In my last article, I gave reasons for the dismal performance of many small investors over the last two years. As things stand today, the morale of Indian small investors is at a very low ebb. The fall in Sensex of about 35% since September 1994 may mask, rather than reveal the full extent of injuries suffered by millions of small investors who have held stocks in companies not included in the Sensex. The average small investor has lost more than 50 percent of the market value of his equity portfolio over the last two years.
One of the reasons often cited for the dismal performance of small investors is the institutionalisation of the Indian stockmarkets. The advocates of this view say that the large institutional investors, especially the foreign institutional investors (FIIs) who have unlimited amounts of money are going to dominate the Indian stockmarket and that small investors have no chance at all competing with big money.
Well, maybe. But there is another school of thought, to which I subscribe, which has quite the opposite view which is this: the institutionalisation of the Indian stockmarkets will make things even better for the rational small investor and that such an investor has certain advantages that, if exploited properly, will result in his outperforming the experts. Just what are these advantages?
No Rules to Follow
Some institutional portfolio managers are not allowed by their bosses to buy stocks in any companies which have labour unions. Others won't be allowed to invest in non-growth industries or in specific industry groups, such as steel. Some mutual funds do not, as a policy, invest in certain type of securities. For example, many concentrate on income-generating securities. Others promise to focus on growth stocks. Some funds are further restricted with a market capitalisation rule: they don't own a stock in any company below, say, a Rs 100 crore market capitalisation. A company with 50 lac shares outstanding selling for Rs 70 a share has a market cap of Rs 35 crore and must be avoided by the fund. But once the stock price has tripled to Rs 210, that same company has a market cap of Rs 105 crore and suddenly it's suitable for purchase. This results in a crazy situation: some funds are allowed to buy shares in companies only when the shares may no longer be a bargain.
If it's not the portfolio managers' bosses making up the rules, then it's SEBI. For instance, SEBI prescribes rules that fix the maximum percentage of the total shares of a company that can be bought by a mutual fund. It also has rules that do not allow mutual funds to invest more than a fixed percentage of the fund's assets in any given stock. While such rules may make sense in certain circumstances, in many cases they end up hurting the investment performance of well-managed mutual funds. The situation is analogous to a cricket umpire telling Sachin Tendulkar how he should swing his bat.
These sort of restrictions do not make sense for getting the best possible returns for the clients. The small investor has no such restrictions imposed upon him. He can invest wherever he thinks it makes the most sense without worrying about any boss or and SEBI official looking over his shoulder. He can even borrow money prudently to enhance his portfolio returns - something that mutual fund managers are not allowed to do.
Small is Beautiful
A fat wallet is the enemy of superior investment results. When Morgan Stanley mutual fund raised Rs 1,000 crores from the investing public in 1994, if it had earned a total income and capital gains of Rs 100 crores (which, of course, it didn't), it would have earned just 10 percent return on total capital raised. A small investor with, say Rs 5 lacs to invest, needs income and capital gains of only Rs 50 thousand to get the same rate of return. Because there are many more Rs 50 thousand ideas than Rs 100 crore ideas of making money in the stock market, the small size of the funds of the small investor is a boon, not a curse for achieving superior investment performance. Of course, this does not mean that one should start investing in the stock market with only Rs 10 thousand. Such tiny sums will not enable the small investor to achieve meaningful diversification. Nevertheless, the fact is that the large size of the biggest of the mutual funds acts as a drag on their investment performance. That, incidentally, is one of the primary reasons of the mediocre performance of UTI's biggest mutual fund - the US-64 scheme.
There is another important point about size. Because of the large sums of money they control, portfolio managers of many mutual funds simply cannot invest in small companies which may have the greatest potential for capital appreciation. Because there are limits on investment that can be made in a single company, such funds are forced to limit themselves to the top 50 to 100 companies, out of the 6,000 or so that are listed on the Indian exchanges. They simply cannot buy a worthwhile number of shares in small, high-growth companies. By definition, then, the mutual fund portfolios are forced to buy large company stocks that offer few pleasant surprises. This is a huge disadvantage for mutual funds and therefore, a huge advantage in favour of the small investor.
No Pressure to Perform
Institutional portfolio managers live in terror of the quarterly performance review. Every quarter, or sometimes every month, the portfolios of mutual funds are subjected to scrutiny by investment committees. There is a pressure to perform in the short run. Daily Net Asset Values (NAVs) are required to be calculated and disclosed to the public. If a mutual fund manager fails to outperform his competitors in three or four quarters, he's fired. In such a situation, he is likely to forego his shareholders' investment gain for his career gain. Many managers end up paying a good deal in terms of forgone opportunity for the privilege of resting comfortably in the lower part of the second quartile and avoiding ever being in the bottom quartile for even a short period. This point was the topic of my article that was published in Intelligent Investor, Vol. I, No 12 dated 28th October.
No Fear of Redemption
Open-ended mutual funds are, by law, required to redeem shares on demand. The irony is that such funds face maximum redemption pressure during bear markets, i.e. precisely when they would like to have more cash available for further investment in bargain issues. A portfolio manager of an open-ended mutual fund simply cannot invest 100 percent of the funds in stocks even though from an investment standpoint, it may make the most sense. He has to hold cash for redemption purposes. The small investor is under no such compulsion to hold a significant proportion of his portfolio in cash at all times.
Volatility is a Friend
Many fear that the volatility caused by the erratic behaviour of the big boys, will leave no chance for the small investor of beating the market. This conclusion is wrong. Volatile markets are ideal for any investor - small or large - so long as he sticks to his investment knitting. Volatility caused by money managers who speculate irrationally with huge sums will offer the true investor more chances to make intelligent investment moves. He can be hurt by such volatility only if he is forced, by either financial or psychological pressures, to sell at untoward times.
Conclusion
To beat the market, the small investor does not have to invest like an institution fund manager. When he invests, he doesn't have to spend a quarter of his time explaining to a committee why he bought what he bought. There's no rule that prohibits him from buying any kind of stock. He is free to own one stock, four stocks, or ten stocks or even a hundred stocks. If he has no good ideas, i.e. when no company seems attractive on fundamentals, he can avoid stocks altogether and wait for a better opportunity. This option is simply not available to mutual fund managers. Can you imagine the fate of a mutual fund manager who reports to his shareholders, "I had no good ideas this year?"
Peter Lynch, an outstanding mutual fund manager, once said it in these words:
"I have been hearing that the small investor has no chance in this dangerous environment where there are 50,000 professional stockpickers who dominate the show and the small investor ought to get out.
From where I sit, I'd say that the 50,000 stockpickers are usually right, but only for the last 20 percent of a typical stock move. It's that last 20 percent that Wall Street studies for, clamours for, and then lines up for - all the while with a sharp eye on the exits. The idea is to make a quick gain and then stampede out the door.
Small investors don't have to fight this mob. They can calmly walk in the entrance when there's a crowd at the exit, and walk out the exit when there's a crowd at the entrance."
Note
This article is submitted by Sanjay Bakshi who is the Chief Executive Officer of a New Delhi based company called Corporate Investment Research Private Limited.
© Sanjay Bakshi. 1996.