's How...

Apr 26, 2018

Girish Shetty, Research analyst

A friend once asked me an interesting question.

'Out of ten stocks you pick, how many would be successful on average'?

I said, 'I don't know and it doesn't really matter because I only need a 30% success rate to beat the market.'

He was surprised. 'Only 30%. Isn't that too low? You're getting more calls wrong than right.'

I said, 'you're right but only if you look at it purely from a success ratio perspective'.

You see, it's important to know that two or three big winners in your portfolio are more than enough to create massive wealth.

Allow me to explain with the help of these two tables...

Portfolio 1
  Amount
Invested (Rs)
Return Final
Amount (Rs)
Stock 1 100 30% 1,379
Stock 2 100 30% 1,379
Stock 3 100 30% 1,379
Stock 4 100 -100% 0
Stock 5 100 -100% 0
Stock 6 100 -100% 0
Stock 7 100 -100% 0
Stock 8 100 -100% 0
Stock 9 100 -100% 0
Stock 10 100 -100% 0
Total Amount
Invested (Rs)
1,000 Total
Return (Rs)
4,136
Annualised Return 15.3%
Success Rate 30%
Portfolio 2
  Amount
Invested (Rs)
Return Final
Amount (Rs)
Stock 1 100 15% 405
Stock 2 100 15% 405
Stock 3 100 15% 405
Stock 4 100 15% 405
Stock 5 100 10% 259
Stock 6 100 10% 259
Stock 7 100 10% 259
Stock 8 100 10% 259
Stock 9 100 -100% 0
Stock 10 100 -100% 0
Total Amount
Invested (Rs)
1,000 Total
Return (Rs)
2,656
Annualised Return 10.3%
Success Rate 80%

Let's suppose we build two portfolios.

In both, we invest the same amount, say Rs 100, in the same number of stocks...say ten each.

Then, after holding them for a few years, we sell all the stocks at the same time.

Did you notice that seven stocks in portfolio 1 went to zero? And only two stocks in portfolio two?

It's no wonder portfolio 1 has a success rate of only 30% and portfolio 2 has a success rate of 80%.

But look at the returns!

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Portfolio 1 has comfortably outperformed portfolio 2.

A better performance with a lower success rate...

But how?

Notice there are three big winners in portfolio 1. Those three stocks easily compensated for the high number of losers.

The conclusion?

A high success rate might give you psychological satisfaction and a sound sleep but in the end, it's the returns that matter.

And you get high returns when your winning stocks win big!

You too can find stocks like these.

Here are a few important points to keep in mind...

  • Is there a huge market in the sector that the company operates in?
  • Does the company have a strong brand with a sustainable competitive advantage?
  • Does the business have strong fundamentals and a good track record?
  • What is the quality of the management?

It's necessary to give such stocks time to grow. I've used 10 years in the example above to make my point.

Once, you pick the right stock, you must let it grow.

Patience is the single most important virtue that will determine your returns in the long run.

I believe, small-cap stocks have an advantage in this regard. The runway for growth ahead of them could be huge.

My colleague Richa Agarwal and her Hidden Treasure team have been able to identify such long-term stocks successfully.

By 'successfully', I mean a success rate of 67% and an internal rate of return (IRR) of 32.1% as per the latest audited numbers. This, compared to a Sensex IRR of 11.6% during the same period.

These are the two top performing picks from Richa's Hidden Treasure service...

Company Reco Date Reco Price Price as on
24 April 2018
Return (%) CAGR (%)
Page Industries 15-Jan-09 305 24,472 7924% 60%
Eclerx Services 14-Mar-09 48 1,337 2685% 44%

More important than recommending these stocks, it was avoiding the temptation to sell that worked wonders.

But is picking small-cap stocks that simple?

No. In fact, it's quite the opposite.

With large companies, you're relatively sure of the management. The brands too, are mostly household names that you can trust. With their streamlined processes, bigger companies can, most of the time, run on autopilot.

Small-cap companies are run by owner-operators. Mostly, they have their skin in the game. As a result, the incentives of the owner are directly aligned to the long-term growth of the company.

While a good management can do wonders for a company, the opposite also stands true. If the owner's judgment turns out to be wrong, it's likely you will be stuck with a dud stock for life.

That's why Richa believes in boots-on-the-ground research. Meeting the management and understanding his vision for the company is as important as (sometimes more important than) the financials of the company.

Understanding how a first-generation entrepreneur has built a company from scratch is intriguing. In stock market parlance, a Rs 1 billion to Rs 10 billion company is considered small.

But make no mistake... It takes a lot of effort to build such a company from the ground up.

Richa and her Hidden Treasure team is always on the lookout for such passionate entrepreneurs.

If you hit the bull's eye with these stocks, the rewards can be spectacular.

Chart of the Day

Crude Oil Can Give You a Chance to Buy Small Caps at Cheap Prices...

Richa Agarwal, editor of Hidden Treasure, tracks the oil and gas sector very closely. I asked her about rising crude oil prices.

She believes it is a bearish sign for stock markets globally. At the same time, any market correction, will throw up interesting buying opportunities in small-cap stocks.

This is what she said...

  • After hitting a low of US$ 30 per barrel in January 2016, prices have more than doubled to US$ 68 in April 2018.

    The recent news of Saudi Arabia wanting crude oil prices to touch US$ 100 per barrel doesn't help. The 2008 recession was preceded by crude oil touching US$ 150 per barrel. Any movement upwards can result in a possible downturn for the global market.

    While the Hidden Treasure team looks for long-term wealth creators, such macro situations can help to recommend such stocks at a bargain. The ones who keeps calm, when everyone else is losing their heads, will gain the most when the tide turns.

Steadily Rising Crude Oil Prices

Regards,
Girish Shetty
Girish Shetty
(Research Analyst)

PS: Richa has the knack for digging out those hidden companies that are the profit-multiplying stocks in any portfolio. Do you have these Hidden Treasures in your portfolio? If not, now is the perfect time to check them out. Until tomorrow only, you can get a free year of Richa's service. Subscribe here.

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