Is Investors' Largecap Bias Justified?

Sep 11, 2015

In this issue:
» China: Still an integral part of the global economy
» Bailout package for Indian steel sector?
» An update on markets
» ....and more!

Should you buy large, mid, or smallcaps? It's a question that props up often.

The usual thinking is that smallcaps rise faster than largecaps during market booms...and fall the most during busts! Many investors base their calls on this. In other words, the mood of the market is the primary basis for marketcap preference.

Should this be your approach to investing across marketcaps?

Well...a rational, more fundamental approach would be better, of course, as you maneuver through the various moods of Mr Market.

Over longer periods, small and midcaps have outperformed largecaps. Rs 100 invested in the BSE 200, BSE Midcap, and BSE Smallcap in April 2003 would be worth Rs 906, 1,168, and 1,274 today.

While smallcaps have outperformed their larger peers during this period, it is safe to assume that within the smallcap index, the ratio of companies doing well to those faltering would be skewed in favour of the latter. That is why it makes sense to be well diversified-by owning a bunch of stocks from this category.

Largecaps, on the other hand, are relatively more stable. This is mainly because they have more resources and better negotiating powers, which trickles down to their quality of earnings. To assess the same, return on capital employed (RoCE) is a good gauge. The following chart shows the small, mid, and large cap RoCE performance for the decade gone by...a period that covers a complete business cycle.

Earnings quality: Largecaps outperform significantly

Please note that in the table, 'L' stands for the latest available data, 'L-1' for one year prior to the latest year, 'L-2' for two years prior to the latest year...and so on.

As you can see, the larger companies have been more resilient than their smaller peers. This was true during both the good and bad phases. The index representing largecaps - the BSE-200 - averaged an RoCE of about 23% for the decade. Midcap companies averaged 19% and smallcaps 17%.

Apart from the average absolute figures, consistency (measured as the deviation from the long-term mean) is important as well. And here too, largecaps ranked first, midcaps second, and smallcaps last.

So...concerning portfolio exposure, should one bank largely on largecaps? We at Equitymaster believe in a balanced approach. Do refer to our recommended asset allocation for an equity portfolio.

The chart above further justifies our reasoning. These long-term numbers do a good job of highlighting the general profitability one can expect from the average company in each category. Investors desiring to invest down the marketcap hierarchy would do well to consider and manage the risk-reward payoffs accordingly.

Do you have a larger exposure of mid and smallcaps stocks in your portfolio? Let us know your comments or share your views in the Equitymaster Club.

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If one goes by the recent news, China seems to stand out as a troubled economy. There is a sense of anxiety floating around as it could negatively impact other economies as well. However, there are some who are not painting such a grim picture. As an article in the Business Standard reads - though the growth in China is slowing it has not collapsed.

As per the author, IMF data points out that emerging markets accounted for around 76% of the global growth based on PPP (purchasing power parity) during 2007 to 2014. This means the advanced countries contributed the balance. Of the total 76% growth, China formed about 30%. This means China delivered more to the growth of the global economy than all the advanced economies combined during this period.

Further, as per IMF projections for 2014-2020, emerging markets will form about 70% of global growth. Of this, China is expected to contribute to about a fourth. In other words, China is expected grow as much as all the advanced economies combined.

When things are put in this perspective, one cannot simply write off China. It continues to be one of the fastest and largest growing economies. It is true that macro economic developments often have a way of bringing out revival. Only the time will tell which way China's story will pan out.

 Chart of the day
Continuing with our discussion on China and its impact on the global economy, commodity prices today are disproportionately hinged on the Chinese economy. Falling commodity prices certainly do not bode well for global commodity players. And same is the case for steel producers in India. China's currency devaluation recently has further augmented cheap imports into the country. The excess global production, underutilized capacities with poor realizations and rising debt burdens have made the scenario worse for Indian steel makers. Major players are witnessing pressures due to rising debts on their books. The impact of the same is not limited to the steel sector, but also the banking sector.

Contribution of stressed loans from Iron and Steel sector

Among these lenders, public sector banks have the maximum exposure to the steel sector with the highest stressed advances. Any further deterioration in asset quality would only adversely affect their health.

Listing the woes of the industry, the steel companies are seeking government aid. The industry has proposed the government for special financial package. According to an article in the Business Line, steel companies have sent a letter to RBI and Finance Minister urging the government to consider setting up an institution such as the Power Finance Corporation, to fund the capital infusion in these entities. Further, the industry has also asked for restructuring their loans, without increasing provisioning requirement for a brief period.

Such a huge debt restructuring plan would be a bailout in a different garb. While government should take some appropriate steps to revamp the activity in this sector, bailout may not be the permanent solution for an issue such as this. Given the cyclical nature of the sector, such companies are constantly part of the boom-and-bust cycles, with some cycles lasting much longer than others. Considering the impact of Chinese economy - the largest consumer of commodities - how long the dull phase could go on would be anyone's guess. As such, bailouts may not be the best solution as it could be a situation of kicking the can down a very long road with no dead end in sight.

At the time of writing, the Indian markets were largely trading firm, with the BSE Sensex trading up by about 50 points or 0.2%. Gains were seen in stocks from the midcap and smallcap spaces as well with the representative indices up by 0.3% and 0.7% respectively. Stocks across sectors were largely trading firm, barring those from the metal and capital goods spaces. The key sectors in favour were realty and FMCG.

 Today's investing mantra
"The individual investor should act consistently as an investor and not as a speculator. This means that he should be able to justify every purchase he makes and each price he pays by impersonal, objective reasoning that satisfies him that he is getting more than his money's worth for his purchase." - Benjamin Graham

Publisher's Note: Vivek Kaul, the India Editor of the Daily Reckoning, just made a bold call - Real Estate prices are headed for a fall. Well, if you are someone who is looking to buy real estate, or is just interested in the space, I recommend you read Vivek's detailed views in his just published report "The (In)Complete Guide To Real Estate". To claim your copy of this Free Report, please click here...

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

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1 Responses to "Is Investors' Largecap Bias Justified?"

R V Iyengar

Sep 12, 2015

All the statistics always point to average behavior.
As per the projections over varying time spans The BSE200 Index is decidedly better.
When it comes to individual investor the resources are limited. He can invest in but a few companies. With such limitation, the performance of one's holdings is dependent on that of those few companies.
As for Small Caps, you advice is that your holding should be only about 10 % of the total holdings. With such limitations diversification is not feasible. Hence performance of a portofolio is totally based on the performance of the few companies that you hold.

Perhaps the charts that have been put up are meaningful for Managers of Mutual funds who have large resources at disposal, and that too to a limited extent.

Equitymaster requests your view! Post a comment on "Is Investors' Largecap Bias Justified?". Click here!
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