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The big money or the sure money

Sep 23, 2008

The debate is perhaps as old as the stock markets themselves and it goes something like this, "In order to outperform the markets over a sustained period of time, should one stay invested in small/medium caps (SMCs) or stick to only large caps?" The battle lines have already been drawn. On one side are the supporters of SMCs who swear by their ability to throw up a few multibaggers every now and then. While on the other side are the supporters of large caps where the chances of a permanent loss of capital stand reduced to a great extent. On the flip side, SMCs can make you lose tons of money while one is seldom likely to unearth a multi bagger from the universe of large caps.

  • Also read: Small caps: How have they performed?

    United they fall...
    As far as aggregate performance is concerned and if the history of the last five years is any indication, don't even think of investing in SMCs. This is because the out performance of the small cap index is so small that it does not even cover the higher risk that an investor takes while investing in these companies. Infact, the other index i.e. the mid cap index has actually underperformed the large cap index between Dec 2003 and now. Thus, on an aggregate basis, SMC indices are not the indices of first choice from a long-term perspective.

    ....and divided some stand tall
    Now the question that begs itself is, what about taking a bottom up approach and investing on a case-by-case basis? Our answer to this query would be the ever so diplomatic 'IT DEPENDS'. And it really does depend on a few things. The most critical would be one's circle of competence. If a person is a passive investor and his idea of research is weekend reading, then we believe he is better off sticking to large caps. This is because unlike SMCs, where the companies need to be thoroughly researched, large caps already come with equipped with proven business models and management. Hence, the chances of going wrong on these parameters stand reduced to a great extent. What only remains to be done is understanding the business model thoroughly and checking whether the large cap is available at a reasonable valuation. Furthermore, if entered into at decent valuations, the chances of 30%-40% downside are a lot less in large caps as compared to SMCs.

    SMCs on the other hand mostly come equipped with untested management and if it's a technologically inclined company, then the products might also be difficult to comprehend for an average investor. Thus, in order to unearth the next multi bagger from this universe, one needs to have a very good feel of qualitative parameters like the caliber of management and also the market potential of the products. Please bear in mind that for every 'Infosys' or a 'Google' there have been hundreds of other wannabes. The key is to have the ability to differentiate the men from the boys.

    Now a word or two on the returns. It should be obvious to anyone that if successful, SMCs can grow at a much faster rate than the large caps for long-periods of time thus leading to a concomitant rise in market values. However, betting on the wrong horse could lead to equally devastating results on the downside. Although this pitfall is eliminated in large caps, they more or less come with a limited upside unless bought at dirt-cheap valuations.

    To conclude, there have been both success stories as well as huge failures in both the cases. The key is to identify one's circle of competence and invest accordingly. Investment legend, Warren Buffett had summed it best when he said, "The really big money tends to be made by investors who are right on qualitative decisions but, at least in my opinion, the more sure money tends to be made on the obvious quantitative decisions."

  • Also read: Lessons from Warren Buffett


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