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Is Your Stock a Big Fish in a Small Pond?

Mar 29, 2016

In this issue:
» China's slowdown hits commodities hard!
» Raghuram Rajan's timely warning.
» And more!
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Devanshu Sampat, Research analyst

"So, which stock did you buy recently?" I asked my friend who I met over the weekend. He's an active stock trader. We don't meet often due to our schedules. But when we do, our conversation always drifts towards the markets.

He took the name of a well-known Indian pharma stock.

"Okay. Why?" I enquired.

His answered promptly with a big smile on his face.

"Because it's a big fish in a small pond!"

"Huh? What? What do you mean?" I asked.

"You see" he explained, "it's targeting diseases like Schizophrenia and Alzheimer's. This is a niche market. The pond is small. But the company is big in this segment."

"Okay" I said.

"Do you know anything about this company?" he asked me.

"No" I replied. "I don't track the pharma sector. But I'm curious. You use technicals for trading, don't you? So, how come you're talking about fundamental stuff?"

"Well, I like these niche companies. They are good for the long term as well as the short term" was the rather general answer that he gave.

This conversation made me wonder if it could be true? Is the size of the pond more important than the size of the fish?

The answer: If the fundamentals are strong, it really doesn't matter too much.

To see why, let's look at both sides of the story.

A small business (fish) in a large industry (pond) has plenty of room to grow. This is obviously good. But if the pond is large, then it's likely to have large fish in it too. These would be the well-established giants of that pond. What chance does a small fish have?

In India, the best example of this is the IT sector. The large fish (TCS, Infosys, Wipro) dominate. It's a constant battle for the small IT firms to survive. But that doesn't mean we don't recommend such stocks.

Our The India Letter subscribers know that we have recommended one such IT stock. I remember the words of the management when I met them. "When you think of the size of this industry, we are a tiny ant." He might as well have said 'fish' instead of 'ant'!

Why did we recommend the stock? Because of the company's rock solid fundamentals. The growth potential was the icing on the cake, not the cake itself.

Now, what about the other side of the story? Aren't niche businesses good long term investments?

Without a doubt, some of them will make great investments. But many won't. How can you distinguish between the two? The answer is usually found in how the management uses the cash on the balance sheet.

Keep in mind that big fishes in small ponds don't have much room to grow. But these businesses tend to generate tons of free cash. If the management is sensible, it will send it out to shareholders as dividends. You can make a lot of money in the long term, if you buy such stocks at attractive valuations.

Just ask our Hidden Treasure subscribers. About two years back, my colleague Richa Agarwal, who heads the service, recommended an IT stock that fit the bill perfectly. It operates in an industry that we don't like. But it's a dominant niche player. Its fundamentals are so good, that we believe Hidden Treasure subscribers are in a sweet spot with this investment.

This is why we believe that just being a niche player is not good enough. It's the fundamentals that matter. So whenever I catch myself wondering if a stock is a big fish in a small pond, I recall the lines from one of my favourite rock songs. The lyrics are pertinent....

  • You might be a big fish
    In a little pond
    Doesn't mean you've won
    'Cause along may come
    A bigger one
    And you'll be lost
    - Lost, Coldplay

What do you think? Are niche businesses better than others? Let us know your comments or share your views in the Equitymaster Club.

2:50 Chart of the Day

China has been slowing, but just how much of an effect this will have on other countries has been a difficult question to answer. Luckily, recent research done by the International Monetary Fund (IMF) and the Asian Development Bank (ADB) has put a number to this effect. The IMF estimates that a 1% permanent negative Chinese GDP shock reduces global growth by 0.23% in the short run. The ADB on the other hand concluded that China's slowing growth is expected to see GDP in the rest of developing Asia by fall by 0.33% in the next two years. Further, today's chart of the day quantifies the effect of slowing Chinese growth on various important industrial commodities.

How a 1% negative shock to China's growth affects commodities

Fortunately, India's weak trade links with China mean that India is less vulnerable to economic shocks from China. However, less does not mean nil. China's effect on commodity prices as illustrated in the chart is one of the non-trade related risks for India. For falling prices mean substantially lower investments by companies whose business is associated with these commodities.

3:40

Countries around the world are getting desperate. Desperate, that is, to get their economies up and going. And they have resorted to aggressive monetary policies in the process.

A new working paper co-authored by Raghuram Rajan warns of the significant spillover effect these actions have on other economies. Especially from those counties whose policy rates are already near zero thus limiting their ability to stimulate the economy further. It goes on to explain that simply because a policy is called monetary, unconventional or otherwise, it may not be beneficial on net for the world. What really matters is the relative magnitude of 'demand creating vs demand switching' effects, along with the magnitude of other net financial sector spillovers.

Thus, if countries are not cautious about internalising these spillovers, they may undertake policies that are collectively suboptimal. The paper suggests that countries should agree to guidelines for responsible behaviour that would improve collective outcomes. While this would definitely be a much more mature approach to take, we wonder whether such an ideal scenario will ever see the light of day.

4:30

Over the four-day long weekend between March 24 and March 27, two exciting cricket matches were played. The Indian cricket team won both the matches.

Vivek Kaul, editor of Vivek Kaul's Diary, saw both these cricket matches end to end. But he saw them with his TV on mute! Just why he did that makes for a compelling read indeed not only for cricket fans, but also for smart investors. You may check it out by clicking here.

4:45

The Indian stock markets were trading flat today on the back of a dull trading session across most index heavyweights. At the time of writing, the BSE-Sensex was trading up by around 7 points. Gains were largely seen in auto and banking stocks.

4:55 Today's Investment Mantra

"Absent a lot of surprises, stocks are relatively predictable over twenty years. As to whether they're going to be higher or lower in two to three years, you might as well flip a coin to decide." - Peter Lynch

This edition of The 5 Minute WrapUp is authored by Devanshu Sampat (Research Analyst).

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