Why buy a Nano when BMW on super sale! - Views on News from Equitymaster

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Why buy a Nano when BMW on super sale!

Nov 21, 2011

The Indian stock market appears to be in a vice like grip of the bears. And it doesn't appear they are going to loosen up the same in the near future. For those obsessed with numbers, some data points will prove the point we are trying to make. Sample this. In the last one year and not counting today's decline, the fall in the BSE-Sensex has come in at close to 18%. BSE Mid Cap and BSE Small Cap index have fared even worse. They have seen their market values plummet a significant 30% and 40% respectively during the period under consideration.

Although the decline hasn't done anyone any good, there is a silver lining that has emerged after the mayhem. And it has to do with the fact that the long term India growth story has been rendered even more attractive. For those who seem to be in doubt about this, let us tell you that this is not the first time the domestic economy is in choppy waters. It has encountered this threat many times before. And in some cases, of a magnitude quite severe than the current one. But each time, it has come out on the other side stronger than before. We don't see any reason as to why it should be different this time. In fact, we believe that India's best days still lie ahead and not behind.

Thus, if one were to take advantage of this story, investing in equities from a long term perspective is a must. But now the question that presents itself is, ‘what kind of stocks should one buy in the current environment? Should one stick to tried and tested large caps with strong fundamentals? Or should one go for mid and small caps which have not only corrected lot more than the Sensex, but also present greater potential for growth?

The answer to this dilemma may not be an easy one. And it could certainly differ from person to person. As far as we are concerned, we are of the view that no matter what the environment, it always pays to look at the downside first and not the potential upside. In other words, what are the potential risks involved in buying into the stock? Do bear in mind that by risk, we do not mean the underlying volatility of the stock price as most of the people on the street are prone to assume. But instead, risk according to us means the chance of a permanent loss of capital.

And once you take this factor into account, it does become quite clear as to which side the investor should gravitate towards. It is indeed the tried and the tested large caps. This is because they have proven business models and have survived in both good times as well as bad. Hence, the chance of a permanent loss of capital in these counters is far less than in say a mid cap and a small cap.

The case for large caps is made stronger by the fact that courtesy the recent correction, quite a few of them are trading at nearly the same valuation as their mid and small cap counterparts. Thus, as one would do in bonds i.e. buy the bond of a safe entity rather than the one of a risky enterprise when the prospective yields on both are the same, it would certainly beat us if investors do the opposite in case of stocks. In view of this, if earnings multiple of a large cap is nearly the same as that of a mid or small cap, the former should certainly be considered before the latter two. To bring in an interesting metaphor, the logic of buying a Nano would seem difficult to justify when say a BMW or a Rolls-Royce is available on super sale.

One can certainly argue that mid and small caps have better growth prospects and hence, they should be considered? Well, it should be remembered that our concern here is to not lose capital first and only then focus on prospective returns. Therefore, by this logic, large caps should prevail over their smaller counterparts.

Please note that we are not saying one should never buy mid and small caps. If the business models of these companies are easy to understand and they have a good management team, even they should come under consideration. But we would still say that for taking that extra risk, the returns that should be demanded from them should also be high. Put differently, mid and small caps need to be valued far more attractively than large caps if an investment in them has to be justified. However, in cases where valuation difference is not significant, large caps is indeed the way to go. One should also bear in mind that typically, large caps should not form less than 70% of one's portfolio with the remaining going into Mid and Small Caps if so desired.


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1 Responses to "Why buy a Nano when BMW on super sale!"

sanjay

Nov 24, 2011

its small cap and mid cap always at receiving ends in this market. they don't get funding when needed most. its large cap which gets support from lic's of world. so game of stock market is not for small cap or for mid cap and common man.even though there can be few exceptions but game is clearly only for large people small guys can watch transperently!!!!!!!!!!!!!!!

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