Our Biggest Reason Behind Beating the Benchmark by Over 3x

In my last article, I shared with you why timing the market is not a good idea.

Instead of focusing on predicting macros - which ways oil prices will move, how will rupee move against dollar, how interest rates and inflation will behave - you should focus on your competitive edge as a common investor.

Wondering what edge you have that could help you beat the big investors?

Let's hear from none other than the world's best investor:

• 'The universe I can't play in has become more attractive than the universe I can play in. I have to look for elephants. It may be that the elephants are not as attractive as the mosquitoes. But that is the universe I must live in'. - Warren Buffett

In case you are wondering what elephants and mosquitoes have to do with investing, these refer to midcaps and largecaps versus smallcaps in the listed universe.

Buffett makes the point crystal clear here:

• 'If I was running $1 million today, or $10 million for that matter, I'd be fully invested. Anyone who says that size does not hurt investment performance is selling.
  
  The highest rates of return I've ever achieved were in the 1950s. I killed the Dow. You ought to see the numbers. But I was investing peanuts then.
  
  It's a huge structural advantage not to have a lot of money. I think I could make you 50% a year on $1 million. No, I know I could. I guarantee that.'

In Buffett's words, it's a huge structural advantage not to have a lot of money.

It allows you to invest in small and low liquidity companies, without moving the stock price high when you try to get into them. Big investors can't do this because of the sheer size of their funds.

You, on the other hand, possess a competitive edge because you're a small investor. This allows you to invest in companies of small size at attractive levels.

But just having an edge is not enough.

Smallcaps, especially the ones with very low liquidity are often volatile. And there is less publicly available information on them.

Unlike big companies where almost everything - the good, the bad, and the ugly - is already known, smallcaps could be obscure, even deceptive.

These companies are not very well covered in the financial media. You would not see their managements giving interviews on business channels. Even the corporate updates are limited, with short annual reports and sometimes no investor presentations and concalls.

The only tool a common investor is left with is the financials, which can be easily accessed on stock exchanges or financial screeners.

But this too is of limited help. Numbers don't always tell the real story. Allow me to share one example that I had shared with my subscribers a few months ago.

A few years ago, I had the chance to meet the management of Arrow Greentech Ltd. The company was based in Mumbai.

It was then known as Arrow Coated Product and was into the business of water soluble films. What got me interested in the business was a very impressive shift in the financial performance.

The business seemed at an inflection point, as the company had started to monetise the patents for which it had been investing significantly in the R&D.

The company claimed to have about 30 patents with diverse applications in high security papers, passports, currency bills, food, and pharma industry. Three of the 30 patents had been commercialised and monetised.

This was visible in its financial performance. The business was offering a return on equity and capital employed of up to 70%, with profit margins of over 55% when I met the management.

Assuming it was able to bring to the market all its research or commercialise its patents, the opportunity size, and upside in the stock, could be huge.

My meeting focused on the road ahead i.e. the timeline and the opportunity related to the monetisation of the remaining patents, and further investments in R&D.

But even after an hour-long conversation, I did not get enough clarity from the management on how big the market opportunity in the other patents could be. Or what would be the timeline for their monetisation.

As I tried probing, I distinctly remember the management suggesting it's a difficult business to grasp.

They also quoted some big investors who confessed to have invested in the stock without understanding the business in depth, because they found the business exciting. This did not give me any comfort.

Not having enough visibility, and clear answers from the management, made me skip the stock. I decided to not recommend it as this seemed to be more of a speculative bet.

The future growth rested on commercialisation of the patents, the timing of which was anyone's guess. Meanwhile, there was a risk of technology evolution and new substitutes.

To my utter disappointment, shortly thereafter, I witnessed the stock rise 10x in around a year.

The market and mainstream financial media had caught on the narrative of potential in the stock after monetisation of three of its patents.

And was equally optimistic about the rest 27. Some big institutional investors too got seduced with the story. At its peak, the institutional investors had a stake of 9% in the stock. The stock in fact traded in the PE multiple range of 80 to over 100.

Had I been wrong in being over cautious?

While skipping the stock, I knew there was a chance I could be wrong. While I did see the possibility in the business from the potential monetisation, there was not a clear visibility. Nor did the management meeting lend us any conviction.

With time, it was clear that the approach was right. The possibility of more patents getting monetised and commercialised never came to fruition.

Soon, the reality took over the hype. The rest of the patents were not commercialised. The markets ran out of patience.

The stock crashed almost 90% from the peak.

The institutional ownership in the stock fell from 9% to 0.2%.

Had I just followed the numbers or big investors, there is a good chance I would have made a recommendation leading to huge losses for subscribers.

But I know we were in a highly volatile and risky market. So we stuck to the discipline of investing only in what we understand and in promoters we believe we could partner with.

As I had shared in my last article, this approach does not always lead to the best returns in the short intervals. We do witness a correction in our recommendations when the markets fall.

But in the long term, having an understanding of the business, and a conviction in the management that comes from meeting and interacting with them, has allowed us to not press the panic button when sentiments go weak.

In the long term, such conviction has been rewarding.

Hidden Treasure, our smallcap stock recommendation service, has reported an internal rate of return (IRR) of 26.8% from inception in February 2008 until March 2022.

Over the same period, the compound annual growth rate (CAGR) is 7.9% for the smallcap index. For the Sensex, the CAGR over this interval stands at 8.7%.

There are many factors that have contributed to this outperformance like prudent allocation to ensure winners outweigh the losses, a long term horizon of 3 to 5 years, and avoiding speculative businesses.

But the biggest factor for this outperformance is betting on the right management team.

We have travelled far and wide to meet the managements of the companies we recommend. Even during the pandemic, when travel was not possible, we continued the practice of management interaction on video calls.

Combined with unique edge in smaller and low liquidity companies, right management team is the catalyst that can lead to multibagger returns and market beating performance.

Warm regards,


Richa Agarwal
Editor and Research Analyst, Hidden Treasure

PS: While tracking the management quality, I have come across an interesting information.

You see, the insiders in some of the quality businesses are not waiting for a big correction. They have already been increasing stakes in the businesses, buying from the open markets at levels higher than what stocks are currently trading at.

Do check out my recent video to get a list of these stocks.