Past performance not a guide to the future
Famous Spanish-American philosopher George Santayana famously said, “Those who do not remember the past are condemned to repeat it”. One of his less famous saying however was, “And those who do study the past are just as likely to make the same stupid mistake as those who do not”. The latter thought applies to the stock market participants more than the first;
Even though the standard guidance to the market participants is that historical performance is no guarantee to the future performance; most of the analysis and behavior is usually based on extrapolation of the past trends.
Analyzing the present consensus view of the analysts, strategists, investment managers and traders about the likely performance of Indian equities in short term (mostly next twelve months), I find that there is an unusually overwhelming consensus on the following trends:
(a) The small and midcap stocks may do significantly better than their large cap peers largely due to sharper earnings upgrade.
(b) Cyclicals businesses (commodities, auto, industrials and financials etc.) may do better than the secular businesses (FMCG, Pharma, Technology etc.) as the economic recovery gathers steam.
(c) Growth stocks (businesses which have direct correlation with the economic growth like cement, steel, capital goods, oil & gas, financials, transport etc.) shall do better than the value stocks (stocks mainly bought for dividend yield, wealth preservation and secular growth, e.g., large FMCG, MNC Pharma, etc.) on relative cheap valuation.
However, a deeper peep into their analysis, gives an impression that most of them are relying heavily on the past underperformance of value, cyclical, mid and small cap etc.
In past 3 years (2018, 2019, 2020) The benchmark Nifty has gained ~34%. Only IT, financial services and services sectors have done better than the benchmark Nifty over this period. PSU Bank (-52%); Media (-52%); Auto (-23%) and Metals (-23%) have been major laggards. Small cap (-22%) and Midcap (-1%) have also lagged significantly.
This underperformance might to be the key driving force behind the present consensus view. I have absolutely no view on the correctness or otherwise of the consensus view, as it has no influence on my personal investment strategy. Nonetheless, I would like to share the following observations with the readers:
· The small and midcap basket usually includes the following five categories of stocks:
(i) Companies which are relatively new in the business. These companies may be growing fast and have the potential to become large; or they may not have potential to grow materially.
(ii) Companies which were much larger in past but lost the advantage or made strategic mistakes on leverage, expansion, products etc.
(iii) Companies which are older, stronger but their businesses are not scalable.
(iv) Companies which have no meaningful business, but are listed on stock exchange for a variety of reasons.
(v) Companies which have highly cyclical business. These companies do very well when their business cycle is good, but usually lose the entire gains in down cycles.
· New companies with high growth potential and strong older companies with sustainable high dividend yields are the categories that create tremendous wealth for the shareholders.
· Highly Cyclical businesses give massive returns to the investors who understand the business cycle and are able to buy the stocks at cusp of the upcycle and sell before the party ends.
· Rest all categories usually inflict losses on investors; which in many cases result in erosion of entire capital invested.
· Another noteworthy observation is that many small and midcap companies that appear to have given stupendous return in one market cycle, just disappear from market clandestinely. All hopes of recovering the losses made from investing in such companies, in future market cycles, are usually belied.
From the above observations, it could be deduced that to make meaningful money from small and midcap companies, one has to either have strong knowledge of the business cycles or have materially higher risk taking ability.
Smaller investors like me therefore should resist the allurement of quick gains. If they must, they should prefer to invest in a small and midcap fund managed by the professional fund managers, who have good knowledge of the business cycles and are usually emotionally unattached with any particular stock.